What explains the weird hold investment consultants have over their pension fund clients?

10 Mar, 2014

The dependence of the pension fund industry of the United Kingdom on the investment consultants is a form of psychological captivity familiar to any abusive relationship. But until I read the results of a survey of its members by the National Association of Pension Funds (NAPF) this week, I had not fully appreciated how serious the condition was. Pension funds in the United Kingdom are clearly suffering from an advanced case of Stockholm Syndrome.

The NAPF conducted 250 telephone interviews with the individuals at pension funds that have the most regular contact with an investment consultant. Four out of five of them, across both defined benefit and defined contribution schemes, would recommend their investment consultant to someone else. Among defined benefit schemes alone, the percentage was even higher.

Investment consultants collected glowing reviews for the clarity of their explanations of technical issues (including presumably those richly priced inflation and longevity swaps that they are now buying in droves from investment banks); for providing well-researched and objective advice; and for the quality of their advice on which fund managers to appoint and which to sack.

The love-struck pension fund manager is a worrying phenomenon. Investment consultants are getting into the asset management business, leading to justifiable fears that they will not treat their own funds dispassionately. Worse the continuing belief in the ability of investment consultants to consistently pick managers that will outperform seems increasingly impervious to the well-attested fact that they cannot.

A paper published in the Rotman International Journal of Pension Management in the autumn of last year by three researchers at the Paul Woolley Centre for the Study of Capital Market Dysfunctionality offers some insight into this curious discrepancy between belief and reality. In “Why do investors favour active management … To the extent they do?,” Ron Bird, Jack Gray and Massimo Scotti argue that there is only “limited evidence that can rationally justify hiring active managers.”[1]

Ergo, in their paper they ditch rational analysis of the problem in favour of psychological, behavioural, political and cultural explanations. To test their suppositions, they polled 48 pension fund managers and investment consultants responsible for $399 billion of assets under management in the Australian superannuation system.

Their conclusion? It is that over-allocation to active asset management is best explained by "a complex of cultural, behavioural, and organisational influences, prime among which are the many principal-agent relationships.”

Culturally, pension fund managers are preternaturally deferential to alleged experts. The Rotman paper identified a "positive correlation between active exposure and having a regular asset consultant."  Like most people, pension fund managers also value what they have over what they might have, causing them to cling to familiar people and decisions, especially when these offer an illusory measure of confidence and control.

Paradoxically, this preference for the familiar seems to work even when decisions have led to repeated disappointment. Fund managers continue to be recommended by investment consultants, and appointed by pension fund managers, with a high degree of confidence on the part of both parties in the ability of the managers to deliver performance. This loyalty to the infallibility of their own judgment is not disturbed when their choices persistently fail.

Even the excessive fees that are often paid for under-performance - one study cited by the Rotman paper noted that "it is hard to think of any other service that is priced at such a high proportion of value" – are seen as reassuring, where they are not ignored, unknown or misunderstood. Certainly pension fund managers have an inexplicable preference for worrying about performance net of costs rather than the tax costs imposed on performance.

In practice, lavish fees are transmuted into a sort of sophisticated lottery ticket. Pension fund managers hope they might one day actually "win" the prize, consoling themselves that, without a ticket, even that remote prospect becomes impossible. Yet by definition half of active managers are going to under-perform their peer group, and even higher proportions under-perform other benchmarks. The bias towards active fund management nevertheless remains impregnable.

The Rotman paper is certainly right to attach high importance to principal-agent problems. The pension fund industry is suffused with them. Investment consultants get paid for decisions whose consequences fall on others. They also have a strong vested interest in propagating the myth that they can identify high-performing managers (including, now, themselves).

Fund managers, on the other hand, are not only investing other people's money, but have an interest in transactional activity to generate commissions they can spend on " research," including access to information from broker-dealers, and corporate access. They also have an interest in portraying performance by the time-weighted methodology that flatters, and not the asset-weighted methodology that is closer to the truth.

Pension fund managers are also riddled with conflicts of interest. They get paid for monitoring and selecting investment managers, so have little incentive to switch portfolios to the passive alternative. Active managers also have more resources to wine and dine pension fund decision takers than their cost-conscious passive competitors.

If the investment strategies pension fund managers select outperform, they can expect a bonus, or a pay rise, or a promotion, or to be head-hunted. Under-performance, on the other hand, can safely be blamed on fund managers, investment consultants or market conditions. It leaves the standard of living of the pension fund managers largely untouched.

The Rotman study thought this conflict between personal and collective agendas sufficiently powerful to argue that competition between pension fund managers to outperform each other in pursuit of personal wealth and status is a factor in the bias towards active management. Trustees are unlikely to stop them: at bottom, they know the fund can always be rescued from the worst mistakes of the managers by a rich plan sponsor or local or national taxpayers.

Organisationally, of course, the pathologies which plague corporate life in general can be found in the pensions industry.  Pleasing an immediate superior, or maintaining employment for colleagues, is more important than doing a good job for beneficiaries. One pension fund manager told the authors of the Rotman paper that "I really do not know why I have so much [active management] when over 12 years they have added nothing."

The explanation almost certainly lies in the political dynamics of the organisation. Bird, Gray and Scotti conclude that “although in principle formal governance structures clarify roles and responsibilities, in practice decisions are made in ways that support the psychological and financial interests of the agents, including trustees, internal investment staff, asset consultants,  and managers."

The distressing truth is some fund managers do outperform consistently, and limit the risk of loss in declining markets, but that investment consultants are an exceptionally poor method of discovering them. Unfortunately, consultants are so well-entrenched in the industry - investment advice is only one of multiple services sold to pension funds at cross-subsidised, bundled prices, a practice which “fiduciary management” threatens to turn into a full master/slave relationship – that it will take regulation to dislodge them.

If regulators were interested, they could do worse than look at the competitive structure of the investment consulting industry. Just three investment consultants advised half of the respondents to the NAPF survey, and the top six accounted for nearly three out of four pension funds surveyed. No wonder three out of five respondents to NAPF survey do not think their investment consultant provides value for money.

The buyers make little effort to keep competition alive. Though the NAPF survey found a "growing incidence in conflict of interest reported by schemes where consultants provide fund management  and advisory services,"' and that half of the biggest funds (those with over £1 billion in assets under management) now have in-house expertise, only one in four used that expertise to challenge their consultants.

In fact, the NAPF survey found only a third of the pension fund managers polled have a formal process of evaluation in place to assess the performance of their investment consultants. According to the survey, the average duration of a relationship between a defined benefit pension fund and an investment consultant is over nine years.

Which helps explain why the Rotman paper makes the relationship between pension managers and investment consultants sound like a marriage approaching its diamond jubilee. Asked why they are biased towards active management, pension fund managers blamed investment consultants, while investment consultants blamed pension fund managers.

When both sides find it easier to blame each other than to change their behaviour, it is clear that the relationship is not a healthy one. One consultant the authors of the Rotman paper spoke to told them that he and all his colleagues invested in passive products only. This is a truly post-modern phenomenon, in which the members of a cognitive elite are able to live with a complete contradiction between their public and their private lives, and still feel good about themselves.


[1] Rotman International Journal of Pension Management, Volume 6, Issue 2, Fall 2013, “Why do investors favour active management … To the extent they do?” by Ron Bird, Jack Gray and Massimo Scotti.

Dominic Hobson