Low returns, fee scrutiny drive rise of pension fund insourcing

Updated with correction.

An unexpected alignment of factors has made now a very good time for pension funds to insource some or more of their investment portfolios.

The combination of a low-return environment for the foreseeable future, far closer — and often more public — scrutiny of money manager fees and a need to better control investments is fueling interest in bringing assets in-house for the first time for some plans and expanding internal management for experienced investment departments.

“The move to manage money in-house is a real trend with real dollars,” said Jeb Burns, chief investment officer of the $9 billion Municipal Employees' Retirement System of Michigan, Lansing, who is in touch with a broad network of public pension plan sponsors around the U.S.

Better internal portfolio and risk-management systems, and middle- and back-office administrative outsourcing packages from custodial banks make it much easier to run money internally than a few years ago.

But lower investment management fees often are the primary driver pushing pension fund officials to pick up a pencil and make back-of-the envelope calculations on the merits of doing so.

“Asset owners are having a hard time paying fees,” said Peter Sanchez, executive vice president and head of hedge fund services, Northern Trust corporate institutional services, Chicago, which provides back-office services for institutions managing money internally.

“The insourcing trend is definitely up,” and cost savings are one big factor because they lead to higher investment returns, agreed Virgilio “Bo” Abesamis III, executive vice president, trust, custody and securities lending group, Callan Associates Inc., San Francisco.

“If you can save even one to two basis points on your cost of investment management, that's like a performance boost,” Mr. Abesamis added.

The average cost of internal management is eight basis points compared with 46 basis points for external management, according to the most recent survey of large pension funds by CEM Benchmarking Inc.

The dollars saved by pension plans experienced at insourcing investment management are substantial, pension fund officials said.

• State of Wisconsin Investment Board, Madison, which manages the $91 billion Wisconsin Retirement System, for example, saved $63 million in external fees in 2015. SWIB gradually has increased the proportion of insourced assets to 59% of total assets in 2015 from 51% in 2011.
• Michigan Department of Treasury, Bureau of Investments, which manages the $60 billion Michigan Retirement Systems, East Lansing, saves a net $20 million to $30 million per year through managing 35% of the total portfolio internally.
• Employees Retirement System of Texas, Austin, pays fewer than 10 basis points for investment management and administration of the $25 billion pension fund, with the cost of internally managed assets four times less than external manager fees. About 60% of ERS' assets are managed internally.
• Michigan MERS runs its entire investment division at a cost of 1.5 basis points per year, including the 20% of assets that are managed internally. External manager costs averaged 35 basis points in 2014.

Pension funds that already insource money management, like Michigan MERS, are actively seeking ways to bring more strategies in-house, strategies well beyond the U.S. passive equity and fixed-income portfolios managed by many pension funds.

MERS manages passive U.S. equity and short-duration fixed income internally, as well as active U.S. large-cap and microcap equities. An active U.S. small-cap equity strategy was launched in March, said Michael Charette, senior investment officer and director of internal asset management.

Next up is analysis of the feasibility of managing international equity — active or passive — internally, a task that has been made easier by technology enhancements and access to real-time market data.

Like several other pension fund investment officers interviewed for this story, Mr. Burns, the CIO, said MERS is managing co-investments internally.

“We are working with a private equity partner for co-investment sourcing, but through our contacts, people who know that we are looking for deals, we are being contacted directly,” Mr. Burns said, noting the pension fund's size and the investment discretion held by the staff means deals can be expedited and underwriting handled in-house.

The $187.4 billion California State Teachers' Retirement System, West Sacramento, has managed passive fixed income in-house for almost 20 years and also runs a large passive U.S. equity portfolio internally. Like Michigan MERS, CalSTRS classifies co-investments as internally managed assets.

The pension fund will increase substantially the proportion of internally managed assets to about 58% of total assets from 45% when it launches a $6 billion international equity fund benchmarked to the MSCI Europe Australasia Far East index on its internal trading platform in June, CIO Christopher J. Ailman said.

Running indexed portfolios in-house is “dirt cheap,” Mr. Ailman said, noting the cost of managing investment strategies internally is about one-tenth of the fees of its externally managed portfolios.

CalSTRS' investment teams are investigating whether enhanced index and actively managed portfolios make sense for internal management. Mr. Ailman said real estate is another insourcing possibility. He's also “watching the Canadians (pension plans)” and sovereign wealth funds with an eye toward internally managed infrastructure investments.

Michael Brakebill, CIO of the $43 billion Tennessee Consolidated Retirement System, part of the state's Treasury Department, also is watching the big Canadian pension funds for clues about how they manage private equity, but isn't ready to take action yet.

Most of the Nashville-based pension fund — 75% — has been managed internally for years, Mr. Brakebill said, in a mixture of active and passive domestic equity, active U.S. fixed income and passive Treasury inflation-protected securities.

Only three asset classes — private equity, non-investment-grade bonds/strategic lending and international equity — are managed by outside money managers. Mr. Brakebill said the investment team is “really happy with our external international managers; there's no need to change them.”

What's most unusual about TCRS is its internally managed direct real estate portfolio. The retirement system has a separate account and works with a number of real estate managers that bring investment ideas to pension fund officials. TCRS investment officers make all investment decisions about properties that the retirement system ends up owning outright within the account.

Mr. Brakebill said his department is “like an investment supermarket” because in addition to the state retirement plan, it also manages state and local operating funds, small endowments and a tuition reimbursement fund. The department also has been active in selecting investment options for the state's hybrid defined contribution fund.

Another unusual aspect of the investment team's work is its part in managing a defined contribution plan option, Mr. Brakebill said. At the request of participants in the defined contribution plans, the investment team rolled out Treasury-managed funds that are shadow funds of the defined benefit plans' portfolios. The new offerings are gaining popularity.

Ultimately, performance net of fees determines the success of internal management, sources said.

The East Lansing-based State of Michigan Retirement Systems, like Tennessee Consolidated, has a long history of internal management. In fact, virtually all cash, fixed income and public equities were managed in-house, said Jon Braeutigam, CIO of the Michigan Treasury's Bureau of Investments, in an e-mail. In the 1980s, investment staff added external managers and private market investments to diversify the pension plan and to help the fund meet the state's 8% actuarial assumed rate of return.

Annualized net returns of SMRS' internally managed portfolios mostly topped their benchmarks in the three- and seven-year periods ended Dec. 31:

• $7.2 billion of passive domestic equity — three-year return, 15.1%, and seven years, 15.3% (benchmark 14.9% and 15%, respectively, for each period);
• $5.7 billion of active U.S. equity — three years, 14.3%, and seven years, 14.3% (benchmark 13.5% and 13.7%, respectively);
• $4.3 billion of active fixed income — three years, 2.18%, seven years, 5.13% (benchmark 1.44% and 4.09%, respectively); and
• $1.7 billion international swaps portfolio — three years, 7%, and seven years, 8.24% (benchmark 4.4% and 8.47%, respectively).

“Internal management capabilities should give us a much better understanding of our external managers because we can have a view (and) understanding of the external manager's underlying holdings as opposed to just looking at past performance metrics,” Mr. Braeutigam said, noting past performance “actually is not a great predictor of future returns.”

Texas Employees' Retirement System also managed assets in-house for many years, but it wasn't until 2007 that the investment needs of the pension fund “reached an inflection point,” said Charles Thomas “Tom” Tull, CIO. “The board had to decide whether to go more internal or external, and it decided on internal,” Mr. Tull added.

The decision was made to manage both investments and middle- and back-office administration, which required Mr. Tull to put his previous experience in building portfolio management systems in-house to work. Deputy CIO Sharmila Chatterjee Kassam applied her prior technology experience to crafting the pension fund's internal back-office operations.

“We built this department to be like a private investment firm within a public pension plan,” Ms. Kassam said, echoing a sentiment expressed by every CIO and investment professional interviewed for this story.

In another echo of what fellow CIOs said, Mr. Tull stressed that recruitment and retention of investment employees remained one of the most daunting challenges for pension funds hoping to build their internal management capabilities.

“Compensation is a challenge for public plans. Our board lets us check compensation levels of the competition, but we are a public plan and we can't afford very high salaries,” Mr. Tull said.

Beyond salaries and bonuses, Michigan's Mr. Braeutigam said the challenge is to find “dedicated, qualified, knowledgeable staff that have the correct organization values and fit,” adding that by fit, he meant integrity, respect, strong investment views based on research, “beneficiaries first” attitude and a solutions-oriented personality.

CalSTRS' investment division is “100% modeled on external money management firms. We studied firms like (Pacific Investment Management Co.) and (Western Asset Management Co.) closely,” Mr. Ailman said.

For pension funds with less heft or no desire to tackle do-it-yourself investment and risk-management systems or back-office capability, external solutions are available.

“It's one thing to insource portfolio management, but most pension funds don't want to insource a back-office infrastructure buildout,” said Andrew Lapkin, CEO of HedgeMark International LLC, New York, a hedge fund managed account platform that is part of BNY Mellon Asset Servicing's client solutions suite.

“When a pension plan hits about $75 billion, internal management starts to make sense because plan economics are tipping toward being able to manage asset less expensively internally,” Mr. Lapkin said, adding “the trend we're seeing is to insource investment management and outsource middle- and back-office functions.”