By Madeline Forrester
In the movie ‘Big’, the main character makes a wish on a carnival game, believing his life would be better if he was bigger. After getting his wish and growing to adult size, he begins to miss elements of his life that could only be enjoyed when he was smaller but had been overlooked in his desire to be big.
This storyline is playing out in the global pension industry, where there is a shift towards consolidation driven by regulatory change and pressure to reduce costs. In Mexico the number of pension funds has decreased from 22 to 12 over the past seven years, while in the UK, the government is assessing the potential for consolidation across Local Government Pension Schemes.
However, is big better? Do bigger funds earn higher returns, if they pay lower fees? What is the impact of size on risk management and risk tolerance?
The return benefit for larger pension funds comes from their ability to get direct access to asset classes and investment opportunities that are not available to smaller funds, for example private equity, catastrophe bonds or infrastructure. However, large pension funds can become too big to fulfil target allocations in alternatives, and can also experience performance drag in traditional asset classes, when the size of their trades gets too large to allow for efficient execution.
Small funds have the option to use multi- asset or fund of fund solutions to delegate asset allocation and due diligence, but these present their own challenges, with lack of transparency, inflexible allocators and an additional layer of management fees. A group of small investors could overcome these challenges through collaboration or by pooling their investments and resources and directly co-investing in solutions that meet their common investment objectives.
It is often assumed that bigger funds are charged lower fees, but this generalisation needs challenging. In addition, more complex structures like performance based fees, instrument based charging and fees based on liability values make it difficult for funds considering consolidation to assess the cost reductions that might be realised post-merger.
To leverage the cost savings that come with size, without pursuing formal consolidation, small funds can take proactive steps. These include ensuring a fee quote reflects the potential for future asset growth, confirming the fee schedule reflects all relationships a pension fund and its sponsor has with a manager, and considering partnering with funds to negotiate a collective fee agreement or create a common investment fund.
While size of a pension fund may unlock access to different strategies, new risks unique to large investors can be introduced. For example, the capacity for banks to transact large derivative trades has declined, suggesting that there is a point when pension funds become ‘too big’ to implement interest rate and inflation hedging at the times and pace they may wish.
Meanwhile, pooled fund structures that spread the costs of administration and ongoing management across investors have opened up derivatives to smaller funds.
The short answer to the question, ‘is big better?’, would be ‘not always’. Collaboration rather than consolidation might allow small funds to capture some of the benefits of being bigger without giving up their flexibility or agility.
So for smaller pension funds that discover an old carnival game that promises to make their wishes come true, perhaps instead of wishing to be big, they should wish to find other funds willing to work alongside them to produce superior results.
Madeline Forrester is head of UK institutional at Axa Investment Managers
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