Outsourcing or in-house
Pension plan fiduciaries should use only one criterion for deciding whether any function should be performed in-house or outsourced: which way is more cost-effective? Research by the global benchmarking firm Cost Effectiveness Measurement (CEM) suggests there is no simple answer to this question. However, there do seem to be two clear decision drivers.
The scale of operations is the first critical factor. Large scale operations tend to make the in-house choice more cost-effective, while small scale operations should generally be outsourced. Thus with regard to pension investments, for example, it should be the mega-funds which have large scale internal investment operations, while we should see smaller funds outsource most or all of their overall investment function.
This hypothesis is supported by actual experience, as captured in the CEM database. For example, in the CEM universe of 150 U.S. pension funds, the median value was $2.3bn, and the average proportion of assets managed internally was only 14%. However, for a peer group of 14 mega funds averaging $64bn (E61bn) in value, the average proportion was 55%. Another indication of how scale leads to increased in-house cost-effectiveness is in relatively lower unit costs for carrying out similar functions. In the cited group of 14 mega funds for example, in-house management in most asset classes produced between three to 10 times lower unit costs than outsourcing.
The quality of a pension plan’s governance and management function is the other important consideration in whether or not to outsource. Funds with strong governance and management functions are more likely to have the confidence and skills necessary to effectively manage operations in-house, rather than outsource them. Where this confidence is lacking, there is a tendency to outsource even though there may be sufficient scale to cost-effectively perform the function in-house. If funds with high proportions of in-house management generally have stronger governance and management functions, they should generally outperform those with low in-house proportions, or none at all.
Once again, this hypothesis is supported by actual experience, as captured in the CEM database. The five year risk-adjusted, after-expense, investment performance of all funds in the database was regressed against the proportions of the assets managed in-house. There was indeed a statistically significant positive relationship between investment performance and proportion of the fund managed in-house. Specifically, the co-efficient was 1.0. This means that, on average, for every 10 percentage point increase in in-house management, investment performance improved by 10 basis points per annum on a risk-adjusted, after expense basis.
To date, empirical evidence that scale and management quality determine the in-house versus outsourcing ratio is confined to the investment function. This will soon change, as CEM has begun to build a database which focuses on the pension administration function. To this point, the only data provided has been by eight very large public sector retirement systems which perform 100% of the pension administration function in-house. The annual pension administration costs per member ranged from a low of $25 to a high of $150. It turned out that half of that variance could be explained by differences in system complexity and service levels. Scale was not a cost driver among these eight mega-systems as all had at least 300,000 participants. CEM expects this database to grow rapidly over the next few years, permitting the pursuit of a broader research agenda in the pension administration arena.
In closing, it is worth repeating that those who seek simple answers to the "in-house or outsource?" question will be disappointed. There is no simple answer. That does not mean, however, that we have no answers at all. Generally, large scale and strong internal management capabilities mean that an in-house orientation will be most cost-effective. Smaller scale and weaker internal management capabilities point to outsourcing as more cost-effective.
Keith Ambachtsheer is president of KPA Advisory Services., which provides strategic advice to many of the world’s major pension funds. He is also a co-founder and director of Cost Effectiveness Measurement. Both firms are based in Toronto, Canada.