Top 400 Asset Managers: The challenges posed by a rapidly changing pensions landscape
Nigel Birch and Nils Johnson see an increasing bifurcation between product specialists and solution providers in the asset management industry
The institutional investment market has long been dominated by defined benefit (DB) pensions. In Europe, around $3trn (€2.3trn) of assets sit in these vehicles, of which the majority are in funded, private sector schemes. For several decades, the management of these assets has been controlled by a cosy oligopoly of banks, consultants and asset managers. This market was stable, un-dynamic and very profitable. Unfortunately, the status quo is now changing and the consequences are rippling across the institutional investment pond, with significant impacts on all stakeholders.
There are two major drivers changing the pension landscape, both of which mean sponsors are no longer willing to tolerate DB pension risk. The first is the much discussed 2008 financial crisis and ensuing recession. The economic events of the past five years have completely undermined the previously stable funding and investment model for private sector pensions. It is now obvious to everyone that the promises that corporate sponsors made to their employees for a guaranteed income in retirement were unrealistic and unsustainable given the economic situation that the developed global economy finds itself in.
The second, and less frequently discussed, driver is globalisation. The international approach to investing that many large pension funds pioneered is resulting in finance directors of large developed market multi-nationals competing directly with developing market companies for investors’ attention. A huge DB pension liability is a hindrance to a firm’s share price that emerging market companies rarely have to consider.
As a result of these two factors, among others, sponsors are closing schemes to new members and future accruals to limit the risks and control the financial obligations associated with defined benefit (DB) pensions. Where they are not closing and moving to pure defined contribution (DC), DB schemes are restructuring, first by moving from final salary to career average, and when that fails, by looking to implement a defined ambition structure of benefits. But precedent tells us that where sponsors can minimise the risks associated with workplace savings, they do it, and that a defined contribution structure enables them to do this. Within five years there will be few true DB schemes open to new members in Europe, and only a minority of schemes will continue accruing benefits for existing members. The vast majority of retirement provisions will be DC.
How will this affect the market?
We have already seen the trend from asset growth to liability management in European pensions and the advisory business is the next sector in the pond to be impacted by the funding and governance problems of pension schemes. Actuarial and investment consultants respectively have for years been profitably advising on the liabilities and assets of scheme balance sheets. But it is now clear that the trend in the UK to close schemes has reduced – and may eventually eliminate – the need for advice on pension liability forecasting and pension asset management alike. Forward-looking advisers have understood this and are re-inventing themselves as holistic solutions suppliers overseeing the whole of the balance sheet and looking to embed advice into new products and assembled solutions with an ongoing fee income stream. This more often than not involves consultants building essentially asset management capabilities – the jury is still out on whether they will be successful in building, resourcing and managing this very different capability.
DB end-game in sight
The changes that have hit sponsors, trustees and advisers have taken longer to reach the investment management community. This is in part because of the persistence of hope over reality for equity-like returns. It is also due to the entrenched interests of advisers and trustees to maintain the status quo. But the relentless growth in LDI and rise in diversified growth solutions now points to a faster decline in traditional equity and balanced mandates. Once yields start to rise, many providers expect a rush for the exit as the affordability of de-risking, scheme closure and buyout becomes more attractive. The end game for DB pension management is suddenly in sight, albeit still much further away than many predict.
Managers must change models
Many investment managers are suffering from cognitive myopia – the condition that prevents you from seeing the bigger picture because it is too painful to accept. Typically, the biggest firms with the most to lose have been most afflicted. Smaller firms with specialist skills, solution-type products and a smaller legacy book to defend have been the winners to date. These include specialist LDI providers, leading diversified growth fund manufacturers, DC default fund assemblers, workplace-focused administrators, and income focused, at-retirement specialists. The common characteristics of these future world winners is an alignment with their clients’ needs and individual member outcomes, and solutions in which advice is embedded into an mix of products to provide a more holistic outcome-orientated solution. Of course not all investment managers will transform themselves into solutions providers overnight. There will always be a need for product specialists to work with assemblers of solutions as component suppliers.
For those firms that decide to focus on manufacturing, there are four critical success factors that will distinguish the winners from the losers. First, more than ever before, it is critical to deliver superior performance in investment returns. In an open-architecture world where fellow investment professionals are your clients, there will be no hiding from poor performance behind relative benchmarking, expensive dinners or obfuscated attribution analysis.
Second, you have to know your niche. It is likely that the investment universe will become increasingly bifurcated between low-cost vehicles such as exchange-traded funds and higher cost vehicles such as active asset allocation funds. Third, knowing your intermediaries is closely related to this success factor as the end investor profile will differ depending on the type of consultant or platform that you are dealing with.
Last, you need to know your margin and defend it as the new buyers of funds in the solutions world will be relentless in clawing back basis points from your cost of manufacture. Put simply, a competitive edge gained by reducing fees will ultimately get passed down to cost savings in other areas, which in the long-term affects your performance, and the vicious cycle has begun.
The learning curve for investment management firms that pursue the solution approach is significantly steeper than their product-focused peers.
First, they must build and maintain direct relationships with their clients. This places a tremendous emphasis on non-saleable services such as client servicing, advisory, education, and new skills such as listening. Importantly, these providers need to be able to align their business models with the interests of their clients. To do this, business conflicts must be removed or managed through a new level of transparency. Performance and remuneration should be measured against and aligned with clients’ long-term strategic objectives, and providers must be able to simplify complex tools and ideas in a way clients can truly understand. Alongside, but also linked to, aligning interests, solution providers must see the value chain as a source of opportunity rather than competition; open architecture will be important and partnerships with leading product specialists will be an increasingly common approach. Importantly, the economies of scale required to enable the depth and rigour of operational tasks, the investment power, systems, resources and talent should not be underestimated. For this reason we expect consolidation in the number of solution providers over the next five years.
The changes taking place in the institutional market are already evident and the effect of this on institutional service providers is already evident. There are opportunities, but in the short term they may not necessarily look all that attractive. Investment is required, margins and or volumes may be small, distribution may be complicated, and demand may not be established. Despite this, action is required, and not acting while the industry changes around you is a very bold decision to make indeed.
Nigel Birch and Nils Johnson are directors at Spence Johnson