The Control Conundrum
October 20, 2010

Pension fund trustees have been through a steep learning curve. Since the global financial crisis has taught them to take on a more active role in the management of their scheme's assets, as part of their fiduciary duties, they have found themselves grappling with a business of multi-layered complexity.

Faced with the need to repair funding gaps and increased pressure to meet growing liabilities, pension fund trustees have been looking to cut costs to reduce the drag on their fund's overall performance. One solution is to bring the fund management function in-house. A number of pension schemes have gone down this route. But the risk with this strategy is that any savings made could potentially be at the cost of an underperforming fund.

As well as lower costs, the justification for bringing fund management functions in-house is a closer control over the investment process. In fact, says Ashish Kapur, DC product specialist at SEI, a fiduciary manager, "if the pension fund trustees are following the same strategy as the fund manager, then probably the in-house solution is cheaper." But the reality is more complex, as such a strategy has a number of pitfalls.

The need for a fully diversified portfolio of investments would force a pension scheme to employ a full range of fund managers, backed up by a research team, says Kapur. Such an infrastructure introduces a cost threshold that excludes all but the largest pension funds from managing their assets in-house. Normally, only the largest pension fund schemes can afford an in-house fund management teams. The biggest is Norway's oil fund, known as the Government Pension Fund – Global. Its has assets of $450bn, which are managed by Norges Bank Investment Management, a part of the Norwegian Central Bank, on behalf of the Ministry of Finance.

Alongside the sovereign wealth funds in the pension fund super league are the two biggest Dutch industry sector schemes – ABP and PFZW (formerly known as PGGM). Both have in-house management teams, driven by a decision taken in 2006 to separate policy (or the structuring of pensions) and implementation (managing the assets and payout). Today, the assets of Dutch pension fund giant ABP, worth some $270bn, are managed by APG Investments, a subsidiary that was handed responsibility for the fund's management in 2008.

But APG too has its own specialist in-house management teams. APG's private equity portfolio (worth about $50bn) is managed by AlpInvest Partners (formerly NIB Private Equity), an ‘independent' private equity specialist owned by ABP and PFZW, the firm's only two shareholders. AlpInvest is an ‘in-house' team in the sense that the bulk of ABP's private equity assets are handled by AlpInvest. Similarly, New Holland Capital manages a €7 billion portfolio of hedge fund investments for APG Investments. NHC provides APG with continuity of professional management of its hedge fund portfolio. NHC was founded in October 2002 as ABP's internal fund of hedge funds team and completed a spin-out in late 2006.

As with ABP, so with PFZW (formerly PGGM), the second of the two Dutch pension fund giants. In 2006, PGGM's assets were transferred to PFZW, leaving PGGM to act as fund manager of the bulk of the assets, as well as those of other funds, a portfolio worth more than $140bn. AlpInvest Partners manages its private equity portfolio alongside that of ABP.

In the UK, the BT Pension Scheme (with an AuM of $51.2bn) is 100% owner of UK fund manager Hermes. According to Hermes, being owned by its biggest client gives it a unique insight and close alignment to the needs of BTPS and other long-term investors. Chris Goudie, executive director in charge of Global Business Development and chief executive of Hermes Fund Managers, North America, at the time of his appointment in June this year, said: "Hermes presents a unique and exciting proposition to the plan sponsor community. Our ownership structure and our tradition as a responsible asset manager, align our interests with those of the plan sponsor. The commitment of our parent to our success, is clearly visible through their investment and support as we have built-out a confederation of high alpha boutiques. We are now in a position to provide creative solutions across multiple asset classes and risk profiles."

Just as PGGM and ABP were spun out of state pension funds, so Hermes (originally known as PosTel) was originally the investment management team of the Post Office Staff Superannuation Fund, when the fund split to become the Post Office and British Telecommunication Staff Superannuation Schemes. In 1995 the Trustees of the BT Pension Scheme bought the 50% holding in PosTel owned by the Post Office scheme, and PosTel's name was changed to Hermes.

As with APG Investments and PGGM Invest, Hermes was originally focused on managing the funds of its owner. Until November last year, Hermes had a small UK-focused sales force, but now also has business development teams in Boston and Sydney. In the first four months of this year, it raised $500 million for seven separate investment strategies. From being an in-house fund manager, Hermes has set out to become a leading fund manager in the third party market in what it describes as "probably one of the biggest expansions of distribution capability anywhere in the sector in recent years".

Hermes is structured as a multi-boutique asset manager that offers investment solutions ranging from private equity, fund of hedge funds and commodities to real estate, fixed income and specialist equity products. Hermes remains the principal investment manager for its owner, the BT Pension Scheme, but has also signed up 180 other clients. It has £24.6bn under management (as of December 2009), with more than £40bn under the stewardship of its Equity Ownership Service, a division that helps pension funds meet the demands of responsible long-term investing.

In Switzerland, one of the biggest funds belongs to Nestlé, whose total retirement benefit assets peaked at $26bn at the end of 2007. Over the financial crisis, the total dropped to $23bn by the end of December 2009, according to company accounts. In common with its Dutch peers, Nestlé decided to separate the pension fund itself from the management of its assets, following a strategy of shared pension fund management services made available across the group, with the aim of lowering costs and boosting net asset performance, while strengthening Nestlé's overview of group pension assets.

In January 2007, Nestlé Capital Management was set up to take over from Nestlé UK Pension Trust the running of the company's in-house Robusta funds. The group was tasked with providing cross-border investment and advisory services to any Nestlé pension fund based in Europe or elsewhere.

Set up at the same time was Nestlé Capital Advisers to offer actuarial and other related services. NCA took over as investment allocation manager for all of NCM's funds. The subsidiary's role is to offer strategic advice and to be a one-stop-shop for any services required by Nestlé pension funds around the world. Under this system, each individual Nestlé pension fund will continue to be under the responsibility of the relevant local trustee board.

In the US and Canada, the large retirement schemes and university endowment funds such as Calpers, Canada Pension Plan, Harvard and Yale typically can afford fully resourced investment boards to handle the management of their assets, most of which is outsourced to fund managers. Further down the AuM league, however, outsourcing the fund management function can become an unwieldy process for trustees with limited technical qualifications or experience to manage an increasingly complex business.

Step forward the fiduciary manager, a concept Anton Nunen set out in a book he wrote in 2001: "One major concern was that the fleet of managers used by pension funds had often grown too large and unwieldy. A more basic concern was that the modern portfolio theory paradigm meant that nobody really had broad responsibility. The division of labour among plan sponsors, consultants and investment managers meant that everybody had a narrow range of interests."

Fiduciary management refers to the outsourcing of pension fund management to a single third party. This manager would normally take over responsibility for advice, portfolio construction, manager selection, monitoring and reporting. The trustees decide on an overall investment strategy, but the fiduciary manager takes responsibility for the asset mix, benchmark selection, risk budgeting and the hiring and firing of managers. Advocates of the approach say the decision process is quicker, allowing more nimble decision-taking in the current volatile markets.

Another strategy open to pension fund schemes is to employ a chief financial officer to oversee the outsourcing process. Last year, the UK engineering group Babcock International Group appointed Andrew Birkett as group pensions manager. Babcock has four defined benefit schemes – the Devonport Royal Dockyard Pension Scheme, the Babcock International Group Pension Scheme, the Rosyth Royal Dockyard Pension Scheme and the First Engineering Shared Cost Section of the Railways Pensions Scheme. As of the end of March 2009, the group's defined benefit liabilities and assets were valued at around £1.7bn.

The Babcock appointment does not indicate a trend towards in-house fund management by pension funds, says Kapur. For him, and others in the fiduciary industry, the appointment came as a welcome development, as under such a system fiduciaries would sit on the pension scheme's management board and assist the pensions manager with the asset allocation. As Kapur says: "Specialist officers like Birkett would be appointed to improve the outsourcing decisions, not to bring the fund management process in-house." In particular, his primary role would be to ensure an optimum asset allocation strategy. Studies have shown that asset allocation determines more than 90% of returns.

Some UK pension funds have gone down the route of hiring their own managers or bolstering an already existing team, including the Universities Superannuation Scheme (with assets of $45.8bn), Railpen ($26.9bn) and the Lothian Pension Fund ($5bn). But fund management is a resource intensive business, Kapur says. "To obtain proper diversification for the fund, a team of specialist managers needs to be appointed, along with a fully resourced research function." In other words, he says, "if a pension scheme wants to match the skills and the expertise on offer from SEI, they would have to appoint as many staff as we have. Otherwise they would be cutting corners," running the risk of an underperforming pension fund, a potentially serious fiduciary issue.

Employing a team of fund managers also has its pitfalls. Leaving aside the problem of recruiting the managers with the right level of skills and experience, the pension fund is committed to using the skills of those managers it has recruited. Should market conditions dictate a change of strategy, a small investment team may not have the breadth of skills necessary to adapt to the new requirements. The fund then runs the danger of allowing the asset allocation to be dictated by the skill set of the fund managers it has hired.

Bringing asset management in-house is cheaper, if the strategy of the in-house team is identical to that of an outsourced team. But following a strategy in this way is not necessarily a good idea, considering the current volatility in the markets, says Kapur. Nor is the saving made going to relieve the pressure on the bottom line for, as fund management costs are squeezed, other costs will be rising.

Operationally, the pension fund becomes legally liable to meet an expanded range of increasingly complex reporting requirements, which adds to the overall management cost burden. The pension schemes that want to take control of the fund management process may also have to take on responsibility for middle and back-office functions.

Previously, these functions would have been managed by the fund manager, who to some degree acted as gatekeeper. In the wake of the financial crisis and the Madoff scandal, pension funds have wanted much closer control of these functions. Valuation, performance data, risk analysis and other services give the trustees a much more detailed picture of the state of their scheme's liabilities, but they come at a price.





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Pension fund trustees have been through a steep learning curve. Since the global financial crisis has taught them to take on a more active role in the management of their scheme's assets, as part of their fiduciary duties, they have found themselves grappling with a business of multi-layered complexity.

Faced with the need to repair funding gaps and increased pressure to meet growing liabilities, pension fund trustees have been looking to cut costs to reduce the drag on their fund's overall performance. One solution is to bring the fund management function in-house. A number of pension schemes have gone down this route. But the risk with this strategy is that any savings made could potentially be at the cost of an underperforming fund.

As well as lower costs, the justification for bringing fund management functions in-house is a closer control over the investment process. In fact, says Ashish Kapur, DC product specialist at SEI, a fiduciary manager, "if the pension fund trustees are following the same strategy as the fund manager, then probably the in-house solution is cheaper." But the reality is more complex, as such a strategy has a number of pitfalls.

The need for a fully diversified portfolio of investments would force a pension scheme to employ a full range of fund managers, backed up by a research team, says Kapur. Such an infrastructure introduces a cost threshold that excludes all but the largest pension funds from managing their assets in-house. Normally, only the largest pension fund schemes can afford an in-house fund management teams. The biggest is Norway's oil fund, known as the Government Pension Fund – Global. Its has assets of $450bn, which are managed by Norges Bank Investment Management, a part of the Norwegian Central Bank, on behalf of the Ministry of Finance.

Alongside the sovereign wealth funds in the pension fund super league are the two biggest Dutch industry sector schemes – ABP and PFZW (formerly known as PGGM). Both have in-house management teams, driven by a decision taken in 2006 to separate policy (or the structuring of pensions) and implementation (managing the assets and payout). Today, the assets of Dutch pension fund giant ABP, worth some $270bn, are managed by APG Investments, a subsidiary that was handed responsibility for the fund's management in 2008.

But APG too has its own specialist in-house management teams. APG's private equity portfolio (worth about $50bn) is managed by AlpInvest Partners (formerly NIB Private Equity), an ‘independent' private equity specialist owned by ABP and PFZW, the firm's only two shareholders. AlpInvest is an ‘in-house' team in the sense that the bulk of ABP's private equity assets are handled by AlpInvest. Similarly, New Holland Capital manages a €7 billion portfolio of hedge fund investments for APG Investments. NHC provides APG with continuity of professional management of its hedge fund portfolio. NHC was founded in October 2002 as ABP's internal fund of hedge funds team and completed a spin-out in late 2006.

As with ABP, so with PFZW (formerly PGGM), the second of the two Dutch pension fund giants. In 2006, PGGM's assets were transferred to PFZW, leaving PGGM to act as fund manager of the bulk of the assets, as well as those of other funds, a portfolio worth more than $140bn. AlpInvest Partners manages its private equity portfolio alongside that of ABP.

In the UK, the BT Pension Scheme (with an AuM of $51.2bn) is 100% owner of UK fund manager Hermes. According to Hermes, being owned by its biggest client gives it a unique insight and close alignment to the needs of BTPS and other long-term investors. Chris Goudie, executive director in charge of Global Business Development and chief executive of Hermes Fund Managers, North America, at the time of his appointment in June this year, said: "Hermes presents a unique and exciting proposition to the plan sponsor community. Our ownership structure and our tradition as a responsible asset manager, align our interests with those of the plan sponsor. The commitment of our parent to our success, is clearly visible through their investment and support as we have built-out a confederation of high alpha boutiques. We are now in a position to provide creative solutions across multiple asset classes and risk profiles."

Just as PGGM and ABP were spun out of state pension funds, so Hermes (originally known as PosTel) was originally the investment management team of the Post Office Staff Superannuation Fund, when the fund split to become the Post Office and British Telecommunication Staff Superannuation Schemes. In 1995 the Trustees of the BT Pension Scheme bought the 50% holding in PosTel owned by the Post Office scheme, and PosTel's name was changed to Hermes.

As with APG Investments and PGGM Invest, Hermes was originally focused on managing the funds of its owner. Until November last year, Hermes had a small UK-focused sales force, but now also has business development teams in Boston and Sydney. In the first four months of this year, it raised $500 million for seven separate investment strategies. From being an in-house fund manager, Hermes has set out to become a leading fund manager in the third party market in what it describes as "probably one of the biggest expansions of distribution capability anywhere in the sector in recent years".

Hermes is structured as a multi-boutique asset manager that offers investment solutions ranging from private equity, fund of hedge funds and commodities to real estate, fixed income and specialist equity products. Hermes remains the principal investment manager for its owner, the BT Pension Scheme, but has also signed up 180 other clients. It has £24.6bn under management (as of December 2009), with more than £40bn under the stewardship of its Equity Ownership Service, a division that helps pension funds meet the demands of responsible long-term investing.

In Switzerland, one of the biggest funds belongs to Nestlé, whose total retirement benefit assets peaked at $26bn at the end of 2007. Over the financial crisis, the total dropped to $23bn by the end of December 2009, according to company accounts. In common with its Dutch peers, Nestlé decided to separate the pension fund itself from the management of its assets, following a strategy of shared pension fund management services made available across the group, with the aim of lowering costs and boosting net asset performance, while strengthening Nestlé's overview of group pension assets.

In January 2007, Nestlé Capital Management was set up to take over from Nestlé UK Pension Trust the running of the company's in-house Robusta funds. The group was tasked with providing cross-border investment and advisory services to any Nestlé pension fund based in Europe or elsewhere.

Set up at the same time was Nestlé Capital Advisers to offer actuarial and other related services. NCA took over as investment allocation manager for all of NCM's funds. The subsidiary's role is to offer strategic advice and to be a one-stop-shop for any services required by Nestlé pension funds around the world. Under this system, each individual Nestlé pension fund will continue to be under the responsibility of the relevant local trustee board.

In the US and Canada, the large retirement schemes and university endowment funds such as Calpers, Canada Pension Plan, Harvard and Yale typically can afford fully resourced investment boards to handle the management of their assets, most of which is outsourced to fund managers. Further down the AuM league, however, outsourcing the fund management function can become an unwieldy process for trustees with limited technical qualifications or experience to manage an increasingly complex business.

Step forward the fiduciary manager, a concept Anton Nunen set out in a book he wrote in 2001: "One major concern was that the fleet of managers used by pension funds had often grown too large and unwieldy. A more basic concern was that the modern portfolio theory paradigm meant that nobody really had broad responsibility. The division of labour among plan sponsors, consultants and investment managers meant that everybody had a narrow range of interests."

Fiduciary management refers to the outsourcing of pension fund management to a single third party. This manager would normally take over responsibility for advice, portfolio construction, manager selection, monitoring and reporting. The trustees decide on an overall investment strategy, but the fiduciary manager takes responsibility for the asset mix, benchmark selection, risk budgeting and the hiring and firing of managers. Advocates of the approach say the decision process is quicker, allowing more nimble decision-taking in the current volatile markets.

Another strategy open to pension fund schemes is to employ a chief financial officer to oversee the outsourcing process. Last year, the UK engineering group Babcock International Group appointed Andrew Birkett as group pensions manager. Babcock has four defined benefit schemes – the Devonport Royal Dockyard Pension Scheme, the Babcock International Group Pension Scheme, the Rosyth Royal Dockyard Pension Scheme and the First Engineering Shared Cost Section of the Railways Pensions Scheme. As of the end of March 2009, the group's defined benefit liabilities and assets were valued at around £1.7bn.

The Babcock appointment does not indicate a trend towards in-house fund management by pension funds, says Kapur. For him, and others in the fiduciary industry, the appointment came as a welcome development, as under such a system fiduciaries would sit on the pension scheme's management board and assist the pensions manager with the asset allocation. As Kapur says: "Specialist officers like Birkett would be appointed to improve the outsourcing decisions, not to bring the fund management process in-house." In particular, his primary role would be to ensure an optimum asset allocation strategy. Studies have shown that asset allocation determines more than 90% of returns.

Some UK pension funds have gone down the route of hiring their own managers or bolstering an already existing team, including the Universities Superannuation Scheme (with assets of $45.8bn), Railpen ($26.9bn) and the Lothian Pension Fund ($5bn). But fund management is a resource intensive business, Kapur says. "To obtain proper diversification for the fund, a team of specialist managers needs to be appointed, along with a fully resourced research function." In other words, he says, "if a pension scheme wants to match the skills and the expertise on offer from SEI, they would have to appoint as many staff as we have. Otherwise they would be cutting corners," running the risk of an underperforming pension fund, a potentially serious fiduciary issue.

Employing a team of fund managers also has its pitfalls. Leaving aside the problem of recruiting the managers with the right level of skills and experience, the pension fund is committed to using the skills of those managers it has recruited. Should market conditions dictate a change of strategy, a small investment team may not have the breadth of skills necessary to adapt to the new requirements. The fund then runs the danger of allowing the asset allocation to be dictated by the skill set of the fund managers it has hired.

Bringing asset management in-house is cheaper, if the strategy of the in-house team is identical to that of an outsourced team. But following a strategy in this way is not necessarily a good idea, considering the current volatility in the markets, says Kapur. Nor is the saving made going to relieve the pressure on the bottom line for, as fund management costs are squeezed, other costs will be rising.

Operationally, the pension fund becomes legally liable to meet an expanded range of increasingly complex reporting requirements, which adds to the overall management cost burden. The pension schemes that want to take control of the fund management process may also have to take on responsibility for middle and back-office functions.

Previously, these functions would have been managed by the fund manager, who to some degree acted as gatekeeper. In the wake of the financial crisis and the Madoff scandal, pension funds have wanted much closer control of these functions. Valuation, performance data, risk analysis and other services give the trustees a much more detailed picture of the state of their scheme's liabilities, but they come at a price.




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