Mariska van der Westen and Miranda Schoutsen report on the growing trend of Dutch pension fund consolidation. What is the optimum size for a pension scheme?

Of course, consolidation can be a good thing: after all, economies of scale are well documented when it comes to pension funds. But there are signs that small Dutch schemes are being liquidated for all the wrong reasons, particularly out of sheer frustration with the proliferation of burdensome rules and regulations. Which raises the question: is the current consolidation trend in the best interest of plan participants?

According to Rob Bauer, professor of finance at Maastricht University, his research clearly shows that large pension funds generally achieve better investment returns than smaller ones. And the smaller the pension fund, the higher the costs per plan participant, according to a study by APG director Onno Steenbeek and DNB researcher Jaap Bikkers.

Looking at the cost of the two primary services a pension fund has to buy - benefit administration and asset management - size definitely matters. The bigger you are, the better the deal, says Edward Snieder of consultant KPMG.

But not everybody is convinced, particualrly when it comes to performance. "I don't believe for one minute that smaller schemes underperform larger schemes," says Ben Kramer, Netherlands country head and executive director at F&C Asset Management. "If I look at our own client base, smaller schemes certainly don't trail the larger ones."

According to Kramer, small funds have several advantages. "Large schemes have all kinds of political interests to take into account and are weighed down by cumbersome bureaucracy where everyone has to tick a box before anything at all can be accomplished," he says. Smaller schemes are generally governed by apolitical, pragmatic thinkers with efficient decision-making processes that allow them to shift gears quickly, "and that works out really well, particularly considering the current interest rate environment and present volatility," he says.

As far as he is concerned it is "utter nonsense" to want to further diminish the number of small funds, "as I don't see any reason why on earth a €600m fund would perform less well than a €40bn scheme."

And if size is supposed to help contain costs, then why aren't the large schemes reporting lower asset management fees, asks Lodewijk van Pol, director of fiduciary management at Lombard Odier. Big players such as the €246bn Dutch civil servants and teachers scheme, ABP, and the €111bn healthcare scheme, PFZW, have so far failed to negotiate lower fees despite their size, he says. "When I hear that PFZW pays some 40 to 50 basis points, I think that is very high indeed. Our clients' assets under management amount to but a fraction of PFZW's AUM and yet they pay much lower asset management fees," says Van Pol.

Risky matters
Besides, even if larger schemes should achieve higher investment returns and lower cost, many are not convinced that this necessarily means plan participants are better off in the end. Smaller pension funds may actually deliver the bigger pension bang for the buck. After all, returns and costs do not tell the whole story. There is the not-so-small matter of risk to consider.

According to his database of 40 pension funds, smaller pension funds suffered much smaller losses in terms of funding ratio during the last crisis, says van Pol, a finding that is corroborated by IPNederland's own research. "There's a clear linear correlation: the bigger the pension fund, the more risky its investments," says Van Pol. "The largest five schemes have the highest risk profile both in terms of investments and capital requirements."

Bauer agrees. Smaller schemes actually achieve better returns in traditional asset classes because they are more likely to opt for passive management. "Large schemes are more inclined to try and beat the market and achieve lower returns in equities and fixed income because of this."

On the other hand, he adds, larger schemes achieve significantly better returns than smaller schemes when it comes to riskier asset classes, "particularly private investments such as infrastructure, private equity and property: these asset classes require close monitoring and larger pension funds can do this at a relatively low cost, thanks to their size."

One obvious choice for smaller schemes would be to stay away from riskier assets altogether. Alternatively, smaller schemes that want to further improve their investment returns should consider ways to achieve economies of scale, for instance by collaborating, says Bauer: "That way they can enhance their performance by moving into private investments, while keeping costs low."

Whether or not moving into riskier assets is a wise move, however, cannot be determined by size alone but should depend on a scheme's risk budget, or funding ratio, cautions Van Pol. Henk Beets, director of consultant First Pensions, couldn't agree more. Investment returns in themselves are meaningless, he says: to make sense, risk and returns need to be looked at in relation to a scheme's liabilities.

Beets examined the performance of the top 50 Dutch pension funds this way. Of course, looking at the top 50 means that the smallest scheme has assets of a couple billion euros, rather than, say, €100m. But even so, his findings, once again, show that smaller size funds do not perform worse than their larger peers. "On balance, schemes that have paid more attention to interest-rate risk have added more value to their participants. This has turned out to be the crucial issue over the past few years," Beets says. "We have also assembled data on governance and pension administration costs, but they are nothing compared to the impact of interest rate risk."

Investment returns are, without doubt, scale-dependent, but managing liabilities is a different story altogether, and it may well be that larger schemes fail to match their liabilities more often than do smaller schemes, says Bauer: "This is something that would have to be reviewed over a longer period of time." And although he is convinced that bigger is better with regards to returns, he concedes that larger schemes aren't always superior investors: "Large pension funds tend to spend too much money on active management." In addition, they run the risk of negatively impacting the market, particularly when trading smaller stocks. "That is why it's not surprising that they perform less well in traditional asset categories."

Clearly, size is no panacea. "A size of up to €20bn AUM is fine. Pension funds of that size can still manoeuvre freely and have no trouble finding what they need in the liquid swap markets. But anything over €20bn? One has to wonder if that can still be applied efficiently," says Kramer. "I would not be at all surprised if the larger pension funds in The Netherlands seek ways to break themselves up into smaller, more manageable and more efficient parts in the years to come."

As for the optimal size in terms of assets under management, opinions differ. According to Snieder, a minimum of €2bn is generally accepted as the minimum AUM required. Others disagree and point out that smaller size funds can be invested just as efficiently, if not more so.

Bauer doesn't think there is an ideal size. "My colleague, Keith Ambachtsheer, has suggested €20bn as ideal, but that would leave just 20 schemes in The Netherlands." He does strongly believe that smaller funds can improve their returns by seeking economies of scale, but suggests it may be best they do so by pooling their asset management in some way, without actually merging in terms of governance: "I believe that will add more value than actually merging schemes."