As the trend for larger pension funds to insource management of their assets increases, Pádraig Floyd asks whether an in-house approach to liability driven investment will be the next step.
“We want access when we need access, not when our providers can fit us in with the rest of their clients – that’s not good for the biggest LDI book in the market.”Barry Kenneth
There has been a growing trend for larger pension schemes to take greater control of their investments and in some cases, bring asset management in-house.
Some of the large North American schemes, such as Calpers, have reviewed allocations to alternative investments as existing portfolios were not felt to be providing best value for the scheme.
The Ontario Teachers’ Pension Plan and the Ontario Municipal Employees’ Retirement System have also taken greater internal control and now run 80% and 88% of their assets themselves.
In the UK, RPMI Railpen which manages the £21bn Railways Pension Scheme, is almost two years into a major restructure to reduce investment costs.
BACK ON TRACK
Craig Heron, senior investment manager at Railpen, says the the move made a lot of sense due to the size of RPMI’s existing in- house team.
“It’s a simple cost/benefit analysis of how much of a cheque you write for a £150m mandate,” says Heron. “If you’re paying 50 basis points a year, that’s £250,000. If that was an equity portfolio, how much would it cost you to build a relatively small team to manage?”
RPMI has taken tighter control of a number of its allocations and has moved to using alternative risk premia – what some would call smart beta, though Heron dislikes the term – implemented through an index provider or third-party managers. “By running highly quantitative strategies, it provides us with great control and visibility, and we decide how to apply them,” says Heron.
Since it is the scheme that determines what is fair value for the services it requires – and there is a heavy use of passive managers – “this is done at a fraction of the cost we may have had in the past but with the same risk exposure.”
Despite larger schemes adopting a more hands-on investment approach, an area so far over-looked has been the management of liability driven investment (LDI) in a similar way. Until recently, that is, when the Pension Protection Fund (PPF) announced it was taking control of LDI in- house for its £22.6bn of assets.
LDI’M IN CHARGE
The reasons for the move were simple, according to Barry Kenneth, CIO at the PPF. The scheme’s benefits are indexed to CPI rather than RPI, so buying gilts doesn’t provide a satisfactory match.
As a result, the team found itself managing a lot of the basis risk for the hedge internally and instructing managers on that basis. So, it made sense if they could build the team, they would save money on mandates where managers were constrained to benchmarks.
Rather than being a cost-cutting exercise, the PPF wanted greater control not only over the assets, but how it got access to the market.
“We want access when we need access, not when our providers can fit us in with the rest of their clients – that’s not good for the biggest LDI book in the market,” says Kenneth. “With direct access to the markets, if 2008 comes again, we will be able to do something about it and quickly.”
Greater control will drive down costs, not only through renegotiation of the fees, but because providers will be able to deal directly with the PPF rather than via a fund manager.
But the PPF is a unique case among UK schemes, operating as the long-stop for members whose employers have gone bust. Their reasons for having a higher level of control over LDI are understandable, but would the benefits be the same for an ordinary private sector scheme?
A QUESTION OF SCALE
Though some large UK schemes have taken investment back in-house, it is an exclusive club. In the case of RPMI Railpen, it was as a result of a strategic review to take control of costs. But there are good reasons for LDI not featuring in those schemes’ equations, says Tim Giles, partner, global investment practice at Aon Hewitt.
“The three main players account for a huge part of the LDI market, between 80% and 90%, as they have the capability to run large passive positions,” says Giles.
An organisation wanting to become an LDI provider – or control its own LDI assets – would struggle to compete, he says: “If you enter the market on a limited basis, you’ll have high overheads and have to offer lossleading prices to build scale unless you try to read to your costs at the front.”
David Hickey, managing director of the institutional group at SEI, is of the same opinion: “You can’t compete with a costcutting mantra and if it is about the benefit of controls and transparency, you may have to be more creative around the benchmark to cut costs.”
Hickey suggests where a manager is benchmark constrained, a scheme has the freedom to deviate if managing in-house.
Even so, when clients talk about taking investment in-house, they don’t include LDI. Hickey says the conversations about insourcing usually begin once a scheme hits £4bn, but he believes it shouldn’t be considered before there are at least £10bn in assets. This is not so much due to scale, but the likely sophistication of the strategy. “If it’s about cost reduction and you are quite passive with some swaps, you could take them in-house quite easily,” says Hickey. A more active strategy is harder to insource, as costs are high and you need to have specialists working on your team.
“Even large schemes will struggle to attract the best talents and build a large enough team to do it in-house,” he says.
The experience of David Adkins, chief investment officer at £7bn The Pensions Trust (TPT) would bear this out. Taking LDI in-house is not a consideration for TPT, but Adkins is on a journey to implement what is in effect an internal fiduciary team by 2020.
This doesn’t mean he hasn’t considered the benefits of insourcing, but is wary of the implications.
“I’ve spoken to other groups and see taking our performance in-house would mean a huge operational risk,” says Adkins. “It also introduces issues that go with having all these people in-house rather than at arms length through an IMA arrangement.”
Those issues include mundane HR concerns and operational gaps when managers are ill, but also if the team – not to mention the systems – required to operate LDI starts to challenge the fundamental purpose for insourcing.
“You can have team decisions and still delegate to a third-party, but once in-house, numbers increase exponentially,” says Adkins. “You need an array of people, not just fund managers, but the support as well.”
NOT FOR EVERYONE
So if a £7bn fund can’t make the maths work, what hope for smaller schemes? Adkins is right to be dubious about not only the numbers but calibre of staff. The PPF’s Kenneth has spent at least two years in preparation for this transition and he has had to hire people like Trevor Welsh from Aviva Investors as head of LDI.
He’s also had to create a new daily investment operation quite separate from the monthly reporting cycle of the investment team. This requires risk managers from the banking world, says Kenneth, because they are used to daily reconciliation and most fund managers are not.
This level of restructuring is too rich for the blood of most mortals, but satisfies the long-term requirements of PPF’s unique situation.
A RARE EVENT
It is only ever likely to be the largest schemes insourcing their LDI investments, says Helen Forrest, policy lead, defined benefit at the National Association of Pension Funds (NAPF).
However, initial results from the NAPF’s annual investment survey show the general trend towards the use of hedging continues.
“We asked in the 2014 survey if liabilitymatching investments had changed and it had increased to 50% from 36% in the previous year,” says Forrest.
There has been a long shift for schemes to manage risk where they can and the DB code will foster longer-term links with sponsoring employers.
“The gilt yield environment continues to be horrific,” says Forrest, “and the cost of taking risks off the table when the employer isn’t seeing any gains will lead them to question whether derisking is always the best policy.”
A QUESTION OF DEFINITION
Not everyone is using LDI, of course. The NAPF figures show 35% use interest rate swaps, 34% use inflation swaps, but of those schemes using swaps, 86% have assets of £2bn or more.
When it comes to derivatives, 40% don’t use them at all and funds under £100m are unlikely to have any hedge at all.
But then it all depends on what you call LDI, says Forrest, as any scheme bringing derivatives or bonds in-house for hedging purposes is already running an LDI portfolio, and this will differ scheme-to-scheme.
Schemes are increasingly looking to fiduciary mangers to manage the day-to-day LDI components via fiduciary management arrangements and even for very large schemes, it may prove to be a false economy, says Hickey, as most clients have some form of LDI through their bond portfolio.
“This is a well-developed market within institutional management and with the exception of charities and foundations – who have different priorities – you can get clients access to strategies that would otherwise be out of their reach.”
ONE IS ONE AND ALL ALONE
Of course, even the PPF isn’t insourcing all its LDI hedging. Kenneth doesn’t believe he can add value in certain assets such as private and distressed equities and won’t build a team he may not need in a few years time. The PPF will continue to have mandates with managers in order to benchmark itself against the market. Though fewer in number, they are considerable sums.
This also provides “disaster protection” for the PPF’s board if they needed to outsource in a hurry should something go wrong. Kenneth’s project for the PPF to take “ greater control of its destiny” may look like the start of the trend, but few, if any, will have the need, resources or stomach for what is required to manage their LDI in-house.