Time to shut the back office
This article considers issues involved in outsourcing each of the main areas of a pension scheme, and in particular back office outsourcing. It is based on an operation I successfully carried out at the £3bn (e4.3bn) TRW/Lucas fund in the UK. This was probably the
first case of an in-house managed pension scheme outsourcing its back office.
There are four main aspects to a pension scheme, each of which can be outsourced: administration, investment, custody and investment back office.
Pension fund administration – the receipt of contributions and the payment of pensions, with associated record-keeping – is a distinct group of tasks. It is closely allied with other personnel tasks, such as keeping employee records and paying salaries. Sponsors should consider these together and judge whether outsourcing makes sense.
Below a certain size (perhaps 5,000 employees and 10,000 scheme members), outsourcing probably does make sense. Above some level it becomes an issue of whether the cost savings justify the management distraction. There is also an important issue of staff morale, as much of the work involves direct relations with employees and former staff.
Any pension fund of more than about £1bn will save money by managing its investments in-house. The actual saving will depend on the make-up of the assets, as fees on active equity management tend to be higher than on other assets. It will also depend on how toughly the fund negotiates with external managers.
However, as a rough guide, a £2bn–4bn fund is likely to cut its investment management costs in half by self-management. This is because external fund managers have to cover huge marketing, sales and client relations costs that in-house funds are spared.
For example, when I was directly involved with an asset management group, I personally had 10 clients, each of which expected to see me in person four times a year, not to mention other departmental clients that expected to see me every so often. That is a meeting a week, usually out of the country, with a day to prepare, plus a day of sales presentations to win new business, and a day to prepare for that. Investment somehow had to be squeezed in between.
When I was chief investment officer of the TRW/Lucas pension fund, most of my staff saw the one client – the trustee board – only once or twice a year, while I saw the client perhaps five times a year. There was no marketing.
Each fund manager at an in-house fund has vastly more time to
think about markets than fund managers at external firms, and consequently can be much more productive, and perhaps achieve better performance too.
There is little evidence of economies of scale in investment management above about £5bn in assets. Small boutiques thrive. The growth in hedge funds implies that the industry is becoming less consolidated.
Indeed, the splitting of the role of chief investment officer in some large firms is an admission that there
are actually diseconomies to scale above a certain value of funds under management.
Although funds larger than about £1bn are likely to save money
in-house, there are other important factors to consider. Creating an environment in which fund managers thrive is very different from managing an auto-parts factory or running
Because you are competing in a different job market, pay scales and employment conditions must be different. Many in-house efforts
have come unstuck because of a bureaucratic inability to keep up with the pay scales of external fund managers (and there is little evidence that job security is any better than in City firms).
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.
More generally, although in-house teams should not require constant attention from senior management, they do require occasional attention. A board that is not prepared to suffer that occasional distraction from what it might consider its main business line should outsource pension investment.
A study by The WM Company recently showed that the average in-house managed pension fund outperformed externally managed funds. TRW/Lucas outperformed its benchmarks in all internally managed asset classes during my tenure as CIO. 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.
Moreover, there are many companies where the pension fund is larger than the market capitalisation of the firm. For these, the board ought to recognise that its pension fund is an important part of the firm’s business. As it is impossible fully to hedge pension liabilities without destroying shareholder value, it is inescapable that these firms are in part investment hedge funds. Close attention to that ‘hedge fund’ ought to be seen as an important management priority.
Aside from these direct and indirect costs of in-house management, there is an unquantifiable gain from having 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.
All in all, for any fund larger than £1bn, there is a strong case for in-house management. Indeed one large externally managed scheme is currently considering bringing investment back in-house. Others should do the same.
Custody – the safe keeping of share and bond certificates and other evidence of ownership – is essentially a commodity business. There is a strong trend among external custodians towards consolidation, eventually to perhaps only four or five players. This trend recognises the economies of scale, especially in computing, in the business. This is in marked contrast with investment, as discussed above.
Moreover, pension scheme members, trustees, and company boards ought to gain comfort from knowing that the assets are securely held by an independent specialist. The case for outsourcing custody appears overwhelming.
Investment back office
Investment back-office functions – trade processing and settlement, performance measurement, fund accounting, trustee reporting – are traditionally seen as separate from custody. Most of the schemes that outsourced custody over the past two decades kept many of these back-office tasks in-house. Even more remarkably, many schemes that outsource investment keep some of these bac-office tasks in-house.
This is most obvious in property, where it is very common for the external manager to choose which properties to buy, but for the property management and record keeping to be done in-house. It is also very common for the pension scheme to prepare the report and accounts itself, even though there is a scheme custodian doing the similar task of preparing regular investment valuations.
Among external fund managers there is a growing trend towards recognising the commodity nature of back-office tasks and outsourcing as a result. Nearly all hedge funds outsource their back offices, usually to their ‘prime broker’. But even large external fund managers find that there are significant gains from outsourcing. For example, Scottish Widows outsourced its back-office operation to State Street a few years ago.
Consequently it is surprising that TRW/Lucas was probably the first in-house managed fund to outsource its back office. It is particularly true as the task is much easier for an in-house group with a single fund and with assets held by a single custodian than it is for an external group having to relate to a number of custodians and many clients.
The investment back office is a natural extension of the custody process, and thus it was relatively straightforward to outsource the back office to the fund custodian, State Street. The theory was that everything associated with holding and counting assets should be done by the custodian, while things associated with asset decisions and trading should be done by the in-house investment manager.
At TRW/Lucas we used an incremental approach. The back office is a broad set of tasks. Rather than plan everything for a big bang move to the external provider, we assessed each task in turn, considering whether it made sense to move it to the custodian. We would then implement any changes before going on to consider the next task.
This incremental approach greatly eased the burden of the project, and clarified our thinking. For example, for most of the transition period we thought that we would outsource trade confirmations, and we probably would have done so had we used a big-bang approach.
However, when we came to look at trade confirmations in detail, it became clear that most trade-confirmation work was easy, an almost trivial task to do in-house. The small amount of trade-confirmation work that is complicated requires the involvement of the trader or fund manager who did the trade; in other words the outsource provider would come back to us for anything significant. It became clear that the difficult part of trade confirmations cannot really be outsourced.
Performance measurement is a task that has long been outsourced to WM or CAPS by many pension funds in the UK. However, the difficult part of performance work is data provision, which is still often done in-house. It would better done by the custodian as part of the back-office outsourcing arrangement.
There is likely to be a trend towards custodians providing performance measurement and attribution instead of specialist providers. The custodians are in an ideal position to provide the data, and the calculations are a trivial task once data is collected. Moreover, if the data is not provided by an independent third party, there is a risk of the independence of the resulting data being called into question.
Fund accounting is another important area. Most fund managers have had little exposure to formal fund reports and accounts. Instead they use quarterly or monthly valuations, prepared in quite different ways from accounting reports. There are some funds where the custodian or the external fund manager prepares the valuations, but the scheme does
the report and accounts internally. It is not obvious why; the custodian is in a much better position to do
both tasks, and to ensure that they are consistent.
There were some tasks that were not done before, for lack of resources, such as providing the trustees with a broker commission report. The custodian had the resources to start doing these reports.
Aside from an emerging-markets unit trust and some UK small-cap investment trusts, property was the only asset class managed externally. Yet in common with many other pension schemes, significant back-office work associated with property was done in-house.
Most of this work was transferred to the investment manager (CB Hillier-Parker), with some accounting related tasks transferred to the main custodian. It is peculiar, and generally disadvantageous, that property is often treated differently from other asset classes; these moves were part
of our general view that it should
be treated in the same way as any
other externally managed asset class would be.
As part of the project, we reviewed internal IT provision. Most of the IT system could be closed down as it was redundant when tasks were transferred to the custodian. Fund managers could use the custodian IT system to check holdings, and continued to use their own (checked) spreadsheets for analysis.
In addition, we concluded that the electronic trading system did not make sense; it was merely a very expensive way of sending trade information from the trader to the back office, especially as pieces of paper were sent as well. The main effect was to transfer work from cheap back-office staff to expensive front-office staff. We made the ‘Luddite’ decision to revert to paper trade tickets passed by hand to the back office. People too often forget that it only makes sense to automate where labour or labour costs really are saved as a result.
Overall the back-office outsourcing at TRW/Lucas was a great success. The quality and timeliness of reports was greatly improved. The independence of data provision became better protected.
Moreover, money was saved in the first year. Back-office staff numbers were reduced by 60% (through natural wastage, not redundancies), the new head of the much reduced back office required less experience and so was cheaper, and a very expensive computer system was shut down.
There is also an issue of whether the group that carries out any in-house tasks is owned 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. There is no clear-cut answer as to which is best.
Larger funds should certainly consider keeping or moving administration and investment in-house. All funds – whether internally or externally managed – should use an external custodian, and they should seriously consider outsourcing the investment back office.
William MacDougall is an independent investment and pensions consultant. Before the February 2003 reorganisation that followed Northrop’s takeover of TRW, he was the chief investment officer of the TRW Pension Scheme (formerly Lucas)