A new study looking at the implications of scale in defined benefit pension plans found size is key for several trends over time, including investment mandates, asset allocation and cost in returns.

The research, ‘Scale Economies, Bargaining Power and Investment Performance: Evidence from Pension Plans‘ was recently awarded first prize in the International Centre for Pension Management’s 2023 Research Awards. The paper sourced data from CEM Benchmarking Inc., a Toronto-based consulting firm that collects information from a large cross-section of pension plans on their asset allocations to each major asset class.

“One of our most interesting findings, I would say, was the economies of scale on the cost side, so really distinguishing the economies of scale by investment mandate — internal passive, external passive, internal active management and external active management,” says Tjeerd De Vries, a PhD candidate in the University of California, San Diego’s department of economics and one of the authors of the report. “And in general, one of our main findings was that passively, the effects of size are just much bigger than for active management.”

Read: Head to head: Should pension plans be investing actively or passively?

The study noted large DB plans are increasingly managing their assets in-house, to cut fees while maintaining a reasonable level of performance. It explored whether in-house management brings greater bargaining power to plans when they negotiate fees for external management services — and whether such bargaining power mainly resides with the largest pension plans due to the fixed costs of setting up and maintaining internal management.

“We see this leads to huge cost savings,” says De Vries. “The economies of scale when you manage your assets passively are much bigger than when you do it internally versus externally.”

Indeed, the study’s results indicated a strong role for economic scale in pension plan fees and investment performance. It noted large DB plans pay significantly lower fees per dollar invested than their smaller peers.

Smaller pension plans also face hurdles in setting up internal investment teams because they can’t afford the fixed costs, he adds. “There’s a huge role for plan size and we see this everywhere.”

Consistent with fixed costs being important in setting up internal investment management capabilities, the study noted large DB plans manage a significantly greater proportion of their assets internally compared to smaller plans. Similarly, taking advantage of their greater ability to identify internal and external investment opportunities in the less transparent markets for private assets, larger DB plans also allocate more of their holdings to alternative asset classes and less to public equities and fixed income.

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While large DB plans’ better ability to identify skilled external managers and negotiate lower fees hasn’t translated into higher net-of-cost return performance in the highly competitive public asset markets, according to the study, it found strong evidence that larger plans earn economically large and significant abnormal returns in the markets for private assets compared to their smaller peers.

“If we look at return performance, we also tend to see that large plans earn higher net returns and, specifically, in private asset classes,” says De Vries. “. . . And generally speaking, we see, over time, they increase their investments to more specialized, sub asset classes, for example. So that’s a major trend we see over time.”

The study concluded the scale disadvantages in investment management costs that were identified for smaller DB plans indicated these plans may perform best when they embrace passive management, which is widely available in public asset markets. However, passive management is generally not an option for private assets and the fixed costs are too high to be covered by most small plans, which consequently have to rely almost entirely on external active management along with the higher management fees typically charged for this service.

Conversely, it noted, large DB plans have the ability to manage private assets internally and negotiate lower external investment management fees. “This helps explain why plan size — scale — is particularly important in determining investment performance in private asset markets and why private asset classes have become particularly important for large plans in recent years.”

Read: Two decades of low inflation push DB pensions toward alternative investments: Bank of Canada