Downsizing, spin-offs, changes in management: many reasons can lead a company to decide to outsource the complete management of their pension plans. An increasing number of US companies are following this path, but it is difficult to assess the size of the “fiduciary outsourcing” business in the US, because the term may include different levels of buying third-party services.
According to some estimates, something around $30bn (E33bn) in American DB (defined benefit) pension funds’ assets are outsourced, up from $18bn five years ago. The practice is even more popular with defined contribution (DC) plans, where traditionally companies want to minimise their role in managing employees’ retirement savings.
In an outsourcing arrangement, a third party takes over all kind of operations related to a pension fund and becomes its “named fiduciary”. Independent consultants like Watson Wyatt are in this business, as well as consultants that offer multi-manager investment funds like Frank Russell Company and investment companies like State Street Global Advisors, Merrill Lynch, Fidelity and Vanguard.
“Cost cutting is not the only reason for outsourcing a pension plan – explains Howard Crane, head of Watson Wyatt Investment Consultants in the US and chairman of the Advanced Investment Solution Operating Committee (AISOC), that deals with outsourcing issues. “Sometimes a company is not satisfied with its plan and doesn’t want to worry about it any more. It realises it doesn’t have the internal resources to fix the problems and instead wants to focus on its core business operation. So it ends up hiring a third party to take on all the responsibilities”. But the trend is not so smooth and quick. “Typically companies tend to keep strategic functions inside, especially in DB plans and they use consultants to implement their own decisions”, points out Crane.
When a company is undergoing a major management change, that could be the occasion also for rethinking the whole retirement benefit system. A new chief financial officer (CFO), for example, doesn’t want to manage the pension plan he has inherited. A consultant like Watson Wyatt can provide all services necessary to run the programme. First of all, the consultants’ actuaries make the asset /liability study and, based on this, the consultant suggests the proper asset allocation and risk diversification. The company approves the strategy and, from that point on, the consultant is responsible for everything: he selects and hires the managers to implement specific investment recommendations without going back to the company for approval; he hires the custodian and handles administrative services.
There is a difference between a ‘pure’ consultant and who also offers a manager-of-managers product. The latter could be alleged of a conflict of interest, because he has special agreements and relationships with the investment managers included in his selection. But the leaders in this business don’t see a problem with being both a representative for the plan sponsor and a representative of the investment manager. Performances and benchmarks are there to measure the managers’ results and who does not meet expectations is replaced, notwithstanding his relationship with the consultant.
Watson Wyatt’s approach is contrary. “We keep separate different businesses – says Crane. “For example, we don’t measure the performances of the investment managers we hired. It is the custodian, that we hired, who has to track the performances and provide reports both to the company and us. Then it’s us who decides to replace a sub-performing money manager, because we control all the decision process, which is a good way to demonstrate our best practice”.
In DC pension plans – mostly 401(k) plans – outsourcing the day by day operations is a very common practice. Especially small and mid-size companies may be particularly overwhelmed by myriad tasks: monitoring the performance and suitability of the investment opportunities offered to employees, keeping abreast of statutory and regulatory changes, running educational programmes for participants, attending training sessions, lectures and seminars and administering plan recordkeeping and reporting. They solve all these problems outsourcing all their duties to one-stop providers, with a preference for retail oriented solutions: big names of the mutual fund industry like Fidelity, Vanguard, Merrill Lynch can manage of the aspects of a 401(k) plan with a bundled, all-inclusive service. Companies like it, because they think it minimises their liabilities.
But there is also the unbundled option, offering services such as recordkeeping and investment management separately. “The unbundled approach can be more efficient - says Crane . “In fact, bundling services can mean higher costs due to missed opportunities. We can identify the best in class for each function, from the recordkeeper to the plan administrator and investment managers, and at the same time find the lowest costs.”
The trend to unbundle 401(k) plans’ outsourcing is quite strong, according to Patricia Pou, consultant with William M Mercer. “We help clients select the funds to be offered in the plan, which are usually ten to 12 for midsize companies; the plan administrator; the recordkeeper and also, if they want, a financial adviser to assist employees in their investment decisions”.
Financial advice for 401(k) participants is a very sensitive issue. Retiring employees are starting to file lawsuits against their former employers because their investment choices didn’t increase their savings enough to pay for retirement – according to a recent report of the Journal of the American Institute of Certified Public Accounts (CPA). In one case, employees who participated in a pension plan maintained by Unisys Corp. charged the company had breached its fiduciary duties by investing in guaranteed investment contracts (GICs) offered by Executive Life Insurance Co. The employees claimed Unisys knew of Executive Life’s financial troubles and should have warned plan participants. The court ruled in favour of Unisys, affirming the company satisfied prudence standards.
But companies are growing more and more careful and aware they need to be cautious in communicating with employees. On one hand they are supposed to financially educate employees according to ERISA (the US pension law) on the other hand they can go too far in providing financial advice. “Rules are changing – says Pou – and will allow more financial advice to 401(k) plan participants”. In the meantime companies either offer participants enough choices to deal with liability concerns or outsource the “financial education” to the mutual fund vendor.