A recent working paper of the Dutch central bank (DNB) on costs sheds light on a debate that is playing out in several European capitals over the size of retirement institutions. The authors of the paper, ‘Scale Economies in Pension Fund Investments: A Dissection of Investment Costs Across Asset Classes’, find lower investment costs of 7.7bps for a fund 10 times larger than a notional counterpart.
But this differs across asset classes – the larger fund enjoys lower costs to the order of 4.8bps for fixed income and 7.8bps for equities. The DNB paper attributes most of the cost saving of larger funds to management costs, including trading, research, risk management and regulatory compliance.
There are, in fact, negative economies of scale in performance fees for equities, real estate, hedge funds and private equity, lending weight to the recent decisions of some large pension funds internationally to divest from hedge funds. A larger fund pays 33.4bps more in performance fees for hedge funds and 41.5bps for equities.
While larger funds may hold more sway in fee negotiations if the manager is willing to sacrifice some of the upside in exchange for a big ticket client, the amounts payable in euro terms will be considerably larger overall.
The authors’ findings contradict their own hypothesis that corporate pension funds are better able to achieve cost efficiencies. The authors also find no evidence that defined contribution pension funds incur higher costs in comparison with their defined benefit counterparts, or that pension funds pay more for longer-duration investment strategies.
The scale question is a vexed one. In the Netherlands, the number of pension funds has declined in recent years, at the regulator’s behest, as corporate funds have opted for insurance solutions or folded their assets into an industry-wide arrangement.
In Sweden the government’s on-going inquiry into the future of the AP buffer funds, initiated in 2011, is reaching its final stages with a less radical recommendation that the four main funds should be reduced to three.
In this month’s issue we note that Italy’s retirement market is over fragmented and the same can be said for the UK, where economies of scale have been harder to achieve and the political culture is very much against interference in the operational affairs of the private sector.
When considering scale, the growth trajectory of funds is important. For instance, in the UK, it may be more important to encourage economies of scale in the growing DC market than in the DB market, even if that market altogether represents the country’s single largest pot of savings. Certainly, in new pension markets, policy makers should consider the scale factor first when considering policies like auto-enrolment.
Those who favour size should bear in mind that very large funds can sacrifice a degree of operational efficiency in asset allocation, for instance, often finding it hard to achieve meaningful exposure to illiquid asset classes. And as the authors of the DNB paper found, the larger funds are more likely to invest in asset classes with higher costs.
If politicians, regulators or trustees favour scale economies, they should be aware when bigger is better and when it is not.
Cost transparency is also increasingly common in pension fund annual reports. Here it is worth bearing in mind that many costs are difficult to compare accurately, leading to misleading impressions when comparisons are made at fund-wide or aggregate level. As delegates at June’s IPE 360 Conference in London heard, funds that are most diligent in reporting costs accurately may report higher figures than their less diligent counterparts.
This ‘From Our Perspective’ editorial appeared in the July/August issue of IPE magazine