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Performing zeal

The recent trend among major financial services providers has been to appoint external investment managers. Having said that, external fund links are not new.

Skandia Life has had external links for many years and, more recently, other companies, such as Scottish Widows and Scottish Amicable, have introduced external fund managers for their pension contracts. So the most recent announcement by NPI to offer external fund links should come as no surprise.

NPI has traditionally prided itself on offering competitive and innovative pension plans through its strong links with IFAs and these priorities have been retained following NPI demutualising and joining the AMP group of companies.

As part of this process, the fund management for all members of the AMP group, including Pearl Assurance and London Life, have been consolidated with Henderson Investors.

Why then did NPI also decide to look outside for additional fund management? It was certainly not based on any dissatisfaction but more as a device to add value to an existing proposition.

In other words, the decision to offer external fund links was made from a position of strength.

IFAs had been increas-ingly saying NPI could takean even bigger slice of their business if we helped them spread their investment risk.

Furthermore, the AMP experience from Australia, where it is the biggest pension provider, is that the multi-manager approach to investment is the norm in the market.

The demands of the UK financial planning market have changed significantly, with a much greater emphasis on pensions and particularly on managing money in retirement. This strategy demands relatively sophisticated portfolio planning and the big sums of money involved mean that a wide spread of investments is required.

Few advisers would feel comfortable under these circumstances in committing the whole of a pension fund to one investment manager.

The problem is to choose the right investment manager and that creates its own problems. How do you go about selecting the right managers?

First, they must have a good and consistent long-term record. Second, they must have a well known name and a good reputation among advisers. They must also have a sound investment process and the strength and depth to cover every eventuality.

This seems like a tall order and NPI&#39s rigorous selection process whittled the first 40 candidates down to five – Baring, Newton, Perpetual, Schroder and Societé Générale.

However, as mentioned earlier, external fund links are not new. And some would argue they are becoming the market norm in the UK.

So NPI decided to take its proposition a major step forward to stand out from the crowd with what we believe are two unique market initiatives.

All the fund managers have agreed to work on the same agreed level of annual management fees and each has agreed to work on a performance-related basis.

At first sight, paying performance-related fees looks like the perfect answer to motivating fund managers. If they perform well then they earn more money and if they do badly they earn less or even nothing.

Unfortunately, nothing in life is that simple, which is why performance-related fees are not generally used in retail funds. The place where they are notoriously employed is, of course, the derivatives and hedge fund markets.

The problem here is that spectacular short-term gains can lead to massive performance fees while sometimes the client is just left with a fixed return. These gains are invariably followed by losses for which there is no compensation and performance-related charges face more neg- ative comments.

Apart from the potentially attritional effect of excessive performance fees, there is also the problem of risk. Is the manager taking unacceptable levels of risk to generate the performance fee? The other end of the scale is almost as bad. An investment manager is hardly likely to pay much attention to a portfolio on which they are earning nothing.

We felt it important that NPI, with the appointed external investment managers,created a formula that was going to work in the retailenvironment.

The fundamental elements of control employed are the benchmarks set for risk and the benchmarks set for performance.

The managers are therefore constrained to operate within the requirements of the pension company but they have the freedom and incentive to produce higher than average performance.

The risk benchmark is the Lipper portfolio benchmark which applies to each type of managed fund.

Lipper, a Reuters-owned analyst, determines the benchmark by analysing the portfolios of all the funds in, say, the balanced managed sector and the composite portfolio becomes the benchmark for that sector.

The benchmark is therefore dynamic in itself and the appointed external managers can be up to 15 per cent overweight or underweight in any one investment area.

So the external fund managers are constrained in the amount of risk they can take.

The second benchmark is performance.

The performance benchmark is set at the 40th-percentile level, which means that first and second-quartile performance is considered good and third and fourth-quartile performance below par.

At the benchmark level, the additional annual man-agement charge on the externally managed funds wouldbe 0.5 per cent.

The other element of control is the fee scale which is capped at both ends and runs from 0.25 per cent to 0.75 per cent. So for consistent performance in the:

First quartile – the manager gets 0.75 per cent.

Second quartile – the manager gets 0.5 per cent.

Third quartile – the manager gets 0.4 per cent.

Fourth quartile – the manager gets 0.25 per cent.

At the top end, the charge is more than a manager would normally get for institutional business and at the bottom end there is still enough to keep working for an improvement.

NPI&#39s external fund links have broken new ground. with five of Britain&#39s leading fund managers agreeingto the same performance-related scale.

This will provide IFAs with a more attractive pension planning proposition and enable advisers to make investment decisions which more closely meet the needs of individual clients.

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