How can the lessons from HBOS help pension trustees?

The question who is the odd one out, Sir James Crosby, Andy Hornby, Lord Stevenson, all formerly of HBOS, or Terry Wogan was recently posed.  The answer is Terry Wogan, as he is the only one with a banking qualification and prior experience of working in banking.  Had the other three also had professional qualifications and experience in banking maybe the problems of the last five years could have been avoided or at least significantly reduced.  This ‘odd one out’ question neatly highlights the issue of professional competence, as a combination of both professional qualifications and relevant experience.

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A moral issue for investment consultants

News that Goldman Sachs had decided, however reluctantly, to pay their bonuses in the current tax rather than defer payment to the new tax year was widely welcomed.  No one had suggested that there was anything illegal about deferring payment of bonuses to after 6 April, thereby benefiting from the reduction of top rate tax from 50% to 45%, but many considered it immoral.  Following on the offer by Starbucks to pay £20 million in corporation tax for the next two years, this was another victory for public pressure.

Goldman Sachs is probably the largest financial firm to have considered deferring bonuses, but it is not the only one.  I understand that several investment consultancies may be considering a similar approach to bonus payments to minimise the tax paid by their employees.  The commitment of many pension schemes to environmental, social and governance issues means this may not be a wise choice for consultants, given the questionable nature of such arrangements.

Are fund managers also considering similar arrangements? To date I have seen no comment from investment consultants on whether any fund management firms are considering deferring bonus payments to the next tax year.  Perhaps consultants are reluctant to raise this issue if they are considering a similar approach themselves, or maybe their moral antenna is not as finally tuned, as it perhaps should be.

Signatories to the UN Principles for Responsible Investment, as many consultants are, recognise that applying the Principles may better align investors with the broader objectives of society.  Deferring bonus payments to the following year rewards the individual at the expense of society.  It is difficult to understand how any signatory to the Principles, consultant or fund manager, could contemplate such an action.

If trustees believe that deferring bonuses to the next tax year is unacceptable behaviour by their advisers, then they should establish how their investment consultant intends to pay their bonuses for 2011 and, logically, all other advisers to the fund including actuaries and lawyers.  They should also establish whether their consultant has raised the issue with the schemes fund managers and, consequently, is in a position to provide information in this regard.  Ideally, this should be done immediately, and certainly before the end of the current tax year.  If so, pressure from trustees should then encourage consultants not to defer their 2011 bonus payments to the next year, as public pressure did with Goldman Sachs.  By contrast, finding out after the event that bonus payments had been deferred to avoid income tax, may leave trustees with a difficult decision.  If they consider this is unacceptable, then they have a choice between ignoring the issue, a difficult option if they are committed to strong governance, or terminating their agreement and appointing an adviser more in tune with their moral standards.

Investment consultants need higher professional standards

I have confidence in my dentist.  This confidence is based on a combination of his practical experience, having been practicing since the 1980's, and his degree in dentistry.  By contrast, the prospect of attending a dentist without a formal qualification or no practical experience fills me, and I imagine most other people, with horror.

In the world of investment consultancy the tangible evidence of competence that we expect of our dentists is in short supply.  Based on a recent survey by IC Select, only 48% of investment consultants have a professional qualification.  Whilst this appears far from ideal the position is actually much worse than the numbers suggest.  Several consultancy firms actually define the Investment Management Certificate (IMC), the basic competency certificate for investment managers, generally completed by investment managers before beginning professional exams, as a professional qualification!  If those people that only have the IMC were excluded then clearly the proportion that are 'unqualified' would be significantly higher.

The competence of those investment consultants without a professional qualification depends entirely on their practical experience.  This may have sufficed in years gone by, but the issues faced by pension schemes and the financial instruments used to deal with them have increased exponentially in complexity.  For example, should someone who has not completed a formal study programme in derivatives, be advising trustees on their use in hedging liabilities.  The potential for poor advice is significant.

I doubt that any trustee board would consider using an unqualified actuary, lawyer or auditor.  Even IFAs now have to pass a series of exams before being allowed to give investment advice to private individuals.  Why then are trustees so sanguine about the qualifications or competence of their investment adviser and why are the consultants themselves not worried?

Part of the answer may be that investment consultancy is not recognised as a profession in the same way as actuaries, the law or accountancy.  Unlike other professions with their long history, it is a new discipline that has only existed for around 40 years and, consequently, has no professional body to regulate standards.

Whatever the reason, investment consultants fill a role at least as critical to a pension fund as the actuary or lawyer and it should be expected that they have a similar professional qualification.  In my experience, and there are some notable exceptions, the best consultants are those that are qualified actuaries or those that have passed the Chartered Financial Analyst exams.  Perhaps this is not surprising given their greater theoretical underpinning to support their advice.

In the absence of the industry regulating minimum qualifications for investment consultants it is left to trustees to ensure that their adviser has the necessary competence.  I would therefore encourage every trustee board to look carefully at the qualifications and experience of their consultant before accepting advice that may be outwith their competence.  If trustees begin to do this, then the pressure on those firms providing investment consultancy services may be sufficient to lead them to ensure that all their consultants achieve a recognised professional qualification.

Give the London boroughs and the LGPS a bit of a break

The Pensions Institute’s recent discussion paper, “An evaluation of investment governance in London Local Government Pension Schemes”, highlights a number of valid concerns about the standards of investment governance amongst the London Boroughs.  However, their critisism of the prudence of the actuarial assumptions appears misplaced, given the history of the scheme, the possible alternatives and the scale of the unfunded government schemes.

Changes in direction by central government have clearly influenced the current funding position and, consequently, the level of prudence in assumptions.  The damage caused by the Thatcher government’s raid on local authority pension funds may never be repaired.  By advising schemes to target a funding level of 75% in order to deliver council tax cuts or freezes, the Thatcher government created the culture, in the Audit Commission’s words, 'where unfunded liabilities are deferred into the future to make the scheme more affordable to employers in the short term'.  When central government then turns around and asks schemes to again target full funding, it has to be expected that this will new goal will not be achieved overnight, even in times of economic plenty.

In the current era of economic austerity where local authorities cutting their spending, where are they expected to find the extra funding for the pension scheme?  In the past they had much greater discretion over their budget to find the funds.  The last Labour government, eager to pursue their education priorities, removed local authorities discretion over funding for schools and colleges and ring fenced the education grant to ensure that it could only be spent on education, effectively, significantly reducing the discretionary spending available to local authorities.  The scope to find the necessary funding for the pension scheme in the short term now falls on a much smaller group of services.  For example, would tax payers consider it acceptable to cut care for the elderly now in order to fund pensions 20 years in the future?  As the report suggests, this is not a vote winner for local councillors.

Achieving the current round of austerity is placing new pressures on the LGPS.  Many local authorities are choosing to outsource services as a means of achieving cuts, in the process transferring employees to the new outsource provider.  These employees often become members of the new outsource providers pension arrangement and become a deferred member of the LGPS.  This decreases the number of active members in the LGPS scheme to fund the existing increasing the level of contributions for each active member.  It is not surprising that the report finds that private sector schemes can eliminate the deficit over an average of 9 years, with an average employer contribution of 14%, while the London schemes will take on average 20 years with an average employer contribution of 22%.  I expect that this differential will increase in parallel with the increase in outsourcing by local authorities.

Faced with the pension issues of the LGPS funds most private sector schemes would close the scheme to new members and possibly also future accruals, thereby capping the liabilities.  In the LGPS scheme, liability management is the preserve of central government and the current political climate does not make closing the scheme a possibility.

Given the environment the LGPS exists in it is easy to understand why their levels of prudence are not as high as private sector schemes.  Perhaps there is no need for them to be.  After all they have the strongest possible sponsor, the government.  That the actuarial assumptions used are higher is therefore not surprising.  The report suggests that Benchmarking actuarial assumptions will lead to pressure for lower rates.  I am not convinced.  Benchmarking may even lead to a rise, as some local authorities may come to consider they have been unnecessarily prudent compared to the other LGPS funds and adjust their assumptions.  Equally benchmarking discount rates will still not give the full picture.  The actuarial methods used vary between actuarial firms, some, with particularly aggressive smoothing, use methods not even recommended by the Institute of Actuaries.  Consequently, even if the same actuarial assumptions were used, different deficit and contribution rates will still result.

This blog only argues that the current optimistic levels of prudence adopted by the LGPS are appropriate given the economic realities faced by local authorities.  It does not address the issue of whether there are benefits from merging the London borough funds.  Indeed I recognise that there should be significant economies of scale that could result.  However, I am not convinced that this will lead to the hoped for improvement in the strategic management of the funds and it may lead to a decline, but that is the subject for another blog.

The report makes generally unfavourable comparison between private sector schemes and the London boroughs.  Our own experience of reviewing the investment governance arrangements of private sector schemes, suggests that, whilst there are many examples of excellent governance, there is also a wide number of private schemes where similar governance issues to the LGPS exist, generally with similar causes.  Perhaps a more meaningful comparison for the long-term implications of the current management of the London borough schemes are the government’s unfunded schemes.  Any future shortfall in the LGPS will be trivial when compared to the unfunded liabilities of, for example, the state pension, civil service and teachers schemes.  Consequently, I would hope that they continue with their current, optimistic, approach to prudence and protect current services rather than sacrificing current service levels to protect against a longer term liability that may yet not materialise and, even if it does, may not be catastrophic, in the larger scheme of things.
Recent Comments
Guest — Andrew Cheeseman
I am not sure where the figures in this article come from but I can confirm that the employer cost of providing broadly comparable... Read More
Tuesday, 11 December 2012 11:08
Guest — Roger Brown
Andrew, thank you for the comment. It is interesting to see figures from someone involved in the practical side of the management... Read More
Wednesday, 12 December 2012 11:35

Improving the Trustees Knowledge and Understanding (TKU)

Reading the Scope Guidance of the Pension Regulator’s Trustee Knowledge and Understanding (TKU) you could be forgiven for assuming that a pension scheme’s most important advisers are the fund managers.  Specific sections require trustees to know how to select a fund manager and how to monitor their fund managers.  By contrast, there is no mention of the selection and monitoring of the investment consultant.  However, this is at odds with the academic evidence, that shows that less than 10% of a funds long term return and risk results from stock selection, the role of the fund managers, and over 90% from strategic asset allocation, advised by the investment consultant.

Why then does the TKU ignore the investment consultant and concentrate on the fund manager?

I recently posed this question to a senior investment consultant at a major firm.  His reply, laughingly delivered in a candid moment, came as a surprise to me.  “We and the other investment consultancies seconded personnel to the Pension Regulator to help develop the TKU and the related Trustee Toolkit.  Our consultants were always going to emphasise areas where we could add value, whilst ensuring that there was nothing that could undermine our business or put us under unwanted scrutiny!”

If it is true that the TKU was developed, at least in part, by seconded investment consultants, then it is just as likely, and less cynical, to believe that the seconded consultants put their best endeavours into the work.  However, this would inevitably be done from their perspective, a perspective that does not include scrutiny of investment consultants, but does contain a significant emphasis on monitoring fund managers.

The amount of change at investment consultants is now just as great as at fund managers.  The old model of appointing an investment consultant for a number of years, without regular review, is no longer fit for purpose.  Consequently, the Scope Requirements of the TKU should be expanded to include information on how to select and monitor investment consultants in addition to the selection and monitoring of fund managers.  In the meantime, trustees should look to develop a framework for regular monitoring of their investment consultant whilst continuing with their existing fund manager due diligence.  In monitoring their investment consultant trustees should seek to answer similar questions to those posed in fund manager monitoring.  For example:

  • Have any key personnel left the firm in the last year and, if so, could this affect the advice we receive?

  • Where has overall fund performance been weak and how can this be improved?

  • Is our investment consultant continuing to work well with the Trustees?

  • Have their been any significant changes in the consultant’s risk models that could impact on decision making?

  • Have there been any recent corporate changes that could affect our service?


As such an improvement in governance becomes common place across pension schemes, the need for the scope of the TKU to be updated to reflect this improvement will increase, although perhaps this time, with slightly less input from investment consultants.