When a pension plan hires an outsourced chief investment officer, it can’t just hand over the keys, nap in the backseat and forget about how its investments will perform.
If a plan sponsor can’t decide on asset allocation or its investment policy, hiring an outsourced chief investment officer won’t help it, says Brad Rowe, a principal at Eckler Ltd. in Halifax.
“They have bigger issues that they have to deal with simply because an OCIO will not take full fiduciary responsibility for a policy.”
Plan sponsors that benefit most from outsourcing, he says, are those that can design investment policies and oversee performance but don’t have the resources to execute acquisitions and sales on a daily basis. Smaller plan sponsors with few finance staff most often struggle with a lack of resources. After all, pension plans aren’t most companies’ top priority. Linda York, senior vice-president at Market Strategies International in Cambridge, Mass., says she has seen a recent uptick in outsourcing among plans with less than $1 billion in assets. According to York, 19 per cent of U.S. corporate pension plans are using an outsourced model.
“[Smaller plans] are trying to do their best to compete with the big funds — the OMERS, the Teachers’, the CalPERS in the U.S. — because obviously, they’re competing for the same investments but they do not have staff, skill and resources to do that,” says Dany Lemay, Montreal investment leader at Willis Towers Watson. “And oftentimes, they came to the conclusion that we’re still underfunded, we haven’t had the result that we had hoped for, so maybe it’s time to change a bit our governance and our approach to [our] pension fund . . ..”
Lemay has also seen increased interest in outsourcing from foreign companies operating in Canada. “Sometimes, they don’t have all the staff on the ground here in Canada to be familiar with all the rules and regulations, the reality of our domestic market.”
Lemay says he has seen Willis Towers Watson’s outsourced chief investment officer practice pick up since the 2008 financial crisis. And Edward Ng, head of portfolio management for BlackRock Inc.’s U.S. outsourced chief investment officer business in New York, suggests the challenging business climate is another factor in the growing use of outsourcing by pension plans. “Twenty years ago, it was easy to have a diversified portfolio that kind of made you money. A lot more uncertainty, lower expected returns — the world of investing is a lot harder today.
I think that will also be a driver to shifting from DIY to outsourcing.”
Apples versus oranges
More corporate plans use outsourcing than public sector organizations, says York. That’s partially because, with many plans having closed, plan sponsors have a better idea of when they have to pay liabilities. As a result, they can more easily develop investment policies for outsourced chief investment officers to work with.
Among the corporate pensions, many plan sponsors are from certain industries, such as manufacturing, and particular regions, such as the U.S. Midwest and Northeast, where that sector has typically been strong, says Gabriella Barschdorff, senior strategist for BlackRock’s outsourced chief investment officer business. “[They’re] not necessarily concentrated in any one sector within that but definitely in what one might characterize as old economy,” she says, noting BlackRock entered the outsourcing space in Canada recently after reaching an arrangement with a multinational company.
Once a plan sponsor decides to proceed with an outsourced chief investment officer, it must choose which company to work with. “Let’s drop the O for a moment,” says Rowe. “It’s one of the C-level people in your firm. The person does not sit in your firm, obviously, but a representative of the organization you select is essentially a senior member of your team. You’re looking for a fit in terms of the people. You’re looking for rigorous internal controls. You are giving a huge responsibility over to someone.”
Both consultancies and asset managers offer outsourced chief investment officer services and, depending on plan sponsor needs, one may be preferable to another.
Asset managers can be nimbler in terms of acting on market trends, says Barschdorff. “We have the ability to actually . . . move assets from one fund to another fund or from a growth strategy to a hedging strategy. . . . That’s a very different operational setup compared to a consultant that perhaps generates a monthly or maybe even quarterly report — or in some cases, even annual — of how [the plan sponsor’s] portfolio is allocated in relation to liabilities.”
On the other hand, consultants may provide more help in developing investment policies. “If you need a lot of help on the planning side, either through de-risking or various sophisticated processes for the management of your plan, there may be a consultant firm that has deeper resources in that area,” says Rowe. “It’s not necessarily that one is better than another. They’re both very good at it. It just depends on what the plan sponsor needs for the ultimate goals.”
The impact of scale
Some plans choose to partially outsource their asset management, whether they want to dip a toe in external waters before fully committing or simply want to retain a favourite manager in a certain asset class.
But such partial delegation can be inefficient. When building a portfolio, an outsourced chief investment officer will use the same set of expected returns and risks to determine a client’s optimal investment strategies, asset classes and managers, says Barschdorff. So when one element of the portfolio follows other parameters, the outsourced chief investment officer faces “a bit of a black hole” where certain investments will operate “at an information disadvantage,” she adds.
Since fees decrease as assets under management rise, those that opt for partial delegation may also pay higher rates than those using fully outsourced services. “If we have a full OCIO arrangement with them, they will be invested in what we call a zero-fee share class, so the only thing they would pay would be the underlying investment manager fees,” says Lemay.
Clients using partial delegation services, on the other hand, may invest in fee-based share classes. “And any time, during a full OCIO arrangement or a partial OCIO arrangement, when they can bring more scale to the table, we can negotiate even better fees for our clients,” says Lemay.
Investment managers, Lemay points out, are often willing to reduce fees for clients that choose to outsource because they don’t have to worry about recruiting and retaining them. “We feel that by bringing our scale for the benefits of our clients, we help them decrease investment management fees and we feel it’s going to help drive better outcomes for them in the long run. That scale component becomes more and more of a factor in the partial OCIO arrangement.”
But even if fees seem high, Lemay argues clients make up for that with improved speed of execution. “I’ve seen some cases where, because it took [a plan sponsor] a year and a half to fire an underperforming manager, they lost two, three, four per cent in terms of returns. [OCIO fees are] nothing compared to the negative impact of having a delayed execution.”
And then there’s the elephant in the room — the potential conflict of interest that arises when a firm with proprietary funds can also buy them on behalf of its clients.
“Everyone sits and says the OCIO is conflicted,” says Rowe. “And I sort of step back and say, ‘Whenever you use the words fiduciary duty, you will follow that up with the potential for conflict of interest.’ I’ve yet to see an investment policy in my career or any governance policy that didn’t have a conflict of interest. And you talk about mitigating conflicts of interest and how you manage them. It’s about transparency, it’s about disclosure and it’s about internal controls and audit.”
Eckler, he adds, will help clients find an outsourced chief investment officer but it doesn’t offer the service itself.
Other consultancies follow that approach as well, in part to avoid the conflict of interest issue altogether.
“We’re not going to be promoting any kind of proprietary product,” says Neil Craig, area senior vice-president for group retirement services at Arthur J. Gallagher & Co. in London, Ont. “We’re more likely going to be looking at what do the guys out there offer and are they in a position of a conflict of interest? If they’re doing the services and a lot of the funds are their own funds that they’re using in their mixes, who’s monitoring that? That’s the way we want to go.”
For asset managers and consultants that provide outsourced services, a frequent first step to mitigate conflict of interest is simply to separate the two sets of offerings within the firm, says York. “Many of these firms . . . are developing separate teams, separate areas of expertise. It’s not affiliated with the asset management business at all, even though it’s under the same umbrella brand.”
For its part, Willis Towers Watson tries to mitigate conflicts of interest through transparency for both its outsourced chief investment officer and consulting clients. “Even in a consulting business, you’re always incentivized to do more for your clients because it generates more revenue,” says Lemay.
“I think OCIO is no different, but we believe properly handling how you mitigate those conflicts of interest and how you’re transparent with your fees and your revenues with your clients is a way to have your clients more comfortable,” he adds, noting clients can see on their invoice how much they pay to the firm as well as external investment managers.
The firm also minimizes its use of proprietary funds, since the more sophisticated the investment, the higher the fees, Lemay adds. “For some of the more alternative asset classes or specialty asset classes where we feel there’s no one product that we can really invest in on behalf of our clients in the way we’d like to, we’ve built a very small number of proprietary funds where we build a manager-of-manager approach within these funds. So we pick and choose the best managers for the strategy.”
But for clients that have full outsourcing agreements with the firm, it doesn’t charge additional fees for proprietary funds, he adds.
What’s the future of outsourcing? While few companies are introducing defined benefit pension plans, many foundations, endowments and insurers outsource their chief investment officer positions. And even within the pension industry, Barschdorff says outsourced services have a robust future. As people live longer, pension benefits have to last longer as well. And in increasingly complicated investment environments, more and more plan sponsors may rely on outsourcing. “They’re not going away any time soon,” she says.”
Sara Tatelman is an associate editor at Benefits Canada.
Get a PDF of this article with all of the top 40 money manager charts that appeared in the November issue of Benefits Canada. Note that following publication, Fiera Capital Corp. restated its assets under management for endowment and foundation fund managers. Fiera now reports its assets under management as being $7,420 million, versus the $3,741.7 million it originally provided.