The trm Report - November 2005

Trustee Risk Management
Testing Times Explained
Keith Faulkner, FIA

Market Testing of Actuaries and Other Pension Consultants:
What on Earth Does That Mean?

Market testing doesn’t have to be a chore. Tackled the right way, it’s a simple but highly effective management tool that maintains cutting-edge services, drives osts
down and puts you into the premier league of modern pension governance. Keith Faulkner of Pension Adviser Review explains how.

Until recently, the expression market testing was largely confined to the arcane world of market research practitioners. According to the dictionary definition, market testing is all about trying to second-guess how a market reacts to new products, changes in existing products, pricing and that sort of thing. So what has this to do with the equally arcane world of pension actuaries?

Answer: following the publication of the Morris Review of the Actuarial Profession in March 2005, market testing is the new buzzword on the lips of pension managers, trustees and, yes, even actuaries. According to the Morris definition, market testing is all about kicking the tyres of the actuarial firms, finding out who is doing what, what they are charging and, in general, what’s new out there. Market testing isn’t just about looking for new advisers because the ones you already have aren’t cutting the mustard; in much the same way that having a favourite restaurant doesn’t mean you don’t check out the menus of a few others from time to time, testing the market is a necessary ingredient in keeping you and those around you up to date. And although the title of the report might suggest a strict actuarial focus, Morris soon realised that they often wear two hats at the same time – actuary plus investment consultant – and this behaviour also came under intensive investigation.

Why bother with market testing?

Market testing, the report said, has important advantages: "through the threat of switching it exerts competitive pressure on incumbent firms, encouraging best practice advice and innovation; and it can help to educate users about alternative actuarial approaches and methodologies."

Here are some specific reasons why testing the actuarial market can pay big
dividends:

The market isn’t the same as it used to be

Some pension schemes have used the same consultants, year in and year out without question, for ten, fifteen, twenty years and more. Although there might be nothing wrong with this in practice, the fact is that the actuarial market today bears little resemblance to what is was even three or four years ago, never mind what it was in the last century. Realistically, schemes owe it to themselves maybe
even to their members) to run the slide rule over the market from to time.

Governance

The Morris Review is a good example of where the application of reasonable doses of governance makes good practical sense. "The review believes", Morris said, "it is essential that users regularly review the performance of all of their actuarial advisers. This will ensure that users can satisfy themselves that they are receiving high-quality actuarial advice." To do this, the report recommends informal annual reviews, formal reviews every three years (with input from a suitable expert if needed and leading to market testing if serious problems are encountered) and full market testing at least every six years.

Maybe you’re having some problems after all

Let’s face it, things can go wrong in any relationship and pension consultants are certainly no exception. Examples include fee levels running out of control, poor service standards, errors, lack of proactivity and one-to-one chemistry that isn’t al
it should be.

There are also some circumstances where going through the market testing process is what is needed, but for slightly different reasons. Instead of just checking up on the incumbents, here are two situations where trustees or companies may need to sift through the market to look at different advisers:

Conflicts of interest

Trustees and sponsoring employers are increasingly finding themselves on adversarial sides of the desk when it comes to tough pension issues and using the same actuary for advice can stretch credibility to breaking point. The actuaries
themselves know this (they sought a legal opinion on the subject in 2004 and found little comfort in the conclusions) and so do an increasing number of companies who are turning their backs on the trustees’ actuary and looking elsewhere for independent help.

Separate actuarial and investment tenders

Traditionally, most pension schemes have used the same firm to advise on both actuarial and investment consulting. The Myners Review first questioned this practice back in 2001 and Morris (and the government, by the way) have now gone further and recommended subdividing the investment brief itself into two: one for manager selection (where, arguably, formal actuarial training provides no meaningful insight at all) and one for asset allocation (where, arguably, it does.) Either way, the hunt is on for best-in-class practitioners to fill the void.

Market testing: a user’s guide

The key to making this happen successfully is to tackle it professionally but firmly and to treat the negotiation as though it was an important business project with major consequences and strong cost implications – which is exactly what it is. Here’s a summary.

1. Design the specifications for your ideal adviser

With a totally open mind, think about what’s really important for you. Lock away any bias, prejudice or preconceptions and concentrate instead on exactly what it is you want.

2. Get the very best long list

Leaving no stones unturned, start with the biggest list of potential candidates that you can get your hands on. Check off each one against your specifications and you’ll soon have it whittled down to the best-looking long list the market can
provide.

3. Write the Invitation To Tender (ITT)

The ITT is where you go public in your market test.

When inviting candidates to present their credentials, make sure you scratch beneath the surface, tell them to leave their marketing façade behind, ask what they can bring to the party and how they intend to make a difference. An automatic spin-off is that, done properly, what you get back in return is much more than just a proposal and amounts to a detailed and pre-agreed business plan between you and the prospective adviser.

4. Take up references

Getting this right can be trickier than it sounds. One obvious problem with references is that they nearly always turn out to look really good. Why? Because the only references you get are from – you’ve guessed it, satisfied clients. Asking for the names of lost clients is a good idea but, again, it’s unlikely you’ll get the names of clients where things went wrong in a big way. Whichever way you look at it, the dice are loaded against you. Don’t take too much at face value and apply lateral thinking to prise out meaningful information.

5. Screen the responses

Ask each member of your selection team to rank the responses using a robust numerical evaluation mechanism. Don’t forget that some features are far more important than others so make sure you weight the results to reflect this. You are now in a position to draw up your first-cut league table. (It’s important to try to keep emotion on the sidelines at this stage. Your first priority is to identify who can actually deliver the goods. Personal chemistry comes later, as it should.)

And before we forget, let’s talk about price.

Price matters a lot, of course, but only after you have decided which firms can do the work you need. Mixing up price with quality too early in the process can produce some misleading results. And while we’re on the subject, don’t automatically assume that price and hourly billing rates go hand in hand; comparisons between consultants based on hourly billing rates can be fairly meaningless.

6. The beauty parade

Finally, you will get to meet and greet the faces behind the words. You’ve already decided, on the basis of those words, that any of these finalists should be able to do a good job at a fair price and now it’s time to find out who scores best when it comes to putting theory into practice. They’ve told you they want to work with you; your job is to decide if you want to work with them.

Although this is when personal chemistry really starts to take over from numerical ratings, maintaining a level head and keeping some analytical ammunition up your sleeve is still worth the effort. This is not a good time to surrender to the seductive charms of a well-polished presentation.

7. And the winner is ……

The reward for all your hard work will be the natural emergence of a clear-cut winner. You’ll have the best fit the market has to offer, a pricing structure that puts you in control and a ready-made business plan just waiting to be rolled out.

And here’s another bonus that you might not have thought about. If, a few months later, a new trustee, pension manager, company director or some other interested party asks why you picked this particular adviser, you’ll have all the right answers!

Keith Faulkner, FIA
Managing Director
Pension Adviser Review Ltd
020 7788 7611
keith@par.uk.com
www.par.uk.com

Copyright © 2005 Pension Adviser Review Ltd