Pension fund consolidation on an upward trajectory

Written By: Andy Todd Head of UK Pensions and Banks, Sector Solutions EMEA State Street

Andy Todd of State Street examines the trend towards consolidation amongst UK pension funds and outlines some of the challenges that will need to be faced

Consolidation is the single biggest trend amongst UK pension schemes. An industry theme brought to the fore by the Local Government Pension Scheme (LGPS) pooling initiative – asset consolidation across 89 participating funds and nearly £250 billion of equities, bonds and other investments. But this trend permeates the UK pensions industry deeper than just LGPS; and the approach taken varies from scheme-to-scheme across the board: from public to private, defined benefit (DB) to defined contribution (DC). For example, some UK pension funds (39%) plan to decrease the number of external asset managers managing parts of their portfolio over the next three years.1 Others intend to consolidate multiple retirement plans by pooling assets, or both assets and liabilities (70% and 65% respectively1), either within the next three years or more.

One general reason often cited by pension funds as the main driver behind consolidation is reduced cost and improved operational effectiveness. Potentially unsurprising in an investment environment of lower-for-longer yields and increasing operational costs caused by external forces – including a swathe of both domestic and global regulation. A startling majority (70%) of respondents from our recent study amongst pension funds stated they are under constant pressure to cut costs.1

Across the industry, many pension funds are under intense scrutiny by boards and stakeholders to cut costs. The challenge is to operate more efficiently and maintain sufficient investment returns to fund acceptable levels of retirement income for members. However, pooling resources should not only be viewed as a cost-saving measure, but also as an important means of developing new capabilities and opening up fresh opportunities.

Barriers to consolidation
Schemes that have not yet consolidated may have delayed taking that step partly because the more investment capabilities they take in-house, the more risk they inherently bring internally. Therefore as they expand their internal investment teams, they also need to have the funds to support a larger in-house risk team and have the governance structures in place needed to realistically back them. In addition to this, as funds diversify their investments their need for specialist talent is amplified. Investment professionals with expertise in niche assets are in demand – as well as new risk management, data analysis, and board-level skillsets.

Pension funds face competition in attracting more specialist talent from investment banks, asset managers and consultancies into their ranks which will not be easy – particularly for those planning to increase their exposure to alternatives. However, benefits outside of remuneration rates such as office location can play to their favour.

Whilst competition is a notable hurdle to overcome, the winds of change are here and this change is one a large proportion are looking to address, with 48% and 44% citing they plan to increase the size of investment and risk teams respectively over the next three years.1

On the flip side, joining forces is, for smaller pension funds, an effective route to obtaining the necessary assets, investment know-how and risk expertise to move into higher-risk, higher-return investments such as alternatives.

Given 77% of pension funds believe it is getting harder to deliver the investment returns needed to ensure a good retirement income for their members, the benefits that come from having economies of scale will only become more and more pronounced; particularly as 42% intend to increase their allocation to hedge funds (single manager), fund of hedge funds, private equity, real estate, infrastructure, or direct loans over the next three years.¹

However, pension funds face a dilemma on risk. They are torn between the desire to reduce investment risk, yet in many cases needing to seek the higher returns that come with a risk premium. For example, more than three quarters (77%) feel they do not necessarily have the operational infrastructure in place to accommodate change, such as alternations to their investment strategy and accommodating the aforementioned new and updated regulations.1

The concern that plans will be unable to meet the increasing demands of their members is universal, but the “right” answer on investment and risk strategy will be unique to each individual fund.

How can pension funds manage these risks?
Only 13% of our survey respondents rate themselves as highly effective at managing investment risk, while 13% say the same about liquidity risk. This is a real concern for pensions, especially as many move into new investment areas that require specialist understanding of different risk types. Alternative asset classes such as hedge funds, private equity and infrastructure expose funds to new types of investment and liquidity risk. In addition to requiring specialist investment knowledge, alternatives tend to be illiquid and tie up a pension funds’ capital over the long term. However, many UK pension funds are not confident they have achieved real transparency on the risks stemming from complex alternative assets.

Funds will need to ensure they have the analytics in place to generate an accurate measurement of portfolio risk as they hold a more diverse range of assets. These tools must be able to aggregate and normalise data for multiple asset classes; to evaluate equity risk – including comparative information for private equity and other non-listed assets; and to shock-test the portfolio. Some larger funds may have appropriate tools in-house that can be optimised for more sophisticated risk-testing, while smaller funds may need to seek outsourced solutions. Bringing in new risk talent will be key in enabling such increased sophistication in risk analysis.

As pension funds increasingly recognise the importance of applying more sophisticated risk modelling, the accuracy of the data feeding those models grows in importance. However, only 30% of UK pension funds are highly confident in the reliability and accuracy of their risk data.1 Each individual pension fund will need a clear picture of the short and long-term liabilities it could face, under different scenarios, to set the most appropriate overarching risk strategy. Whatever risk strategy it needs to pursue for the sake of its members, it is clear that a combination of new skills, risk analytics tools and specialist knowledge will be required to succeed.

What to do?
Pooling assets and resources can also bolster smaller funds’ bargaining power when it comes to engaging the external asset managers with the specialist expertise they need. Larger funds too are pooling assets and sharing specialist knowledge in order to access more unfamiliar investment opportunities. As pension funds come under pressure to deliver better returns to members at lower cost, it seems clear that pooling assets and knowledge to cut costs and reduce the risks of seizing new investment opportunities will be a serious consideration for more funds. Finding the right partner to complement the attributes of a particular pension fund will be the key to ensuring this strategy pays off.

Whilst insourcing is appealing to many funds, it is far from a panacea – consultants and external asset managers will continue to play a vital role in key areas. It seems that pensions are looking for fewer, but more valuable relationships with external suppliers. This will intensify competition among consultants and asset managers alike, but it will also open up new opportunities for the most forward-looking firms.

1. Longtitude research conducted on behalf of State Street, Pensions with Purpose: Meeting the Retirement Challenge, 2015. Conducted amongst 400 global pension funds including 30 UK participants