Province of a select few?
More than ever, pension funds are handing large chunks of their portfolios over to external asset managers. Outsourcing is often the most efficient way of investing, particularly for smaller funds that could not justify keeping a fully-staffed investment department, say experts.
But some larger funds are still doing it for themselves - citing flexibility and economies of scale.
In the Netherlands the growth of outsourcing has been dramatic. According to research by Dutch consultancy Bureau Bosch, total Dutch institutional assets managed externally were €502bn at the end of the first quarter of 2006, up from €353bn a year earlier, which means an increase of 42%. Going back to 1993, only €95bn of assets were managed externally.
The firm’s director Frits Bosch has said the increase is strongly related to the introduction of the new financial assessment framework (nFTK). Dutch pension funds have been keen to pass on much of the complexity of asset allocation.
Now, it is typically only the larger pension funds that manage their investments in-house, Lodewijk van Pol, consultant at Towers Perrin in the Netherlands explains.
“Economies of scale and the potential to develop a stable high-expertise investment team are required,” he says. Van Pol believes this that in order for in-house investment to be worthwhile, a fund needs to have an asset base of between €2.5bn to €5bn at least.
There is definitely a decline in in-house investment management, he says. “Areas of expertise and the desire to be best in class lead to outsourcing,” he observes, and adds that pension funds can implement plain vanilla investment products easily and cheaply with passive managers.
But how does a pension fund decide which investment to outsource? Is the choice based purely on cost efficiency, or are there other considerations? “Expertise and costs are the drivers,” says Van Pol. “Investment products and strategies tend to become more complicated and sophisticated, which requires high-end expertise.
“The market is developing globally and pension funds have a serious governance responsibility; this means they look around for the best manager to do the job,” he concludes.
David Blake, director of the Pensions Institute at the Cass Business School in London, says it is a combination of costs and anticipated superior performance that form the basis for any pension fund’s decision on whether or not to outsource.
In the Netherlands, Bert Kiffen, managing director of consultancy Kiffen International said it is only those pension funds with assets of €10bn and more that do their investment in-house. “So only a few funds conduct in-house investment,” he says.
“The amount is declining; like the Akzo Nobel Pension Fund more and funds are outsourcing the in-house investments,” he says. “The problem is how to have the expertise in-house.” Quite simply, it is difficult for pension funds to compete with asset managers for qualified staff,” he explains.
Last year, the €4.7bn Stichting Pensioenfonds Akzo Nobel signed an outsourcing agreement with the privately-owned financial services group Eureko. At the time, the fund’s general manager Lex Bolwerk and Rob Prins, chairman of the fund’s trustee board, said the main reason for the move was increased complexity - at a time when the membership numbers were falling. The outsourcing deal would guarantee cost effective management of the fund, they said.
In the UK, some of the larger pension funds such as the British Airways Pension Scheme and the Railways Pension Fund - and particularly those in the public sector such as the Universities Superannuation Scheme (USS) and local authority pension funds - still keep in-house investment managers.
David Blake comments: “They value the ability to respond quickly to changing circumstances and not wait until the next quarterly meeting with the external fund manager.”
But despite the advantages for a pension fund of keeping investment within its own doors, the trend does seem to be towards external managers because of the greater specialist expertise they can command, he adds.
Many local authority pension schemes in the UK, however, such as Scotland’s Strathclyde Pension Fund, do not have any in-house investment at all. “It’s all outsourced and that has always been the case,” says Richard McIndoe, head of pensions at Strathclyde. “That’s very unlikely to change in future,” he adds.
McIndoe cites the difficulties of creating a global investment infrastructure within a local authority environment as the reason why the fund outsources.
Likewise, the €2.8bn British Energy pension fund puts 100% of its investment management out to external asset managers. This has always been the case, and the decision to use outside firms for the task is down to “cost, efficiency and access to a wide range of specialist managers,” according to group pensions manager Graeme Robertson.
In some other countries in Europe, the decision as to whether to use in-house manpower to invest the scheme members’ assets or outsource is a simple one. In Italy, for example, outsourcing is the only legal option.
“All pension funds, based on the current legislation, have to stipulate an agreement with one or more money managers in order to manage their assets,” says Claudio Pinna of consultancy Hewitt Associates in Rome. “They cannot directly manage assets.”
However, on the basis that the larger the pension fund is, the more viable it is to recruit and retain an in-house investment team, Europe’s pension reserve funds should have good reason to keep their investment activities at home.
Together, Sweden’s AP Fonden pension reserve funds manage €101bn of assets, ranking them collectively as the third largest pension fund in Europe. AP3, for example, manages most of its assets in-house, with 57% in this bracket, and the remaining 43% in the hands of external managers.
Coming to a decision on which parts of the portfolio to outsource was largely a matter of the fund’s perceived ability to build expertise. “We use external managers in areas where we have limited ability to build internal expertise,” says communications canager Christina Kusoffsky Hillesöy. “For example US small and mid cap equity and Asian equity are areas where we use external managers,” she says.
But there are no hard-and-fast rules for pension funds on this, she says. She does not believe there are any asset classes or investment types that should always be handed over to specialist managers, for instance.
For AP3, Kusoffsky Hillesöy points out that the balance between in-house and out-of-house is not fixed. “I believe that the balance between in-house and outsourcing will constantly be reviewed in order to achieve the best mix. In-house management versus external management will always be weighed against expected return, skills and costs,” she notes.
Deciding to go down the route of internal investment is one thing, but hiring and keeping skilled investment staff is another. Large commercial investment institutions are notoriously high payers, particularly when it comes to salary add-ons such as bonuses. Can pension funds really hope to keep up?
“Clearly [pension funds] have to compete on both base salary and bonuses,” says Blake, “but still they will not attract the best talent who will always stick to mainstream fund managers.”
However, many of Europe’s pension funds believe that when it comes to recruiting investment professionals, they have certain points in their favour that the asset managers do not.
Though she acknowledges the difficulties, Kusoffsky Hillesöy says that in this area, money is not everything.
“Being a state-owned pension fund we can’t offer the same kind of remuneration as private asset management firms can do,” she says. “However, we believe that we can attract talented people to work with us due to our assignment, which many find interesting.
“Being a long-term investor with investments in a wide range of different asset classes all over the world is something that many people find interesting to work with,” she says.
ilvio Vecchi, principal director and administrator of the European Patent Office Reserve Funds (EPO), says it is hard to find suitable investment staff to work at the fund, even though he is happy with the professional competence of his current staff.
The EPO fund is able to attract staff because of the attractions its work environment has to offer beyond bonuses. “They have more job security than with asset managers,” Vecchi maintains. “So you attract candidates who have a longer term perspective for performance, which is more in the interest of long-term investors as a pension fund.”
Also, pension funds tend to have smaller investment departments than asset management houses, and many people prefer this more personal working environment. Investment staff at pension funds often have the opportunity to get involved with a far wider range of activities than would be the case at a large commercial firm, with their typical segregation between disciplines.
Apart from these considerations, there are many European pension funds headquartered in the regions rather than concentrated in the financial centres of London, Frankfurt or Paris, as is generally the case with asset management firms. A talented investment manager might opt for a job at a pension fund as a way of getting out of the city.
With €2.6bn in assets to take care of, the Munich-based reserve funds of the European Patent Office certainly have the size to justify maintaining an efficient investment management team within their walls.
The funds have four members of their investment team apart from the fund administrator: a portfolio manager for European equities, one for non-European equities and another who is dedicated to bonds. All the of the fund’s investment is outsourced, says Vecchi, and this is not likely to change
In Denmark, the €5.4bn industry-wide pension fund PenSam conducts 65% of its investment activities in-house. “We have, however, outsourced all activities on foreign and domestic listed equities,” says chief jnvestment officer Benny Buchardt Andersen.
Apart from Buchardt Andersen himself, there are 10 employees at PenSam handling investments.
He agrees that within the industry in general, it is hard these days to recruit investment staff, and PenSam is not immune to these difficulties. But the sheer size of the institution does work as an important weapon in the battle for good candidates.
“PenSam is among the largest pension funds, which means we can attract employees that are interested in large-scale investment handling,” he maintains.
Whether or not a certain type of investment or asset class is put out to external managers or tackled by the pension fund’s own investment team depends largely on the comparative cost of the two options, he says.
“When deciding to outsource we weigh if it is a competency we already have in-house or wish to have,” says Buchardt Andersen. “We look at cost to see which solution - in-house handling or outsourcing - will be most cost efficient. Looking at these scenarios we decide if we want to outsource certain activities or not.”
Even though PenSam still invests most of its assets in-house, there has been a gradual move towards outsourcing over the last few years.
“Since 2003 we have seen more outsourcing in PenSam, starting with our portfolio of private equities and listed equities, and soon after our portfolio of foreign bonds,” Buchardt Andersen explains. “In PenSam we have decided to focus our core competencies on strategic asset selection, tactical asset selection and manager selection, and that is what started our outsourcing.”
Hardly a day goes by without news of a pension fund outsourcing some portion of its investment portfolio to an outside organisation. But is there any chance that in-house investment could become more popular again? Perhaps not on the level of individual pension funds, but rather within collective ventures, Van Pol suggests.
“A comeback might be envisaged in terms of pooling of assets and developing a central global or European centre of excellence of investments,” he says. “But we see more and more multinational companies establishing global directors of asset management in order to pool assets, share expertise and exploit economies of scale.
“However this does not imply direct management of assets, but can also be implemented in a fiduciary role,” he notes.
PenSam’s Buchardt Andersen also sees scant chances of an early return to in-house investment at pension funds. “We don’t think that in-house investment will see a comeback in the near future. We think that the increasing use of alternative investments in institutional portfolios will increase the outsourcing process, and the use of external managers,” he predicts.
Despite the fact that in-house investment may be on the decline among pension funds for many reasons, Vecchi insists that it is still a very good solution for funds above a certain size.
“It is a more economical solution, it aligns the fund’s interest with the investment managers’ and if the staff are good enough, they can generate - as it is in our case - a long-term positive risk adjusted active return,” he says.
UK: personal accounts herald new investment giant
In the UK, the forthcoming National Pensions Savings Scheme (NPSS) - now referred to as the personal accounts system - is set to become a major pensions investment institution. Though decisions on investment strategy are still a long way off, the likely size of the pension scheme could potentially warrant an in-house investment operation.
There will be millions of UK citizens enrolled in the scheme, according to a spokesman for the Department of Work and Pensions. Employees will contribute 4% of salary, with employers putting in a further 3% and the Government providing tax relief of 1%. Assuming five million participants, the scheme could receive around £10bn (€14.3bn) in gross contributions annually.
The body that will oversee the creation of the scheme - the Personal Accounts Delivery Authority - is already in existence. In its response to the consultation on personal accounts, the government said in June that personal accounts would be a trust-based occupational pension scheme, with the legislative foundation of trust law.
The scheme trustees would be ultimately responsible for investment decisions.
The trustees responsible for investment decisions would be appointed in advance of the scheme launch so that they can review this proposed strategy and make the final investment decisions, the government said.
But it has laid out the following principles which the delivery authority will have to bear in mind. Among them are the requirements to delivering low charges to members and provide an appropriate range of fund choices.
Existing trustee legislation requires trustees to take care in choosing investments, the government pointed out. “In addition, investment choices must be made prudently and be sufficiently diversified taking into account the best interests of the members,” it said.
ABP sticks to global competence lines
Confident of its own investment expertise, and as a way of capitalising on its economies of scale, Dutch pensions giant ABP does the lion’s share of its equities investment itself.
Some €74bn of ABP’s €209bn in total assets are invested in equities, and 60% of the equities portfolio is invested in-house, Deirdre Ypma, senior portfolio manager in the fund’s New York office, told the most recent IPE e-symposium.
“The department is organised along global competence lines, resulting in six distinctly different funds that have largely uncorrelated alphas,” she said.
In-house, ABP Equities runs a fundamental stock selection, top-down thematic approach and a fund comprising of purely quantitative strategies, she explained. “Besides investment expertise, the key edge is that we can scale the strategies and therefore contain costs,” she said.
As asset management fees have risen in recent years, this advantage has become even more valuable.
Ypma said there were several reasons why the pension fund would outsource.
For example, the fund might be looking for very specific know-how that was either not available to the fund in the Netherlands, or that it did not want to acquire strategically, she said.
“A second reason could be we are active in market segments where we feel local expertise is vital; another reason might be that we require allocation flexibility and, or, we’re not ready to commit indefinitely,” she said.
Or, she added, another market participant might be able to offer better economies of scale. “Although we’re one of the largest pension funds in the world, there are some [firms] on the asset management side that have better economies of scale on certain strategies.”
ABP Equities outsource most global emerging markets investment, because of the need for local expertise; enhanced index management, because some parties have greater economies of scale, and high alpha strategies, she said, “which require very specialised or local expertise.”