Outsourcing investment: hit or miss?
Does investment outsourcing add real value for pension schemes and their members? Award winning journalist Stephanie Hawthorne weighs up the pros and cons
In an era of cost cutting and retrenchment, outsourcing is arguably one of the great business successes of the past two decades. When it comes to a large pension scheme with tens of thousands of members and billions of pounds of assets at stake, can it still pay dividends for sponsors and savers?
As most defined benefit pension schemes approach the end game, sponsors have outsourced all they can – operations, administration and even the selection and monitoring of investment managers, increasingly through a much-touted new initiative from pensions consultants – fiduciary management. Indeed, according to Isio research, the Outsourced Chief Investment Officer (OCIO) market now commands assets of more than £200bn. The reasons are manifold. Regulation has intensified, operational costs have risen, and investment complexity has increased.
Virtually all small pension schemes employ external managers. But a seminal moment came in June 2021 when the Airways Pension Scheme and New Airways Pension Scheme, two of the UK’s largest corporate defined benefit schemes, managing pension benefits for over 85,000 British Airways Scheme members and beneficiaries outsourced a stupendous £21.5bn of their assets to BlackRock.
Commenting on this transaction, Penny Cogher, partner in law firm Irwin Mitchell said: “This is the biggest deal on record in the UK and this may lead a movement of other large companies to outsourcing investment management.”
Other notable schemes which have moved to outsourced investment management include Nestlé and National Grid. Why the change? Kerrin Rosenberg, CEO of Cardano UK, sums up:;up; “The bottom line is that commercial investment managers can usually offer a lower cost solution that is higher quality than most internally managed solutions.”
Outsourcing asset management allows the main stakeholders (typically trustees) to focus on their journey plan: where they’re going and what the total portfolio needs to do to get there (the investment objective). William Parry, associate partner at Aon, expounds: “They can then outsource a range of issues, for example, investment decisions so that professionals monitoring the portfolio on a daily basis can react to changes in markets much more quickly; operational ones such as managing disinvestments to meet cashflows; and commercial ones such as fee negotiations to ensure value for money for members.”
Investment outsourcing: pros and cons
Sources: Irwin Mitchell, Law Debenture, Willis Towers Watson, Cardano
Despite the disadvantages of investment outsourcing, pensions are tightly regulated, and assets are well safeguarded.
Formal written advice under the Pensions Act is required to invest in a regulated vehicle which protects trustees from companies looking to use the pension scheme pots unscrupulously as in the Maxwell scandal. Indeed, there are few significant risks in outsourcing investment management. But Natalie Winterfrost, trustee director, Law Debenture, does warn: “there is usually no long-term guarantee on the fee level. “She adds: “it being a highly competitive industry, with significant downward pressure on fees and nothing to stop most mandates being switched from one investment manager to another, any such risks are muted.”
Fiduciary management in favour
The biggest trend in outsourcing is the rise and rise of fiduciary management where day-to-day investment decision-making and implementation is delegated with trustees retaining responsibility for deciding high level investment strategy such as risk and return targets. William Parry, associate partner at Aon, estimates: “Around 20% of pension schemes work with a fiduciary manager which (in turn often outsources security selection to a third-party manager).”
The Competition and Markets Authority has recently shone a spotlight on this area. Now trustees looking to outsource investment management must abide by the mandatory tendering requirements which came into force in December 2019 because. Cogher notes that the rise of fiduciary management led the CMA to conclude “there was an adverse effect on competition in the investment consultancy market and fiduciary management market.”
Tenders are now usually required from at least three parties prior to an appointment but Parry warns: “The more tasks that are outsourced, the greater the potential risk that the party you outsource to starts to err, as you become increasingly reliant on them. This makes it extremely important to set out up front the measurable goals and getting reporting against them.”
Trustees are still responsible for investments as Cogher explains “even if you outsource aspects to the fiduciary manager and, even if you outsource it, you still need to completely understand asset allocation and what you are invested in. If you have a fiduciary manager who is investing in asset classes that you don’t understand, how can you really ensure that they are doing the right job? Try comparing it to outsourcing administration. It is important to spend the time developing the right metrics with you.”
Outsourcing is catching on in the defined contribution world too. Asset manager-owned DC master trusts usually use their own teams, but other master trusts will typically use outsourcing. Nest, the not-for-profit pension scheme, with 10 million members and managing £20bn is targeting an allocation of 5% of its AUM to private equity, an estimated £1.5bn by the end of 2024. Over the next 20 years, it expects to invest around £80 billion.
Commenting, Stephen O’Neill, Nest’s head of private markets, said: We want private equity to play an important role in our portfolio, offering strong returns and diversification” but there are liquidity risks associated with DC which uses daily pricing. Other DC funds have so far feared to tread into illiquid assets partly because of this and the 0.75% charge cap imposed on DC default funds.
This introduction of the charge cap, although largely beneficial, has led to untended consequences such as deterring investment in alternatives.
Charge cap issues
Many feel the charge cap does constrain investment strategies. Indeed, Kerrin Rosenberg, CEO of Cardano UK stresses: “It stifles innovation and has also encouraged “herding” around high passive equity exposure. As it happens stock market returns have been very strong over the last decade, so the proponents of the charge cap will argue that results have been great and costs low – a win-win.” He adds: “it does mean that DC schemes are taking a lot of risk and in a severe equity market crash they will suffer hugely, with potentially very negative consequences to the savers.”
Recent changes in regulations stemming from the Pension Schemes Act 2021 allow some smoothing of the charges but this may not be enough to remedy one perverse consequence of the rules as Winterfrost points out: “The alternative manager might perform particularly well, such that outperformance fees and carried interests lead to the breaching of the charge cap.”. She believes; “The move to smooth these charges seems insufficient to alleviate concerns.”
But “there is significant industry engagement underway to help mitigate this problem including the consultation on smoothing performance fees and the long-term asset fund (LTAF) being considered by the FCA,” notes Katie Sims, head of multi-asset growth in Willis Towers Watson’s specialist portfolio solutions team.
One obvious no brainer outsourcing decision is for investing in passive funds as Alistair Byrne, head of retirement strategy at State Street Global Advisers Street, enthuses: “While the largest schemes and master trusts can amount to billions or even tens of billions of pounds of assets under management, the largest index managers now amount to multiple trillions, and so can deliver very substantial economies of scale, and efficiency in areas like trading. These benefits may be difficult for even a very large pension scheme to replicate.”
A few pension schemes have even gone the other way and repatriated externally managed funds in house, including a portion of Pension Protection Fund assets. Parry believes: “It’s definitely a less well trodden path – the market dynamic now is towards more outsourcing/ consolidation not less. That said, it wouldn’t be impossible “.
Worryingly, schemes don’t always get the maximum value for money when it comes to outsourcing. Joe Dabrowski, deputy director policy, of the trade association, PLSA, cites evidence from the regulators that “smaller schemes often face higher costs from managers. He advises using “resources such as the Cost Transparency Initiative” to “provide greater oversight of costs.”
Track record for outsourced arrangements
The track record for fully outsourced arrangements is relatively short. Keira-Marie Ramnath, director in the pensions team at PwC, points out: “Overall, on average, Outsourced Chief Investment Officer (OCIO) managers have met client objectives. The firm believes: “on average, they have done better than a number of large UK defined benefit pension schemes.”
In conclusion, the jury is still out on outsourcing but one thing is clear - detailed performance comparisons with pension peers are not readily and freely available at no cost as a matter of course to the pensions industry and even more so to pension savers and consumers – perhaps regulators should grasp the nettle and insist on such performance comparisons for all UK pension funds – arcane bespoke benchmarking is not enough. The retirement income of millions of pensioners and their whole financial future depends on total transparency from the industry . Yet too often abstruse annual reports and investment statements are a miasma of opacity. Time for change.
About the author: Stephanie Hawthorne
Financial journalist Stephanie Hawthorne is an honours law graduate of King’s College, London. Winner of numerous prizes for her writing, Stephanie has been a financial journalist for over three decades. She began her career as a researcher/marketing specialist for a national financial independent adviser and subsequently a leading life office, moving on to Financial Times’ Money Management where she was deputy editor. Her former editorships include Pensions World and Counsel: Journal of the Bar of England and Wales.
She has contributed articles to The Independent, The Times, Sunday Times, The Sunday Telegraph, The Observer and The Mail on Sunday, the Financial Times and the ’I’ Newspaper.
She also writes on property and legal issues both for consumer and professional magazines.