The Changing World of Fiduciary Management

A growing trend among pension funds toward the disaggregation of the fiduciary outsourcing model could fuel a wave of global innovation and an increase in options for institutional investors.

The concept of fiduciary outsourcing, known as “implemented consulting” in the United Kingdom and “investment outsourcing” in the United States, is a concept wherein an outside provider is appointed to the chief investment officer role. A fiduciary manager’s responsibilities typically include:

• Investment policy design and risk budgeting (including asset and liability management)
• Asset allocation, investment manager selection and portfolio construction
• Monitoring and risk management

Several factors drove the growth of the fiduciary outsourcing model, including ever increasing liability pressures, the growing professionalism of the pension fund industry and limited resources. Further, the increasing uncertainty of financial markets and support from well-known academics in the Netherlands, for example, where the fiduciary outsourcing model originated a little more than a decade ago, promoted the trend. By 2010, more than 75% of externally managed Dutch pension assets were under fiduciary management.

Now, however, the trend in the Netherlands is toward the disaggregation of the standard fiduciary outsourcing model. Issues such as tighter regulatory constraints, calls for increasing transparency and the desire for more control on the part of sponsors are factors, as are growing expectations for pension boards in terms of investment knowledge. The Northern Trust Client Solutions Group thinks disaggregating certain functions of fiduciary managers, such as strategic goal setting, plan design, investment manager review, guideline compliance and risk-budget monitoring will appeal to many institutional investors globally.

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The New Regulatory Environment

New pension regulations — “Pensioenwet” (Pension Act) and “Financial Assessment Framework” (FTK), which is a part of Pensioenwet that lays down, among other things, the statutory financial requirements for pension funds — were created in the Netherlands as a reaction to the market turmoil that originated at the beginning of the century. The purpose of these new regulations, and especially the FTK, was to set up a framework around the principles of market valuation, risk-based financial requirements and transparency. After the recent financial crisis, Dutch regulator De Nederlandsche Bank (DNB) seemed to express concerns about the fiduciary outsourcing model and to support a strict separation of risk management and implementation. In early 2011, the DNB established four themes for its supervisory efforts — supervision of strategy and conduct, anchoring of new supervisory frameworks, better risk management and a sharper focus on data quality and interpretation.

Under the rules, the fiduciary responsibilities of pension funds and sponsors were increased. DNB and the Netherlands Authority for the Financial Markets (Autoriteit Financiële Markten / AFM) supervise compliance with Pensioenwet and with the rules ensuing from that act. In order to be able to exercise effective supervision, DNB has a number of instruments at its disposal. For instance, DNB has the power to collect information and issue an instruction.

The FTK is built around the principles of market valuation, risk-based financial requirements and transparency. Market valuation means that investments and pension obligations are valued in the same way.

In addition, changes in accounting rules “IAS19/FAS158” left pension funds with a new element of volatility on company balance sheets. Under FAS 158, valuations require the use of a qualified actuary. The characteristics of IAS19 include that the rate used is the current rate of return on high-quality corporate bonds with maturities consistent with the duration of benefit obligations.

The new regulatory environment also highlights the need for enhanced pension fund governance principles. As a result, pension funds are evaluating their current structure, resources and expertise to determine the appropriate outsourcing or fiduciary model. Utilizing multiple, best-in-class outsourcing partners is one approach being considered as it provides an additional level of oversight and helps address potential conflict-of-interests concerns that arise when using a single provider. Regardless of the model used, the key factors in defining robust pension fund governance are transparency, accountability and identifying roles and responsibilities.

“The performance results and market volatility during the past few years have tested the current model resulting in investors considering new approaches. And interest in a disaggregated fiduciary outsourcing model could continue to grow,” says Arnaud Bizet, business development manager at Northern Trust, Amsterdam.

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Dividing the Responsibilities

Instead of selecting one provider, investors have the option of choosing a specialist for each element of the portfolio construction and monitoring process.

“There’s a lot of competition coming in. However, the number of firms able to do this on a global basis is fairly limited,” says Thomas Benzmiller, managing executive in the Client Solutions Group at Northern Trust, Chicago. “Disaggregation requires a customized, high-touch approach,” he adds.

In response, Northern Trust has developed the Implementation and Oversight Solutions (IOS) program. The program offers a detailed analysis of a wide number of factors, facilitates asset class construction and contains qualitative and quantitative evaluation.

“The IOS program is flexible in that it can offer implementation for both an entire program or a selected asset class,” Benzmiller says. “It offers a very robust approach to the process. For example, manager due diligence is conducted by three separate teams focused on investment process, operations and compliance.”

Benzmiller adds, “The risk management and oversight capability is also customizable.” Continued growth and expansion of the trend toward disaggregation of fiduciary outsourcing to other regions of the world would likely further the development of innovative and customized third-party solutions.

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