Quantifying the Value of an Advisor
- Investment consultants play a central and growing role in institutional advice, but industry consolidation and rising client expectations have intensified the industry’s competitive pressures. Consultants report that the greatest threat to their firms is an inability to distinguish themselves from their competitors.
- Vanguard Institutional Advisor’s Alpha outlines how consultants can further differentiate their value proposition by focusing on controllable outcomes in order to advance society by giving institutional investors the best chance of achieving their mission, be it charity, education, or retirement. Consultants can enhance and distinguish their value by placing even more emphasis on their fiduciary expertise, their experience with investment policy statements, and other topics such as retirement plan design.
- Consultants to defined benefit, defined contribution, and nonprofit clients can add value to each client engagement and many are already doing so, but the nature of the services and the potential benefits will vary significantly by client type and circumstances.
- We believe that, when executing the Vanguard Institutional Advisor’s Alpha framework, consultants can add on average, about 2% to 3.5% in value.
The Role of the Consultant
Institutional investors range from small-business owners seeking to provide employees with qualified retirement plans to the largest public state pension plans. For the purposes of this paper, we focus on how three particular subsets of institutional investors engage with the consulting community: defined contribution plans (DC), defined benefit plans (DB), and nonprofits. In the case of DC and DB retirement plans, the assets will be used to secure the retirements of individuals and families. In the case of nonprofits, the assets will be used to fund the ongoing operations and investments of educational or charitable organizations.
The consultant is an essential partner for the many institutions that do not have the expertise, willingness, or access to execute on their goals. Even those that have these capabilities often find it beneficial to engage with consultants. By providing dedicated resources and expertise, consultants can help their institutional clients achieve their goals and fulfill their fiduciary responsibility in an environment of growing operational complexity and regulatory scrutiny.
Growing Influence, Significant Headwinds
Institutional assets in the U.S. have increased to over $20.7 trillion (Cerulli, 2017b). As these assets have grown, so, too, has the intermediated nature of the industry. Approximately 65% of surveyed managers’ net flows in 2016 involved a consultant (Cerulli, 2017a).
While investors’ preference for low-cost investments is often in the headlines, institutions continue to push for lower fees on the service side as well. This has led to a variety of responses from consultants and their firms. Some firms have expanded their service offer via mergers and acquisitions to better capitalize on economies of scale and serve institutional investors looking to reduce the number of their relationships. Others have focused more on niche specialization. All of them, though, have placed greater emphasis on customization and personalized service.
The Evolving Fiduciary Standard
Effective consultants deeply understand the complex landscape of fiduciary law and regulatory compliance as it relates to their clients. They will also communicate this understanding to clients while applying best practices and conducting fiduciary training. But the best consultants? They will diligently do the above while simultaneously looking to the future. Increased regulation has resulted in intensified enforcement actions and litigation over the past few years. The best consultants balance compliance with today’s fiduciary standard with proactive research on trends and shifts in regulatory focus and litigation, setting their clients (and their business) up for success.
It’s important to note here that the fiduciary standard looks different for DB and DC plans than it does for nonprofits. The Employee Retirement Income Security Act of 1974, also known as ERISA, imposes the fiduciary standard on DB and DC plan sponsors. Because ERISA does not provide direct governance for the non-employee benefit investment activities of nonprofit clients, the term fiduciary has a different connotation in the nonprofit space. Nonprofits are guided by a number of statutes adopted by the National Conference of Commissioners on Uniform State Laws (NCCUSL), the most recent of which is the Uniform Prudent Management of Institutional Funds Act (UPMIFA). That said, helping clients act in the best interests of their beneficiaries is a value-add by consultants, whether required by law or not.
Being a Dynamic Fiduciary
By effectively navigating the regulatory backdrop and helping clients avoid lawsuits and enforcement actions, consultants can add a significant amount of fiduciary alpha. Nobody knows which or how many plans will be subject to fiduciary penalties in any given year, but we assume that the possibility of such action is the baseline experience. While settlements and even the mere defense of lawsuits can be extraordinarily expensive for plan sponsors, the headline risk to the consultant cannot be understated, either. Given the client-specific nature of fiduciary considerations for different types of institutions, we designated the value-add relative to the baseline experience as > 0 bps.
One key fiduciary consideration for consultants with DB clients are the premiums charged to plan sponsors by the Pension Benefit Guaranty Corporation (PBGC). The PBGC ensures benefits for plans’ beneficiaries if employers are not able to fulfill their obligations. These premiums have tripled in the past five years and are slated to increase by another 25% to 50% by 2019 (October Three, 2018). According to this report, plan sponsors have exacerbated the financial burden of these premiums through suboptimal contribution timing and recording errors, resulting in sponsors’ overpayment of more than $100 million annually. By engaging with the clients’ actuaries to promote best practices around effective premium management and developing a deeper understanding of premium reduction strategies, consultants can add significant alpha for their clients.
Another element of fiduciary alpha is avoidance of enforcement actions. Employee Benefits Security Administration (EBSA) civil investigations can result in sizable sums levied against DB and DC plan sponsors alike. The third element shown in Figure 4, specific to DC plan sponsors, highlights the largest sums paid to settle 401(k) class-action lawsuits. These lawsuits have typically focused on excessive fees paid by participants for plan administration and investment management. Consultants can take steps to protect their clients from incurring costs from class-action lawsuits by promoting fee transparency and evaluating the plan’s investment lineup on an ongoing basis with a proactive focus on monitoring fiduciary trends and shifts. In addition, consultants can help prepare clients for inevitable surprises by ensuring plans are set up so that swift, prudent action can be taken. By approaching fiduciary considerations in a comprehensive and forward-looking way, consultants can give their clients the best chance to carry out their mission and drive success for their end beneficiaries.
Maximizing the Institutional IPS
The responsibility for overseeing an institutional pool of assets inherently involves quite a bit of decision-making. Understanding how institutional clients make these decisions is crucial for consultants to build a strong foundation for their working relationship. A Vanguard research paper, Reframing Investor Choices: Right Mindset, Wrong Market, found that investment decision-makers often use decision heuristics, or shortcuts, in order to make what they feel is a more informed decision. Further complicating investment decision-making in the institutional space is the potential for behavioral derailers that uniquely arise from the investment committee structure (Bosse et al., 2017).
A commonly used decision heuristic is a ratings system based on the assumption that past performance will continue in the future. While a shortcut like that may prove effective with decisions such as buying a car or selecting a university, they can be risky when making investment decisions for a portfolio. And this type of past-performance, relative-comparison mentality is deeply ingrained, as it works very effectively in most other decisions. Although shifting away from it can be difficult, consultants should use one of the most important tools at their disposal to do so—a document that essentially acts as a guide for decision-making. By helping clients create and adhere to an investment policy statement (IPS), consultants can add significant value and help prevent behaviors such as performance-chasing and market-timing. What should the process of developing an IPS look like? We believe that the vast majority of institutions create an IPS, but it may not always represent a high-quality plan. This can prevent the institution from being able to rely on the statement’s contents over the long term.
Consultants can deliver the next level of value by ensuring the IPS is comprehensive enough—emphasizing detailed processes, realistic goals, and clear articulation. Crucial elements include the portfolio objective, asset allocation policy, risk management framework, manager search and oversight process, and committee governance procedures. After a high-quality IPS has been developed and put in place, adhering to it often presents the consultant with a larger challenge. Factors such as committee turnover, market corrections, and manager underperformance can make it challenging to stick to a long-term approach laid down within the IPS—and harder to resist performance-chasing and market-timing. Additionally, given the current emphasis on alternative investments and active managers, the more complicated nature of traditional institutional portfolios provides more opportunities to take action based on performance.
Consultants can combat these challenges by emphasizing a thoughtful IPS and behavioral consulting to tap into the third level of value. Keep in mind that some clients may already be operating at their optimal level. That means they have a high-quality IPS in place that they adhere to in a disciplined manner, and they do not succumb to the potentially harmful value-detracting behaviors that we’ll discuss.
However, evidence abounds that this is far from the norm—cash flows clearly show that there’s an opportunity to do better (Kinniry et al., 2016a). This difficulty is denoted by the decrease in ubiquity going up the IPS value stack. The fourth and final layer of value represents ongoing oversight for the IPS, which includes revisiting the IPS regularly to ensure alignment but modifying the IPS only when necessary. While an IPS should not be etched in stone—there certainly can be appropriate reasons to modify it, such as a change in objective or in the regulatory landscape—it should not generally be changed based on market movements.
By putting in the time up front to build a deep relationship with and educate the client, consultants can leverage this relationship to effectively navigate adhering to and implementing the IPS. In doing so, consultants can maximize the value of the IPS through behavioral consulting. For DC clients, the types of decisions they need to make will vary significantly given that the assets themselves are invested by the end participant. However, ensuring that clients are maximizing the value of the IPS at the plan level is still important in identifying the plan’s objective and detailing processes for selecting and monitoring the investment lineup. As stated in the Vanguard research paper Framework for Investment Policy Statement, DC fiduciaries still risk overreacting to the latest performance trends without such documentation in place.
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