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The Actuary The magazine of the Institute & Faculty of Actuaries
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Investment: Aiming for a good outcome

When it comes to ensuring good investment outcomes, the role played by qualified actuaries as investment consultants is vital. And with the introduction of auto-enrolment in 2012 — predicted to bring an extra five to eight million people into saving through workplace pension schemes — this role will only grow in importance. But what does this weighty responsibility mean for consultants?

Traditional trust-based occupational pension saving is built on the legal foundation of fiduciary obligation. Trustees have a clear duty to act in the best interests of their beneficiaries: this includes a duty to avoid conflicts of interest, to treat beneficiaries impartially and to make prudent decisions based on appropriate advice (which is where the consultant comes in). So far, so simple. But these legal assumptions were developed centuries ago, at a time when trustees were mostly individuals making investments on behalf of family or friends. A very different landscape, then, from the hugely complex web of relationships that characterises today's capital markets.

Today, it is generally agreed that trustees can delegate their powers, but not their fiduciary responsibilities. But does this mean that those they delegate to have no parallel responsibilities? Consultants and asset managers arguably exercise as much discretion as the modern trustee. Asset managers make many of the day-to-day investment decisions that were the preserve of trustees themselves in days gone by. Consultants are not given the same operational discretion. But trustees are legally obliged to seek their advice and, as the Myners Report noted a decade ago, rarely have the expertise to challenge that advice. This puts consultants in a position of enormous power — but does that power imply a fiduciary responsibility?

Fiduciary duty is a common law concept, which means there is no dusty old statute book listing all the positions that entail fiduciary duties. Instead, there is centuries of case law establishing various criteria for when a fiduciary relationship arises. The Law Commission has summarised these criteria as "discretion, power to act, and vulnerability". It also concludes that these criteria are met by the relationship between investment advisors and those they advise. Indeed, in the US, the Supreme Court has explicitly confirmed that investment advisors are fiduciaries — although there's been no similar confirmation in the UK.

The reaction to the suggestion that consultants may be fiduciaries has been intriguing, with responses ranging from ‘Of course we're not' to ‘Of course we are'. One consultant argued that asset managers might be fiduciaries but consultants weren't, because they didn't exercise the same discretion over assets. Another argued that asset managers weren't fiduciaries but consultants were, because the decisions they advise on are much more strategic and fundamental. This in itself is a powerful testament to the confusion and ambiguity surrounding what is, after all, a pretty fundamental question.

But does it really matter, or is this all just academic? Do we need to know who is a fiduciary and who is not, as long as all parties in the investment chain are clear on their contractual responsibilities? To try and answer that, let us look at the two key fiduciary duties: loyalty and prudence.

Fiduciary investors have a duty to invest prudently, exercising due skill and care and taking all relevant considerations into account. A strong case can be made that this confers a similar duty on consultants even if they are not fiduciaries in their own right — since they have contractual and professional duties to help trustees fulfil their own fiduciary responsibilities. This implies a duty not just to react to what trustees ask of them, but to proactively raise issues that could affect outcomes for beneficiaries, even — perhaps particularly — if trustees seem unaware of them. An increasingly relevant example is the exercise of stewardship and ‘responsible ownership'.

The debate around the new UK Stewardship Code — which encourages fund managers to be active owners of their investee companies — has focused largely on corporate governance. In the run up to the financial crisis, investors were accused of being ‘absentee landlords', failing to take the banks they owned back off the edge of the cliff. Yet investors' legal responsibility is not to the companies they own, but to the people whose money they manage. Stewardship matters because it contributes to stable long-term returns, and that is very much a fiduciary issue. Asset owners are being encouraged to apply the Code by including it in their mandates and monitoring. But this suggests that consultants in turn may have a responsibility to proactively raise the issue with asset owners.

More specifically, there is increasing evidence that shareholder engagement on environmental, social and governance (ESG) issues can improve long-term returns. In addition to the wealth of theoretical and empirical research, last year brought a stark lesson in the perils to investors of ignoring ESG issues, when an environmental disaster led BP to cancel its dividend for the first time since World War II. There were plenty of warning signs about BP's lax approach to health and safety — if investors had heeded these warnings and demanded improvements, the Deepwater disaster might have been prevented. The consultant's role in this context is to help schemes ensure that their policy on ESG issues is robust and that their asset managers are on top of the risks involved.

Yet in a recent survey on this issue, around half of consultants viewed their role as ‘secondary or reactive'. Another survey concluded that "client demand remains the main driver for consultants to offer responsible investment services". This approach seems to be mirrored elsewhere in the investment chain, with the unfortunate result that nobody feels truly responsible for ESG integration. A survey of asset managers in 2009 found that one of the biggest barriers cited to greater integration of climate change was lack of client demand. In other words, it was up to trustees to ask their asset managers to do more. Yet when trustees themselves are surveyed, they often argue the opposite — if these issues are material to investment outcomes, then surely managers will factor them in without having to be told?

The traditional assumption that trustees alone have fiduciary duties would place the responsibility squarely at their door. But from a wider fiduciary perspective, it is arguably everyone's duty to ensure proper integration of material ESG risk factors. Consultants, far from being extraneous to this chain of accountability, are in a particularly good position to break the impasse — proactively raising the issue of stewardship with trustees, and helping them to assess prospective managers' approaches.

So what about the second core fiduciary duty — the duty of loyalty? It is this that really distinguishes a fiduciary from someone with a contractual or professional duty to uphold someone else's fiduciary duties. Fiduciaries must act in the best interests of beneficiaries — and (crucially) in case of a conflict, in the beneficiaries' sole interest. This means both avoiding personal conflicts of interest and not prioritising the interests of third parties. This duty of undivided loyalty lies at the heart of fiduciary obligation — its whole purpose is to protect vulnerable people from self-interested or reckless behaviour by those who act on their behalf. Yet when commercial investment agents use the term ‘fiduciary' to describe themselves, this rarely seems to be what they have in mind — instead, they talk about the duty of prudence, which, as we have seen, is perhaps less unique to the fiduciary position.

So if consultants really are fiduciaries, what does this mean for their duty to avoid conflicts of interest? Clearly, potential conflicts can never be eliminated completely — for instance, while schemes have an interest in controlling costs, commercial providers inevitably benefit from recommending more costly and complex services and investment approaches. Indeed, there is some evidence that advisors may unwittingly privilege these commercial interests over the best interests of scheme
members. 

For instance, the average externally managed pension scheme now has nine mandates, compared to just three a decade ago. This trend has cost pension funds up to a third extra in management fees, as well as extra consultants' fees due to the higher number of manager selection processes. It is questionable whether the performance advantages of this increased complexity really outweigh the costs.

Of course, this is not to suggest that consultants — or indeed, asset managers — are inattentive to the need to manage conflicts of interest. Consultants may be subject to FSA rules or to actuarial professional standards that require conflicts to be managed. But these are less stringent than fiduciary duties, and there is clearly no room for complacency when it comes to making sure that beneficiaries' best interests are protected. With up to eight million people about to be introduced to the world of private pension saving, it is vital that trust and confidence in the system is built and sustained. Making this a reality is everyone's responsibility — including consultants.

Christine BerryChristine Berry is policy officer at FairPensions and author of the report, ‘Protecting our Best Interests: Rediscovering Fiduciary Obligation'