To meet the challenge of achieving their objectives, some plan sponsors and other asset owners have embraced a relatively new tool: investment outsourcing — that is, outsourcing all of the investment management and oversight function.
The tool has been around for some years and began building a credible but small client list of asset owners in the 1990s, but outsourcing has grown tremendously in the past five years, reaching $995 billion as of March 31 on a full or partial discretionary basis.
At such a scale, with 56 firms whose outsourcing assets range from $1.1 billion to $108.5 billion, as well as new entrants seeking to capitalize on a trend, the marketing drive to deliver clients and expand assets will pressure fiduciaries to come to terms with so-called delegated fiduciary investment management as an alternative approach to overseeing the investment function internally.
Until relatively recently, pension plan sponsors and other asset owners were generally on their own developing and implementing their investment policies, asset allocations and investment management structures to meet their contribution targets, funding levels and payout objectives. They could draw on investment consultants to assist in the development of the investment structures, and lean on them as another layer of fiduciary protection. But that traditional model requires dedicating significant resources to the plans, depending on the level of sophistication, diversification and complexity executives choose to develop. All of this requires an expensive continuing commitment of staff and resources.
Outsourcing all of these functions offers an alternative approach, and it might be the next big thing in investment management. Outsourcing offers a potential of making pension plans more sustainable by streamlining costs and enhancing asset performance.
Investment returns account for most of the financing for defined benefit plans and defined contribution plans. Anything that can enhance the net returns will have appeal to plan executives.
Keith Brainard, Georgetown, Texas-based research director of the National Association of State Retirement Administrators, estimates at least 60% of defined benefit plan funding comes from combined investment income and appreciation, while the other 40% comes from contributions.
However, pension executives and other institutional investors must be cautious. An interesting new idea can strongly influence decision-making. As the institutional investment community has experienced, new ideas such as alpha portability and hedge strategies, liability-driven investing and risk parity, command attention and attract assets. But the performance and sustainability of a new idea often depends on market conditions.
With outsourcing, executives have to question what are they getting — and what are they giving up — in using such an approach.
One key challenge of delegated fiduciary management is: What do you compare it with, traditional oversight? Or do you compare competing outsourcing firms with each other? Or both?
Many outsourcing firms don't publicly report performance. Prospective and existing clients must insist on greater transparency to enable better investment performance and risk management evaluation. They should insist on the development of standardized reporting to enable better use of analytical tools to measure results.
An infrastructure for doing so already exists in the CFA Institute's Global Investment Performance Standards. The standards were written for investment managers and not with asset owners or outsourcers in mind. But the CFA Institute this year released an exposure draft, and is seeking comment, on guidelines to extend GIPS to asset owners. The GIPS committee overseeing the standards ought to propose guidance for use by outsourcers.
In a comment letter on the GIPS proposal for asset owners, Gregory E. Hiers, manager, performance processing center, Towers Watson Investment Services Inc., Atlanta, wrote, in regard to its “having discretion over assets under management and provide performance” for clients: “How is it anticipated that this exposure draft would relate to an investment consulting firm which offers delegated fiduciary services to prospective clients (plan sponsors), with existing delegated clients being a subset of the firm's overall client relationships?”
David Spaulding, CEO, The Spaulding Group, whose focus includes GIPS verification services, said in an interview. ”There probably should be (guidance) in the standards that ... address outsourcing.”
Jonathan A. Boersma, executive director, GIPS, said in an interview the committee hasn't discussed applying the standards to outsourcing, but he thinks they already contain the framework for doing so.
Among other challenges of outsourcing, asset owners risk having an approach that comes out of the box, designed generally rather than for specific needs. Any customization to better fit objectives likely comes with an additional price that asset owners will have to assess in their cost-and-benefit analysis.
Asset owners also will have to have an exit strategy. In traditional pension fund oversight, terminating an external investment manager comes with costs, including the costs of a search for a replacement and other transition activities. While it can be disruptive, it is contained within a fraction of total assets.
A termination of an outsourcing firm requires more planning, even before moving to a delegated fiduciary structure.
To outsource, asset owners would dismantle much or all of their internal investment oversight infrastructure, including staffing and technological analytics.
If terminating an outsourcer were required, such an infrastructure could not easily be rebuilt. Asset owners might be compelled to seek an interim outsourcer that might not be the best choice until they could find a better one.
One the other hand, moving to multiple outsourcing firms would appear to defeat the purpose of streamlining investment management oversight. Asset owner trustees, who would still retain fiduciary responsibility, would have to step up their internal resources to oversee the multiple firms, seemingly diminishing the gains from outsourcing.
Outsourcing seems to offer appealing benefits. Asset owners theoretically can draw on outsourcers' strengths, including investment management expertise, research and risk management, which have the perception of being more comprehensive and superior. With more assets under oversight, outsourcers can achieve an economy of scale potentially far beyond what a traditionally managed pension fund could.
But outsourcing firms have to show that perception is indeed reality.
