Can fiduciary managers have their cake and eat it?

I wanted to take time to reflect on a less well-known impact of the LDI crisis and an emerging trend that we are seeing with fiduciary managers. There is no escaping that in the aftermath of the LDI crisis, the size of assets managed by UK defined benefit pension schemes has fallen significantly (in line with the fall in the present value of their long-term liabilities), driven by a significant increase in gilt yields. From a scheme perspective, as assets have generally fallen by a lesser extent than the liabilities, improved funding levels are good news for employers with pension deficits, and indeed members themselves with increased benefit security. However, this is not good news for asset managers or fiduciary managers as it has resulted in significant reduction in revenues. The majority of fiduciary managers structure their fee model as ‘ad valorem’ (a percentage of the assets they manage). We have seen an emerging trend of some fiduciary managers significantly increasing their fees to offset the falls in their revenue, this is in stark contrast to mainstream asset managers who have tended not to increase their fees. The most significantly impacted asset managers are LDI managers, given the stark fall in liability values. However, to date we have not seen any LDI managers propose an increase in their fee models. In this blog I explore if the proposed fee increases we are seeing by some fiduciary managers are fair or appropriate. So, let’s have a look at the arguments both for and against increasing fees, using my first-hand experience of previously working as a fiduciary manager.

Justification for an increase in fees

It is important to remember that the fee paid to a fiduciary manager should be all encompassing, in short it should cover everything the trustees need, including keeping pace with changing regulations. Whilst this requires an element of ‘finger in the air’ to price any appointment fairly, the regulatory burden of providing investment services has increased materially over the past few years. This is especially true with greater reporting on items such as Environment, Social and Governance (ESG) aspects. Therefore, it could be argued by the fiduciary manager that it is justifiable to increase the fees to cover the additional services.

There is no escape from the inflationary pressures we all face in nearly everything we do, the investment industry is no exception. With fiduciary managers facing higher costs from wage inflation and higher cost of services it could be argued that it is appropriate to increase fees accordingly. Finally, a fiduciary manager may believe that if retendered for an existing appointment, in order to maintain an appropriate fee in £ terms, the % basis would be higher than the now out of date fee basis. In order for a commercial arrangement to work for all, it’s important that suppliers are able to earn a reasonable profit from their work.

Justification against an increase in fees

I have set out the main justifications for an increase in fees for fiduciary managers and now I will explore the justification against any increase, it may not surprise the reader that there are more reasons against than for.

Firstly, and importantly the majority of trustees are not contractually obliged to accept any proposed increase in fees, as the contractual arrangements typically don’t set out circumstances or time periods that would result in a review of the commercial arrangements of the fiduciary agreement. Over the decade prior to 2022 fiduciary managers benefitted significantly from falling gilt yields and increasing asset values, materially increasing their revenues and profits. In short fiduciary managers’ fee revenue increased but they were not doing any more work or providing additional services to clients, just the assets managed were greater. During this period fiduciary managers kept their % fee the same, with very few offering tiered fee scales which would have benefitted clients in this circumstance. Unsurprisingly, fiduciary managers did not offer to reduce the % fees so as to temper the £ fee increases. I would argue that if you are prepared to operate under an ad valorem fee arrangement then you can’t take all the benefit from increasing asset values and then ask for increased % fees when asset values fall. You’ve got to take the rough with the smooth, not heads I win, tails I win. The recent increase in gilt yields can be thought of as having smoothed the revenues of fiduciary managers over time, and the current reduction in fiduciary manager fee revenue will have been more than offset by the prior years of higher fee revenue.

“The justification I was always told by fiduciary managers for charging the additional fees was to be compensated for the risk in managing a larger value of assets on top of the work undertaken, so if this is true then the opposite should be applied when asset values fall”

Fiduciary manager fee agreements also benefitted from industry tailwinds. For example, several years ago the majority of schemes using fiduciary management were cashflow positive, this meant that investment returns, benefit accruals and company contributions were greater than the benefit outflow, so the size of the pension scheme was increasing year on year (often at a faster rate than inflation). This makes the fee model proposed by the fiduciary manager a model with greater than inflation increases naturally built in, even when at face value it looks to be same % fee but in £ terms it is increasing. Having worked as a fiduciary manager I know what costs go into pricing a new appointment and there are several sunk costs such as the cost of winning the appointment, onboarding the new client and transitioning the assets to the new investment arrangements building this into the fiduciary management fee. Once these costs have been covered by the fiduciary manager in full, many schemes continue to pay them as they form part of the % fee. However, in my view the fee should be reduced once the costs have been paid. Finally, many schemes are in a materially better funding position than they were before the LDI liquidity crisis, which means more assets in lower-returning asset classes and less in growth assets, potentially resulting in a lower cost of managing the portfolio, which should be passed on to clients.

Conclusion

It is clear that the commercial arrangement of any fiduciary mandate is complicated and, with the significant fall in the value of the assets managed, we expect more fiduciary managers to look to increase their fees to offset their increasing costs.

It doesn’t feel equitable that fiduciary managers take all of the benefits of rising fees from favourable market conditions and then ask for increased fees when markets move back the other way. It is key for trustees and sponsors, who ultimately bear the costs, to understand if any fee change proposal is appropriate in light of the existing commercial arrangement and the level of service being received. Fiduciary managers have had several years of bumper fees, driven by market led asset growth, and this should be remembered when considering any proposed fee increase.

Should they have their cake and eat it? In my view not if it is at the expense of pension schemes.