Like many new products or services in various industries, when something “fresh” comes to the market with the promise of being a “better” solution, many consumers rush to embrace it before truly understanding its nuances. Within the world of investment consulting, that relatively new service has been generically branded as the outsourced chief investment officer (OCIO) or Discretionary Service Model. To add more confusion to this topic, some providers have come up with enticing brand names, such as “Fiduciary program,” to differentiate their offering. In addition to different names, the actual consulting services delivered to clients can vary depending on what is included in each company’s distinct program. The purpose of this blog is to help educate Trustees (consumers) on the potential differences and pitfalls between each discretionary service model approach so a more informed decision can be made in regard to whether Boards should move in this direction with their portfolio or stay within the more traditional 3(21) non-discretionary consulting service model.

Portfolio Direction: this is the first important factor each Board must consider when contemplating a discretionary service model. Essentially, these new services offer Boards more efficiency, potentially lower cost, perceived enhanced liability protection and higher accountability for performance with their advisor. In exchange for these services, clients must be willing to pay a higher cost for general consulting services.  In traditional consulting relationships, 3(21) advisors normally bring their best ideas to clients (or conduct open RFPs) and then make a recommendation to the Board on what strategies, styles and specific managers make the most sense for their specific portfolio needs.

The ultimate decision to move forward and invest is made by the Board. Many clients have gotten frustrated with this process due to the time it can take to complete Board education, strategy reviews, manager searches and ultimately execute on the decision that is made. Additionally, some Boards are feeling increasingly ill-equipped to make or rule on such major financial decisions. Couple this frustration and overload with an ongoing deluge of new investment products promising nirvana and you have an industry ripe and ready for a new solution. That solution is the discretionary service model in all of its forms. Even though some consulting firms have offered discretionary programs for some time, increased litigation and pressure on Boards from internal and external sources for better results has created a much deeper market for discretionary consulting services.

Since this service is being talked about frequently at Board meetings, along with most conferences Trustees attend in the institutional space, we thought a brief overview outlining the differences among discretionary and traditional programs may be helpful.

What Should I Know About Discretionary Programs?

1) The Board gives up day-to-day control of the investment decision-making process by retaining a consultant with the discretionary authority to make ongoing decisions for their portfolio.

2) The Board will pay more for a discretionary consultant than for a traditional consultant. The consultant’s costs are higher with discretionary relationships due to increased liability of the advisor and enhanced resources needed to effectively implement and manage the program. Overall costs for the entire management of the portfolio may came down due to economies of scale with underlying managers utilized in some discretionary models. This is something Trustees need to review and fully understand.

3) The discretionary service model streamlines the efficiency of the decision-making process since much of the general portfolio administration and investment selection is completed without Board input.  However, there will be service variations depending upon the consultant’s specific discretionary platform. This efficiency also tends to shorten the overall length of Board meetings since clients do not have to allocate significant time to make ongoing investment related decisions.

4)  Retaining a discretionary expert to oversee the portfolio is not a panacea for clients. Results may be stronger or weaker under a discretionary service model than a traditional consulting model.

Types of Institutional Programs – Non Discretionary and Discretionary

  • Non-Discretionary Advisor (Traditional Service Model)

A Non-Discretionary advisor is a Fiduciary to their clients in that they render investment advice for a fee.  However, a Non-Discretionary advisor has no discretion or direct control over the client’s investment portfolio. The consultant cannot conduct portfolio administration or retain or terminate any service provider without the client’s approval and authorization. While a Non-Discretionary advisor certainly facilitates the decision-making process, all final authority to implement and execute portfolio actions remain with the Board. The Non-Discretionary advisory relationship was the dominant approach to investment consulting until recently, as institutional funds began to consider giving their consultant more control in the hope of enhancing portfolio results. In terms of today’s consulting marketplace, most Public and Taft-Hartley plans still operate under the more traditional advisory relationship with their consultants, while the trend within Endowment, Foundations, and Corporate portfolios has been toward establishing Discretionary advisory relationships described below.

  • Discretionary Advisor (Discretionary Service Model)

A Discretionary advisor is also a Fiduciary to their clients but since they also take varying degrees of discretionary control (dependent upon the advisor’s specific platform) over the investment portfolio, a Discretionary advisory relationship represents a streamlined consulting option designed to enhance the decision-making process in relation to the institutional pool of assets. Working within the guidelines of the client’s investment policy, the consultant exercises administrative and investment discretion over the portfolio. This means portfolio actions are implemented on an ongoing basis without Board input or advanced knowledge.

This is where different Discretionary advisory models diverge. While there are dozens of nuances, we can identify three major variations in discretionary service model offerings. Some discretionary programs offer a full “turn-key” approach where the consultant takes full signatory authority over the client’s portfolio using purely third party managed strategies, entering into contractual arrangements on behalf of the client without the client’s input. In another variation, the discretionary consultant invests client assets in a variety of captive investment products that are internally structured and offered by the consultant for clients in their discretionary program. Once again, these investments are made without the client’s input. In its final form, investment contracts, when required for third party investments (not internally-sponsored products), are reviewed by the consultant from an investment standpoint, but legal review and execution of the recommended agreement by the client is still required. As illustrated, there are critical differences in philosophy and control within different discretionary service models.

Is a Discretionary Relationship Right for Me?

As previously articulated, implementing a discretionary service model is not a guarantee of stronger portfolio results; you must ask a few important questions to determine if this is the right approach for you, as well as if you have the appropriate firm engaged:

  • Are you comfortable turning over control of your portfolio’s various investment decisions to an outside advisor or do you want to be involved in the education and decision-making process?
  • If you want to go with a discretionary advisor, do you fully understand the type of model that would be best for your portfolio, given the variety of implementation options available within discretionary service models?
  • Does the discretionary consultant have the capacity to understand your portfolio and does their approach to discretionary services increase the probability of meeting the portfolio’s objectives and goals? Is it a good fit for your specific needs?
  • Can you hold your advisor accountable in a discretionary relationship? One of the key tenants of all discretionary models is the increased efficiency of the investment decision making process. As such, if a Board retains a discretionary advisor and modifications are not implemented on a regular basis without your input, you need to question whether or not the provider you selected can really perform the job. In contrast, if there are no current opportunities and the portfolio’s underlying managers are doing well, you need to be comfortable with status quo in the portfolio.

Final Thoughts and Considerations

We have a few final pieces of advice for those considering a change in institutional consulting services:

  • If the Board currently employs an institutional consultant under a traditional Non-Discretionary relationship, understand the reason you are considering a change. Is the current program really broken?
  • Understand the type of control you are willing to delegate to an institutional consultant. Making the wrong decision on the front end of the decision-making process could have negative long-term effects on the portfolio and cause Board frustration.
  • Understand the nuances of the different models before starting your search. Realize there are differences in the scope and variation in the services offered by Non-Discretionary and the multiple platforms of Discretionary advisors.
  • Ask ample questions if you decide to implement a discretionary consultant. Board expectations should align with the specific discretionary model chosen. There are no foolish questions when it comes to implementing a discretionary portfolio service.
  • Take your time making the right decision for your portfolio.

If you have any further questions about institutional consulting services or the nuances of investment plans, please do not hesitate to reach out to our team of experts today.