Consolidating pension funds has its pros and cons but the investment office could benefit the most
• The leading countries in the Melbourne Mercer Global Pension index 2017 have fewer but larger pension funds
• Consolidation in the UK has been minimal, in stark contrast to the 75% reduction in schemes in the Netherlands
• Admin savings are obvious but investment consolidation could bring about the greatest benefits
Denmark, the Netherlands and Australia, the top three countries in the Melbourne Mercer Global Pension index 2017, which measures sustainability of retirement schemes, all have a relatively small number of large pension funds. Is this coincidence or is the consolidated nature of their pension industries the reason these countries occupy the top slots?
In Denmark, pension funds were designed as sectoral schemes from the start, with the agreement of the social partners. In the Netherlands, while the pension market was designed in a similar way via industry-wide pension funds, there were also many corporate pension funds that did not want to join the union-influenced industry-wide pension funds. But many of these, looking for better governance and economies of scale, have consolidated, decreasing the number of pension funds by 75% over the last 20 years, according to the Dutch central bank.
In Australia, the market was allowed to dictate how many pension funds there were. Market possibilities meant there were 7,000 funds in 2006, but Australian Prudential Regulation Authority data show that transparency and competition reduced this to just over 2,000 in 2016.
In contrast, the UK pension market has more than 6,000 pension funds, having declined marginally over the last decade. The disaggregated nature of the market is certainly a benefit to scheme providers but what about the schemes themselves? An obvious example of the diseconomies of the current structure is that each of the 6,000 schemes pays an actuary to come up with an assumption of future inflation to be used in the triennial actuarial valuation, yet most of these assumptions will be exactly the same.
The savings in general administration costs might be obvious, but it is in the area of investment that the benefits of consolidation are more likely to be the greatest. In the public sector, government intervention has led to the important creation of the Local Government Pension Scheme (LGPS), which consolidated 89 investing entities into eight. With 6,000 schemes, the potential savings for private-sector pension schemes are even greater.
“Schemes with different investment beliefs might also require different portfolios. The governance structure needs to be flexible enough to cope in the face of crisis, ensuring all the schemes within the consolidated model get enough attention”
Each of these 6,000 pension funds has some form of governance infrastructure, with trustees, one or more committees, a pensions director, and dedicated finance, administration and investment staff for the bigger funds. Despite this expense, most are juggling too many tasks with under-resourced teams.
Investment management is typically outsourced to external providers, as is investment advice. Providing proper oversight over these outsourced activities is essential, given the agency issues associated with outsourcing in general, and with highly valuable and complex issues like investment management and advice in particular. Many schemes struggle to demonstrate clearly the benefit that is delivered from this expense. From an economic perspective, consolidating 6,000 ill-equipped buyers of investment management and advice makes eminent sense.
A consolidated vehicle, for example the LGPS, is able to properly staff an internal pensions investment office with a chief executive, a CIO, a COO and, importantly, a chief risk officer. The more professional the investment office, the easier it will be to attract high-calibre staff. The larger the investment office, the easier it will be to provide career progression, retain high-calibre staff and reduce the impact of key-person risk.
Other important advantages are the ability to ‘right size’ (if an organisation only needs one third of a chief risk officer, for example, the result will often be not to employ one), to pay for professional trustees and committee members, and to implement the correct governance structure, where trustee boards concentrate on strategic issues and operational aspects are dealt with by the investment office. If properly staffed, the investment office will have the expertise to deal with investment-related technical and operational issues far better than the trustee board.
The increased scale and expertise of an investment office servicing a large number of pension schemes allows efficiencies in the use of external consultants (including actuarial, investment and legal) but also in the use of internal resources. The cost of risk and portfolio-management systems can be shared, as can the cost of risk analysts. Other specialist oversight expertise can be insourced, eliminating, for example, the fund-of-fund costs for alternative investments. In short, the pension fund can be run as a business.
The list of advantages does not end there. A larger asset base makes the pension fund a more attractive proposition as a preferred investor (or co-investor with other asset owners) for non-public assets, enabling not just better fee arrangements but also better asset diversification. This should improve the financial experience of members, sponsors and taxpayers (in the case of the LGPS).
Consolidation involves pitfalls, of course. It is important for consolidators, including the LGPS funds, to learn from some of the painful lessons elsewhere.
Probably the most important lesson is not to underestimate the difficulty of moving from a single captive client model to a multi-client one. This requires not just systems, efficiencies and changes in working practice, but importantly a change in culture, which can take many years to accomplish.
It is crucial to get the governance of the consolidated organisation right, with the appropriate levels of delegated decision making, incentive structures, and balance between internal and external resources. We have already seen some of these difficulties being experienced within the LGPS environment.
Another pitfall is overestimating the efficiency gains that can be realised. Schemes with different pension deals, different funding levels and different liability-maturity profiles have significantly different needs, not just in terms of investments available but also in terms of the investment staff supporting them.
Schemes with different investment beliefs might also require different portfolios. The governance structure needs to be flexible enough to cope in the face of crisis, ensuring all the schemes within the consolidated model get enough attention.
We have seen the early stages of consolidation play out to mostly excellent effect in the defined-contribution master-trust market, arguably prompted by the UK government’s intervention via the establishment of NEST to show what could be done.
There are already some consolidation models within the defined-benefit market that deliver many of the benefits listed here, but it appears difficult for those charged with the governance of individual schemes to even consider the possibility that another model might deliver better outcomes for their members than they can.
Hopefully it will not require another government intervention – as was necessary for the LGPS – to prompt a change in attitude.
Bart Heenk is managing director at Avida International. Sarah Smart is senior adviser at Avida International and chair of TPT Retirement Solutions