Selecting Investment Consultants for Pension Plans With Imperfect Information
An article in the business section of the New York Times last week reported some surprising conclusions reached by a recent study of the performance of pension plan investments. ("Doubts Raised on Value of Investment Consultants to Pensions," September 30, 2013.) The study, performed by two Oxford professors, revealed that the performance of some of the highest paid consultants in the business over a 12 year period was below benchmarks for comparable investments. But more interesting, from the standpoint of those of us who advise pension plan fiduciaries, the study found that these high powered consulting firms do not even make available the kind of information that would allow prospective clients to evaluate and compare their track records. Ultimately, the study concluded, investment consultants should be required "to provide the same high level of disclosure as that which is provided by fund managers on their performance, or the same level of disclosure provided by research analysts on their stock recommendations." This got our attention. Without the kind of disclosure proposed by the Oxford study, how can a pension plan investment fiduciary select an investment consultant and feel it has complied with its duties under ERISA?
Three key points create a context for this discussion. First, investment firms with which we are concerned here must be distinguished from investment managers or fund managers – these firms are not being engaged to select actual investments, they are being engaged to recommend the firms who will choose the investments. Second, most investment consultants (including the ones named in the New York Timesarticle) do provide disclosures on a voluntary basis in accordance with the Global Investment Performance Standards (or "GIPS"). The GIPS standards are a set of uniform, industry-wide ethical principles that guide investment firms on how to calculate and report their investment results to prospective clients. Compliance with these standards is purely voluntary and the resulting reports or disclosures are not as user friendly as the kinds of performance disclosures that investors can find about any mutual fund on any number of websites. Nevertheless, a prudent expert with experience in the field can use GIPS data to gauge the investment performance of investment firms.
Finally, the work done by investment consultants for pension funds is not as susceptible to the kind of transparent track records that investors routinely review regarding fund managers. There are two reasons for this. One is that pension funds (at least larger ones) generally engage multiple investment consultants to help select investments across a number of discrete categories or asset classes. For example, a pension fund might engage Firm A to help choose a few broad-based hedge funds, Firm B to choose a set of more focused hedge funds, and Firm C to help choose investment managers focusing on corporate bonds. While the consulting firms certainly will review the track records of the fund managers they select, their own track records in selecting managers will be harder to report since the work they are engaged to do may vary from client to client. Perhaps more important, many pension funds focus on "liability driven investment" (or "LDI") either entirely or at least in part. LDI is designed to invest the assets of a pension fund in a way that matches the specific cash flows needed to fund future liabilities. This is very different from the "benchmark-driven" strategy that characterizes most mutual funds and fund managers, who are simply trying to achieve better returns than an external index (e.g., the S&P 500) or combination of indices for given asset classes. For a pension fund, the LDI strategy will focus on what the plan will have to pay out to participants and beneficiaries within a given time frame. But the LDI strategy of a pension fund that is adding new participants each year will be very different from the strategy of a frozen pension fund or a fund that is in the process of termination – obviously, the projected payments and the time horizon for investment are huge factors. When LDI is factored in, the feasibility of producing a meaningful "track record" for an investment consultant, and the utility of that kind of disclosure, become questionable.
So how might a prudent investment fiduciary for a pension plan go about selecting an investment consultant, for example through an RFP process? As always, a threshold evaluation can and should be made based on the thoroughness and responsiveness of the written proposals. (If you have asked for X but they try to sell you Y, there's a good chance that they aren't very good at providing X.) And any available objective comparators – such as fees, longevity of the top consultants, number of other pension funds represented, and the like – should be carefully considered. But the selection process will also have to involve the much more time consuming work of interviewing the firms and asking pointed questions to learn about how the firm goes about developing their recommendations ("What are the three hedge funds you recommend most and why?"), how they work with clients ("How frequently do you like to meet with clients and what level of collaboration works best?"), and then following up with the client references they provide ("Were you happy with the service, the advice, the rate of return?").
After thinking about this issue, we were put in mind of the cautionary words that often appear in exciting automobile advertisements: "Professional driver on closed course." More plainly, "don't try this at home." Pension fund fiduciaries interested in selecting investment consultants should be prepared to roll up their sleeves, bring in any necessary outside expertise, and devote a considerable amount of time and effort to the process.