Is bigger better?
That’s the question posed by Alexander Dyck and Lukasz Pomorski, professors of finance at the Rotman School of Management, University of Toronto, in their study, Is bigger better? Size and Performance in Pension Plan Management. The authors concluded that larger plans outperform smaller ones by 43-50 basis points per year due primarily to two factors—cost savings of internal management and greater allocation to alternative investments. What are the takeaways from these intriguing findings?
Over the long-term, costs certainly matter. Additional costs of 25 basis points per year would detract 2-3% from performance over 10 years or 6-7% from performance over 30 years. In today’s market conditions, where no one is expecting a recurrence of the double digit returns of the last few decades, costs will have an even greater impact. This is not to suggest that one should select a management approach based simply on cost, but that the decision threshold for any investment mandate or strategy should reflect its expected cost structure.
What about alternative investments? A skeptic might point out that the returns on alternative investments are often uncertain until someone turns out the final light. At the very least, a smaller plan needs to be cognizant of the extensive governance, complexity, legal review, fee structure and oversight required for some of the less traditional asset classes. The portfolio complexity should take into account the number of internal investment staff available to oversee the portfolio structure and the relative experience of such staff. In today’s environment, where traditional asset classes (such as equity markets in developed countries) have been delivering disappointing returns, alternative asset classes may indeed become more compelling.
What should smaller plans do with this information? The answer (as usual) is, “it depends.” Firstly, note that the cost gap depends very much on plan size—although the gap between the jumbo plans and the smallest plans is about 20 basis points, the gap between jumbo plans and medium plans is a more modest 8 basis points. One proposed solution is for a smaller plan to partner with a larger plan for cost efficiency. Such a decision would depend on the level of net savings available to the smaller plan (including concerns about whether a larger plan would pass on their investment experience at “cost”) and recognition of the residual costs still required by the smaller plan for oversight of the outsourced portfolio (unless the governance was changed to reflect the new structure).
In terms of alternative investments, the data suggests return differentials of up to 2% between jumbo plans and smaller plans. Plans at the $1 billion mark appear to be the worst off, with the biggest differential from the largest plans. Curiously, smaller plans (less than $1 billion) appear to be less affected, which suggests many of them may be (wisely) avoiding alternative investments altogether. While smaller plans could benefit from partnerships with other plans (including larger plans) in this area, this does not relieve them of their fiduciary oversight duties. Perhaps the “benefits” of alternative investments could be better achieved by paying more attention to traditional investments, instead. After all, this data pertains to the “averages” and a top performing plan with a traditional approach can still outperform a larger plan with badly managed bells and whistles.
To conclude, smaller plans need not despair at these findings, but use them as a timely reminder that one size does not fit all. Portfolio structure and strategy should depend on one’s circumstances and the challenge remains to play the cards you are dealt to maximum advantage.