As the dust settled on September’s pension scheme crisis, John Ralfe, a pensions specialist and early proponent of liability-matching investment strategies, did not hesitate to select his target.
Investment consultants were the “villains of the piece”, he told MPs in November, having advocated products that built up hidden leverage in the system and sparked a market crisis in the wake of former prime minister Liz Truss’s “mini Budget”.
“They’re all about pushing complex, expensive products of one sort or another,” Ralfe said. “And the product they have been pushing for the last few years has been leveraged LDI.”
Liability-driven investment requires pension funds to focus not on asset growth but on tracking liabilities — the present value of the pensions they have promised to pay out in future. It involves heavy purchases of government bonds but also the deployment of leverage, or borrowing, in the use of instruments such as gilt repurchase agreements, or repos.
When long-term gilt yields shot up following the “mini Budget”, pension schemes’ LDI hedges came unmoored, forcing them to dump hundreds of billions in assets to meet collateral calls in a sell-off that only abated when the Bank of England intervened in the bond market.
Institutional investment consultants intermediate more than $25tn in assets globally, according to the UK’s Financial Conduct Authority. In the UK, the pension consultant industry is both hugely influential and particularly concentrated, yet its investment advice to trustees is not currently regulated.
The top three consulting firms — Aon, Mercer and Willis Towers Watson — control up to 80 per cent of the UK advisory market based on proportion of client assets, according to 2017 estimates from the FCA that industry experts do not believe have shifted much since. For defined benefit pension schemes, the part of the market that got into trouble, the proportion is probably higher.
“The investment consultant is pretty fundamental to DB pension funds in the UK,” said one manager who works with pension clients at a major asset manager. “Very few trustee boards go against their advice. They are very much a gatekeeper to the client.”
Calls to regulate the pension consulting industry more closely have gained traction since the LDI crisis after a previous attempt to bring it under the FCA’s remit faltered during the pandemic despite gaining broad support from investors, trustees and the major consultancies.
“Perhaps if [pension fund] advisers had been more sensitive to dealing with levels of stress like this, some of that risk would have been managed more effectively,” FCA boss Nikhil Rathi told a parliamentary committee in November.
However, he added that “I wouldn’t go so far as saying that, in and of itself, would have prevented such a situation.”
Concentration in the advice market is a key concern for regulators, although competitors to the big three — including Lane, Clark & Peacock and Redington — have gained market share in recent years. The rise of professional trustees at UK pension schemes is also thought to provide some ballast to the dominance of consultant advice.
“The advice given to schemes was very similar across the board . . . and because they all did the same thing, it resulted in a systemic problem,” said Toby Nangle, an independent analyst.
But Nangle doubts whether more complex products were favoured by consultants for their own sake. “Schemes have used leverage to solve accounting and regulatory problems,” he said. “If everyone could do it without leverage, they would.”
The sway consultants hold over the UK market is largely due to particularities of the regulatory regime, which demands a focus on schemes’ funding levels, and accountancy standards introduced in the 1990s that forced companies to put their pension deficits on to their balance sheets.
An industry sprang up around advising pensions on how best to manage these liabilities, and LDI became a popular solution. By 2022, UK defined benefit pension scheme liabilities had grown to about £1.8tn, according to LCP, 85 per cent of which was hedged using LDI.
The Competitions and Markets Authority announced a number of new measures in 2018 to allay industry concerns over governance, requiring trustees to run tendering processes on fiduciary management arrangements, as well as greater transparency on fees and performance from consultants. It also echoed calls for advisers to be brought within the scope of FCA regulation.
But regulatory concerns that consultants pushed complex products on trustees — many of whom are not financial experts — and the difficulty of assessing the quality of the advice trustees receive remain unresolved.
Handling of conflicts of interest for consultant businesses that house advisory practices alongside fiduciary management arms — where investment decisions are delegated by the trustees to the business — is also a key concern for the regulator.
“There are definitely some quite major conflicts in the industry, which still need addressing . . . in terms of being both the assessor of asset managers and the manager of assets themselves through their implementing orders,” Peter Harrison, chief executive of Schroders, told a Financial Times summit last month.
Some view attempts to cast the spotlight on consultants as blame-shifting, however, as top LDI managers including BlackRock, Insight Investment, Legal & General, Schroders and Columbia Threadneedle look to defend their reputations.
“Peter’s statements on regulation of consultants run the risk of it looking like . . . he’s trying to deflect the story on to someone else,” said one pensions consultant, pointing out that companies such as Schroders and BlackRock also have in-house advisory businesses as well as fiduciary management operations.
“There are of course conflicts in this business, I’m not attempting to minimise that, but [these firms] also have them all in spades . . . He’s throwing stones in a very fragile glass house,” the person said.
Sir Nigel Wilson, chief executive of top LDI manager Legal & General, claimed the insurer was the “hired help” in such structures, and stressed the role of the consultants in guiding schemes’ decisions. “We don’t advise them to advise their clients,” he told peers, saying that nearly all communication with the schemes went through advisers such as Aon and Willis Towers Watson.
Mercer and Aon had both warned clients over the summer about risks to their LDI hedges as UK bond markets sold off.
In the aftermath of the crisis, “trustees have had ‘stewards inquiries’ going on and the hard questions are being asked”, said James Brundrett, a partner at Mercer. “There’s a debate about pooled versus segregated LDI funds but also, did we have the best LDI manager?”
Another consultant to pension funds said that during the crisis some LDI managers were “not communicating” with advisers over how their pension clients were positioned. “They wouldn’t tell us what was happening [but] they were telling us they wanted collateral,” the person said. LDI is a “complex business and [the consultants] are a very substantial part of that machinery”, they added.
After regulatory intervention averted a deeper liquidity crisis, many pension funds are expected to have emerged from the crisis with stronger funding levels now their liabilities have been shrunk by higher gilt yields.
But the industry is still poring over whether UK schemes took on too much risk in an attempt to close their funding gaps, whether stress testing and collateral levels were sufficient, and whether the advice to schemes on these issues was adequate.
“I don’t think anyone made huge money selling LDI through consultants — it’s not high-margin and it’s pretty scaleable,” the UK institutional manager said, but “it’s a bit weird that consultants are not regulated [when] the little one-man-band financial adviser on the high street is”.
Another insurance executive, speaking on condition of anonymity, said consultants were “in a bit of a panic” as the blame game heated up. “If you are a reasonably big scheme . . . I think you will go after your adviser.”
Willis Towers Watson and Aon declined to comment.
Additional reporting by Josephine Cumbo