Technological tools, data management, attention to governance and transparency are the most important issues for pension fund CIOs right now. “I was recently in Boston to meet a group of CIOs and I was told that everybody is talking about those problems,” says Marty Sullivan, State Street senior vice-president and head of asset owner sector solutions for North America.
The more general trend that is changing the pension industry is insourcing, according to recent State Street research. Some 81% of pension funds plan to accelerate insourcing by increasing the percentage of their portfolios managed in-house over the next three years in order to strengthen their governance, lower costs and increase long-term value for members.
“There is a lot of public pressure on pension funds to manage their assets in a more cost effective way,” explains Sullivan. “People ask money managers how much they pay to capture alpha.” A survey by CEM Benchmarking, which assesses large funds on their costs, showed that on average they spend 46bps on external management, compared with 8bps on in-house capabilities. “Deciding whether to insource or outsource will be a decision each fund makes based on their investment strategies and resources. Larger pension funds have the resources and risk appetite to insource those alternative investment related to alpha.”
“In order to be able to manage their assets in house, pension funds are considering hiring talent and investing in technology – the technology they need as regards data management and its transparency, especially for the limited partnerships that plan sponsors use to invest in alternatives,” adds Sullivan. “Tech can provide better analytics of returns and portfolio risks, and it helps look at portfolios in a holistic way.”
The trend in favour of alternatives depends on the increasing risk appetite of pension funds: 77% expect to weight their investments toward higher growth/higher risk strategies over the next three years, trying to boost their returns while interest rates stay at historical low levels and traditional asset classes such as equities and fixed income may look pricey. Among alternatives, private equity emerges as a hot area for investment: 62% of pension funds anticipate increasing allocations in private equity and especially in direct loans (54%), real estate (46%) and infrastructure (39%).
Contrary to recent news about pension funds exiting hedge funds, State Street’s report found that 29% of managers that already invest in this asset class will increase their allocation and 25% will invest in it for the first time in the next three years.
“As a result of this trend towards alternatives, pension funds’ portfolio will become more and more complex,” Sullivan points out. “For CIOs it will be more difficult to aggregate risk data from multiple managers and gain a complete picture of risk-adjusted performance. But taking a broad perspective on risk management is a key ingredient of good governance”.
Indeed , fortifying governance is another crucial trend emerging from the survey. More than half of the respondents view strengthening their overall governance as a high priority for the next three years. “Regulation is another factor in this trend,” Sullivan continues. “Pension funds are aware of their need to get better oversight, transparency and disclosure, but are less attentive to a broader approach to risk management. Only one in 10 respondents in the survey rated contingency plans as a high priority. However, they should have disaster recovery plans to keep working not only after a natural disaster but also after a cyber attack.”
State Street’s message is that the pension industry is facing a watershed moment and in this fast- changing environment there is a lot of need for innovation. If funds are taking more control of their destiny by insourcing asset management, asset managers must “master the transition from product providers to becoming fully-fledged ‘solution builders”.