News came out late last week that CalSTRS has decided to consider reducing their reliance on external investment managers to manage their US$132 billion plan. Other extremely large pension plans in both the US and here in Canada have been doing the same. When you consider the economies of scale that large pension plans benefit from, the move makes a lot of sense. According to the report, CalSTRS spent about $140 million on external managers last year. The compensation arrangement for investment managers is primarily based on a percentage of assets under management, usually on a sliding scale.

Let’s consider a $2 billion dollar plan that allocates 5% of their assets ($100 million) to an investment manager and is charged 20 bps, which amounts to $200,000 in annual fees. If a $50 billion dollar plan allocated the same percentage of their assets to the same manager and gets a significant fee discount (say 10 bps) due to their size, the annual fee would amount to $2.5 million. Obviously the small plan can’t go out and hire an investment team for the amount that they are paying to the manager, but the larger plan can certainly do so.

Data is not available on the type of mandates (active or passive) that are being run internally by large pension plans, but it would make sense for plans to consider passive mandates first. Passive mandates require less investment skill than active portfolios as they are designed to simply match a pre-specified index. Not only is this less expensive than hiring portfolio managers to try to beat the index, it also largely reduces potential agency conflicts that might arise.

But there is a potential drawback to moving in this direction. When plan sponsors are dissatisfied with the results of their external investment managers, they can simply terminate the mandate and allocate capital elsewhere. However, if they are dissatisfied with mandates that are run internally, the process of terminating an entire investment management team who are also employees of the plan could prove more of a challenge.

Adam Bomers is director, investment solutions, Aurion Capital Management and a member of the editorial board of Canadian Investment Review.