The in-house solution
Ihe case for in-house management of pension assets is strong. There are significant cost savings, with the same or better performance, plus it is easier to meet post-Myners’ requirements for in-house expertise. But there are significant challenges involved; creating an environment in which fund managers thrive is very different from managing an auto-parts factory or running an airline.
I estimate that any pension fund of more than about £1bn (E1.5bn) could cut its investment management costs in half by managing its investments internally. The amount saved will vary with the amount of each type of asset held; the greatest savings are on active equity management, where the fees tend to be higher than on other assets.
External fund managers have to pay for enormous marketing, sales and client relations costs that in-house funds are spared. Indeed, it is not uncommon for external fund managers to spend half, or more, of their time marketing for new clients and communicating with existing clients. Most in-house managers would spend no time on marketing and much less on communicating with the one client.
Each fund manager at an in-house fund has much more time to think about investment decisions, and consequently can be much more productive, and perhaps achieve better performance too, compared with fund managers at external firms.
This concentration on markets is often a major attraction for staff. An in-house environment is ideal for the fund manager whose main love is investing money. At the same time it can also be a disincentive to joining an in-house team. Some managers are frightened that if they lose client facing and marketing experience they might have trouble later in getting jobs with external fund managers. This, and helping the trustees do their due diligence, was one reason why at the TRW/Lucas fund in the UK we went out of our way to have all fund managers give presentations to the trustees.
Because the in-house team is competing in a different job market from that of the parent company, pay-scales and employment conditions must be different. Many in-house efforts have failed to attract adequate staff due a bureaucratic inability to keep up with the pay scales of external fund managers. In some in-house firms, lower pay might have been accepted in the past in exchange for greater job security, but many in-house groups now have as little job security as any city firm. In house groups which fail to keep up with external investment manager pay scales will in the end fail.
Moreover, in addition to pay and conditions, different management styles are likely to be required for in-house investment teams: senior managers need to be aware of that in judging those managing in-house groups.
Staff turnover will follow a very different pattern from that of industrial firms, which tend to have much more stable staff than investment management firms. When the City job market is strong, as in the late 1990s, it may be difficult to retain staff without rapid salary increases, while for the last couple years staff stability has been much easier to attain.
Cover is another important issue. Holiday cover and succession planning mean that more staff will be required than strictly needed for day-to-day management. Keeping this extra personnel motivated requires care. This issue is much more serious than in a large external manager with much larger teams. One extra person in a team of seven is in relative terms much more expensive than one extra in a team of 30.
The head of an in-house management team requires a much broader skill set than is common among external fund managers. Obviously he will require knowledge of all major asset classes, and research experience will also be valuable. Unlike external fund managers, he is also likely to be involved in asset-liability studies. Coverage of important pension issues will be needed too.
Moreover, even with a strong back office head, the in-house CIO will have to give more management time and consideration of operational issues such as settlement, record keeping, computing systems, performance measurement, reporting, accounting, and even office management than would an external fund CIO.
For example, few managers will have seen - much less prepared - pension fund reports and accounts. These accounting reports are very different from the fund valuations normally used by investment managers in managing portfolios and in client presentations. The former are prepared with the prime aim of ensuring all flows are matched by corresponding holdings to ensure precise accuracy and prevent fraud – accuracy is more important than timeliness.
The latter are prepared with the aim of ensuring clear understanding and analysis of significant risks and exposures, with an emphasis on being very up-to-date even at the cost of perfect accuracy down to the nearest few thousand pounds. Translating from one to the other is not a trivial task.
A growing number of external investment managers have concluded that they can get the best and most cost effective back office by outsourcing. The case is even stronger with in-house back offices, where there is not the additional complication of having to deal with multiple custodians. TRW/Lucas was probably the first in-house team to out-source the back office to one custodian. This saved money and improved reporting quality in the first year.
There are some tasks such as establishing performance measurement systems for which the amount of work is greatest for the first portfolio. Writing quarterly investment report on economic and market conditions takes nearly as long for one portfolio as for one hundred.
More generally, although in-house teams should not require constant attention from senior management, they do require it from time to time. A board that is not prepared to suffer the occasional distraction from what it might consider its main business line, should out-source pension investment.
A WM study showed that the average in-house managed pension fund outperformed externally managed funds. At TRW/Lucas, benchmarks were outperformed in all internally managed asset classes. So there is no reason why performance should suffer. But there will occasionally be a bad year, or even a string of bad years, even with the best managed teams. Senior management must be prepared to accept some of the blame when that happens, in a way they might not with external managers.
Regulation is a growing concern throughout financial markets. At TRW/Lucas the cost of regulation rose from nothing 10 years ago to over 10% of costs. This is not the cost of good practice, but rather of doing things that would not otherwise be done, like employing a compliance officer, filing reports, paying fees and devoting management time to regulatory issues.
Aside from these direct and indirect costs of in-house management, there is an unquantifiable gain from having in-house expertise. This is particularly important in the post-Myners environment with the greatly increased requirements for in-house expertise. In some of the surviving in-house managed groups, that has been the main swing factor behind the decision not to out-source investment.
The group that carries out any in-house functions may be owned either by the plan sponsor or by the pension trust. There are arguments and precedents for both options, relating to management skills and the locus of responsibilities. Ownership by the trust is arguably the better option as it will probably lead to fewer conflicts of interest with the parent company; legally the in-house group has to report to the trust, but management might not see it that way.
William MacDougall, formerly an in-house chief investment officer at TRW/Lucas, is an independent investment and pensions consultant in London