Regulating investment consultants would not have prevented the LDI crisis

The UK financial regulator said this week it was looking for ideas about how to improve regulation of the country’s £11tn asset management industry.

One idea being discussed in the wake of the pensions crisis last year is whether the full scope of investment consultancy services should come under the Financial Conduct Authority’s remit.

Regulation sounds like a good response to a recent crisis but there are easier and quicker ways to improve the market.

For years there have been questions about the highly concentrated and opaque nature of investment consultants, which act as gatekeepers between fund managers and institutional investors. But a near-catastrophe has renewed urgency to re-evaluate the issue.

Investment consultants were propelled back into the spotlight because of the key role they played in channelling the UK’s 5,200 defined benefit pension schemes into liability-driven investing strategies — designed to help match liabilities to assets but which blew up spectacularly last year due to “poorly-managed leverage”.

John Ralfe, an early proponent of liability-matching investment strategies, declared they were the “villains of the piece” because they pushed leveraged LDI products on pension funds. Some of these LDI funds imploded in the wake of former prime minister Liz Truss’s “mini” Budget, which provoked an unprecedented sell-off in UK government bonds and a rush to meet collateral calls.

In a subsequent MP hearing to dissect what went wrong, FCA interim chair Richard Lloyd pointed to the existence of a “gap in regulation” linked to investment consultants. FCA chief executive Nikhil Rathi said that if advisers to pension funds “had been more sensitised to dealing with such levels of stress, some of that risk may have been managed a bit more effectively”.

But the FCA has stopped short of suggesting that the LDI crisis would have been avoided if the consultants were regulated.

That said, it still feels odd and inconsistent that the investment advice provided by such influential players is not regulated. They intermediate more than $25tn in assets globally, according to the FCA.

The UK market is concentrated in the hands of three consulting firms — Willis Towers Watson, Mercer and Aon — who between them control up to 80 per cent of the advisory market based on their share of client assets, according to FCA and industry estimates.

But while the consultants’ investment advice to trustees is not currently regulated, the largest three players in the UK are among those that also have fiduciary management arms, which do already fall within the FCA’s scope.

Fiduciary management involves the delegation of investment decisions by trustees to advisers, alongside providing investment advice. This sets up potential conflicts of interests because it positions consultants as both assessor of asset managers and the manager of assets themselves.

In 2018 the Competition and Markets Authority announced measures addressing this, including requiring trustees to run tendering processes on fiduciary management arrangements, and heralding greater transparency on fees and performance from consultants.

If financial regulation was starting from scratch, it would certainly be neater to bring all of the investment consultants’ activities under the purview of the FCA.

But changing the status quo now, with the ensuing costs and hassle, including the need to change the law, is unlikely to either encourage new entrants or make it easier to assess the quality of advice — two improvements that would bring benefits to the end investor.

Even Ralfe said that he didn’t think more regulation would necessarily help, arguing that it was not about regulating investment consultants but about increasing transparency and forcing difficult questions to be asked, notably around margin requirements and systemic data on leverage.

“It’s not clear that you end up with a better world,” he added.

Andrew Clare, professor of asset management at Bayes Business School, agreed that it was uncertain what purpose regulating the investment consultants would serve. “Would it improve the quality of the investment advice? Probably not. Would it make it more commoditised and stifle innovation and new entrants to the industry? Probably.”

The underlying problem is that assessing the quality of advice received is notoriously difficult and regulation might not help with this. What is actually needed are measures to increase competition and make it easier for investors to compare the performance and fees of consultants and the quality of their services.

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