Wake-up call from the FSA on conflicts of interest in investment
Asset managers sometimes act in ways that is not in their clients’ best interest. This will not come as a surprise to many people. That this is the conclusion of Financial Services Authority (FSA) research into how asset management firms manage conflicts of interest is probably slightly more unexpected.
The key finding of the research is quite startling:
We identified that many firms had failed to establish an adequate framework for managing conflicts of interests. We also identified breaches of our detailed rules governing the use of customers’ commissions and the fair allocation of trades between customers. We concluded that most of the firms visited could not demonstrate that customers avoid inappropriate costs and have fair access to all sustainable investment opportunities.
The FSA points the blame at senior management:
in most cases senior management failed to show us they had understood and communicated this sense of duty to customers or even that they had reviewed or updated their arrangements for conflicts management since 2007. In these firms, employees too often lacked awareness of situations where short-term business goals conflicted with the long-term interests of customers.
There are a range of specific findings, focusing on both cultural and procedural issues. It probably isn’t immediately obvious why this matters to most people. But pension funds are among the most important clients of many asset managers, so the asset management industry has a vital role on delivering retirement incomes in the UK. If you’re in a defined benefit scheme (DB) you will probably get the pension you have accrued anyway, no matter how badly your money is managed – unless your scheme performs so badly it ends up in the Pension Protection Fund, meaning your benefits will be reduced.
Your scheme may also remain solvent but closed to future accruals – which will harm you in the remainder of your career, and also future generations who will lose access to DB schemes. There will also be a negative impact on the wider economy if capital is being poorly allocated (although the report does not make this specific claim). There is a workshop on investment management at this year’s TUC trustee conference.
However, it is perhaps in relation to defined contribution (DC) pensions that the mismanagement of conflicts of interest matters most of all. DC schemes are typically provided by insurance companies, who are also major clients of the asset management industry (many financial services groups are both insurers/pension providers and asset managers). Most workers will in the future be in DC schemes.
Given that DC schemes usually lack trust-based governance (the exclusive role of trustees is to protect member benefits), FairPensions have advocated a greater use of fiduciary duties to compensate for this governance gap. Asset managers with a fiduciary duty to their client would resolve a conflict of interest because they would have a legal duty to put the client first (rather than simply ‘treating customers fairly’, the FSA’s most important regulatory principle at the moment) irrespective of their employer.
But this is where it starts to get really complicated. Conflicts of interest might actually matter most of all in DC schemes where there are trust-based governance arrangements. And because of this, it is not clear the FSA has resources or appetite to intervene. The asset managers employed by any type of pension scheme fall under the regulatory umbrella of the FSA, but in terms of the direct provision of pensions, the FSA is only interested in contract-based schemes which do not have a trustee board.
Trust-based schemes belong instead in the regulatory universe of the Pensions Regulator (TPR). However, many pensions providers are now establishing multi-employer ‘master trusts’. They are offering products that look very similar to the contract-based insurance products that the FSA oversees, but they can avoid the scrutiny of the FSA because trustees are assumed to be playing a vital governance role between provider and customer – and TPR deals with trustee standards.
But can trustees in master trusts really be considered independent guardians of member interests? There are of course some examples of good practice available in the pensions market – as well as the risk the some providers might engage in ‘regulatory arbitrage’. FSA rules and expectations on asset management will still apply to these master trusts in theory, but if the investment managers have been chosen, to all intents and purposes, by a trustee board, surely supervisory functions will end up slipping through the crack between the FSA and TPR.
Worse, where master trusts are established by firms with ‘in-house’ asset management, does either regulator have the ability to forensically determine exactly where the potential conflicts of interests have arisen, let alone determine whether they have been managed effectively?
It is worth pointing out that, at the moment, this problem remains largely hypothetical. We simply do not know what the pensions industry will look like after millions of workers have been auto-enrolled into workplace schemes in the next few years. Interestingly, several master trusts have recently established the Master Trust Association, and promised to establish a code of conduct on conflicts of interest. But the FSA report should be a wake-up call to everyone involved in delivering pensions in the UK, as well as managing assets more generally.