A growing number of schemes are beefing up internal resources, and the trend is set to continue
Pension schemes, like many other organisations in the UK, have been busy outsourcing for the last three decades. Early adopters began winding up internal teams in the eighties, and the sale of the National Grid scheme’s £13bn in-house asset manager last year shows some schemes are still moving in this direction.
But in recent years the trend has been reversed. Larger funds with long time horizons are bringing a growing range of functions back in-house to cut costs, align their investment strategies with their needs, and make their funds more nimble.
“Over the last 24 months we have seen the largest pension funds in the UK bring more and more investment resource in-house,” says Ian Hamilton, managing director, asset owner solutions at State Street.
Headline grabbing-examples include the Tesco scheme setting up its own asset manager, and the BT Pension Scheme taking its bond portfolio away from Hermes (which was originally set up as its in-house manager) to run internally.
And State Street’s research suggests this is part of a wider trend: 38% of large UK schemes surveyed by the firm intend to beef up their internal investment team over the next three years, while 26% said they would scale down their team.
Hamilton believes the logical next step is to bring more risk management experience on board, with a growing number of schemes looking to hire chief risk officers. “People recognise that the more decisions they are taking in-house, the more risk they are taking in-house, so they need to match that investment expertise with risk expertise,” he says.
This is borne out by the firm’s research with found 44% of big schemes expected their internal risk team to grow.
A high cost, high return model works when you’re getting high returns, it’s less satisfactory when they aren’t available
The motivations for insourcing differ from scheme to scheme, but cutting costs is a common theme. The Railways Pension Scheme – which had been mostly outsourced since 1987 – was prompted to review its arrangements by the financial crisis in 2008.
“It wasn’t the fact that we had big drawdowns,” says chief executive Chris Hitchen. ”It was the realisation that we were into a low return, low interest rate environment. Frankly, we were going to have to reduce costs. A high cost, high return model works when you’re getting high returns, it’s less satisfactory when they aren’t available.”
The scheme carried out a thorough review which resulted in it disbanding its investment sub-committee and the setting up an investment board with fully delegated authority over scheme assets. It also significantly reduced the number of external managers it uses.
Research carried out by the Economist Intelligence Unit on behalf of BNP Paribas found many large asset owners were moving in this direction – building deeper relationships with fewer managers. To do this they need more investment experience in-scheme.
The railways scheme will continue to work with outside managers for certain asset classes, and has just handed out a global credit mandate. But Hitchen says the changes have reduced costs and made sure its investment strategy is more aligned with its needs.
These are also the reasons Universities Superannuation Scheme (USS) has always managed most of its assets in-house, according to the fund’s chief operating officer Howard Brindle. The scheme, which is the UK’s largest, runs approximately 80% of its £49bn of assets itself.
Brindle says the USS gets detailed annual benchmarking reports on its investment costs across all asset classes.
Everything we do internally is much cheaper than going externally
“The clear results are that everything we do internally is much cheaper than going externally. If you’re a pension fund over £10bn, you should be thinking about going internally for some core functions where you know you’re going to have a sizeable allocation, over a reasonable length of time so you know you can invest in the people.”
The cost of running the scheme’s 130-strong investment office, which includes a direct investment team of 26, is just 13 basis points according to Brindle.
He also believes bringing asset managers in-house helps them perform better. They are free to focus on longer time horizons and do not have to devote time to marketing funds and raising assets.
“Our guys have a relatively easy life in that they just have their head down, managing the assets, they don’t have to do any marketing or manage multiple portfolios,” says Brindle. “Even an average portfolio manager would do better in an internal role than externally.”
We are seeing a natural trend for large schemes to say ‘we have to have the ability to control that as efficiently as we can’
The Pension Protection Fund is another scheme that is significantly increasing in-house resources. It is in the unusual position of being a defined benefit fund that is expecting to grow significantly. This, combined with its ambition to completely hedge its assets, is behind its decision to bring a proportion of its liability driven investment (LDI) portfolio in-house.
The lifeboat fund is building up its capacity to execute its own trades. Recently installed head of LDI Trevor Welsh says this is one area where schemes can achieve significant savings, because LDI programmes tend to be tailored.
“It is not a generic product for large schemes,” he says. “It is an increasingly dominant part of the assets, it tends to have a derivatives overlay, and needs very substantial input from the asset allocation team, the actuarial team, the consultant team.
“It infiltrates everywhere. As a consequence, we are seeing a natural trend for large schemes to say ‘we have to have the ability to control that as efficiently as we can’.”
Changing role for trustees
Both the Railways scheme and the USS have also made major changes to their governance structures that have moved asset allocation decisions from trustee boards to professional teams. This move towards what is effectively in-house fiduciary management is a developing trend at larger schemes.
If you were building a pension scheme, one of the first things you would do is take control of asset allocation
Brindle says the USS has moved allocation decisions from an investment sub-committee that met quarterly to the investment office, although with carefully drawn risk parameters. “If you were building a pension scheme, that is one of the first things you would do – actually take control of the asset allocation,” he says.
This may worry trustees, but Hitchen believes it is a change that needs to happen. He explains: “My trustees, who are great trustees but mostly know about running railways, recognise that actually the trustee model of deciding things through an investment committee was no longer fit for purpose, so they delegated through to a more sophisticated investment board staffed by external professionals.”
This is leading to a fundamental change in the trustee job. Boards of schemes with significant investment and risk management expertise will take on more of a monitoring brief.
Trustees will also have get comfortable overseeing increasingly complex investments. State Street’s Hamilton says: “They are being asked to increase their investment knowledge. Extra training is needed, and we will see an increase in independent trustees as boards try to close this knowledge gap. People that remain on trustee boards will be those that really get engaged with the process, and are happy to go up the education scale.”
The trustee model of deciding things through an investment committee was no longer fit for purpose
Schemes that bring functions in-house also face a data challenge. Managing assets internally requires huge amounts of information to be processed. For those taking asset allocation decisions, this has to be gathered from external managers.
“You need to understand what you own and what that’s worth every day if possible,” says Brindle. “That’s not realistic for some of the direct assets, but you need to have a good idea of what it is you own.”
Recruiting the best
There is also the question of how schemes can compete with the well-resourced asset management firms for staff. Schemes often target investment professionals at the beginning of their careers who are looking for more responsibility and exposure than they could get at an asset manager.
The days when you did investments with an investment sub-committee that met once a quarter – that model is going away
Alternatively, schemes can sell a move in-house as offering a better lifestyle to experienced managers. Hours are closer to nine-to-five, and schemes’ longer time horizon means the job is often less pressurised.
Hamilton says: “The other place you are seeing schemes that are looking more high level at asset allocation or strategic decisions take from is consultancies – which have a different compensation structure to asset management firms.”
But Welsh, who joined the PPF from Aviva Investors, says the lifeboat fund has no trouble attracting talented LDI managers.
“From an LDI perspective, this is one of the premier funds in the UK, so this is a fantastic opportunity for anyone to make a name in the LDI business,” he says. “It is a small team but the size and scope and excitement about what we can do here is a long way in excess of anywhere else.”
As more schemes explore this route, and more investment professionals are persuaded to switch sides, trustees will have to get used to the change. Although in-house expertise will always be beyond smaller schemes, Hamilton says £2bn plus schemes are in the frame.
“The days when you had a pensions manager who was administration and payroll focussed who did investments with an investment sub-committee that met once a quarter – that model is going away,” he says.