Amid low returns, consolidation of fund asset management likely

Consolidating money management for state or provincial public pension plans under one entity is a concept that has been accepted both in Canada and in a few U.S. states, leading at least one analyst to suggest that investment expectations of the future will require other states to do the same.

“They will have to,” said Jill Eicher, visiting scholar at Stanford University's Pension Infrastructure Collaborative, Global Projects Center, Palo Alto, Calif. “It's not possible for state and local funds to sustain even a 4% return on a one- to three-year basis. Change is going to happen, and low returns will be the driver of change. ... So pension plans that provide a model, like Indiana and Ontario, and that cause people to try and make changes are a big help. The expectation is for the stock and bond markets to be below return averages for the next decade. If you're the CFO of a state or local government, you have to do something.”

Independent Canadian money management companies that manage public pension assets include the Investment Management Corp. of Ontario, which was launched in July and is expected to begin investment operations in early 2017; the C$248 billion Caisse de Depot et Placement du Quebec, Montreal; the C$121.9 billion British Columbia Investment Management Corp., Victoria; and the C$90.3 billion Alberta Investment Management Corp., Edmonton.

In the U.S., the $30.8 billion Indiana Public Retirement System, Indianapolis, has managed assets of the state's five pension plans since they were combined under one investment management and administrative system in 2011. However, INPRS does not operate as an independent money management corporation as do IMCO and the other Canadian companies.

Officials in Canada and at Indiana point to the economies of scale, overall cost savings and broader asset-class investment options that such combinations provide.

Canada in particular is attractive, Ms. Eicher said, because its managers, though created by their provincial governments, operate independently of the governments and the pension funds maintain control of their individual asset allocations. The Indiana system, along with the other 15 U.S. state investment boards — 12 of which manage assets for all their states' pension funds — do not operate independently of state government and do not allow individual funds to set their own asset allocations.

“The idea of a non-profit investment management function at the heart of a platform, I just don't know how the U.S. plans can do that,” Ms. Eicher said. “State investment boards are a baby step on a progression toward what IMCO is trying to do, which is a more efficient approach. IMCO takes that to the next level. Canadians are much further ahead than the U.S.”

Steve Russo, executive director of the Indiana system, said combining investment management and administration of the five statewide plans has resulted in documented $200 million in net present value savings, with possible additional savings of up to $175 million that can't be specifically tied to the consolidation.

Mr. Russo has talked with pension plan executives from other states, but “what's the most interesting thing is that there hasn't been a whole lot of consolidation out there.”

In Ontario, IMCO is being started with seed money and investment professionals from two provincial asset owners — the Ontario Pension Board, which oversees the investments of the C$23 billion ($17.7 billion) Ontario Public Service Pension Plan, Toronto, and the C$26 billion Workplace Safety and Insurance Board, Toronto, the province's workers' compensation program. It follows the model of other government-created entities in Canada that manage pension assets.

Mark Fuller, president and CEO of the Ontario Pension Board, said a confluence of interest sparked OPB's interest in IMCO.

“This started from an investment program we wanted to implement, and we saw real potential in co-investments in private markets, to get opportunities with scale,” Mr. Fuller said. “But that's expensive. We concluded that the advantages of scale through consolidation would be beneficial. We also saw the benefits of internal management. But again, that's expensive, too. We're in Toronto, and competing with others for investment talent would be difficult, so consolidation would benefit us in that way as well. So generally we're getting economies of scale. And the Ontario government has been in search for savings on public services in general, and they looked at the potential for asset pooling. So we had a situation where WSIB and OPB were aligned in interest and the government was on board as well.”

At the workers compensation board, Tom Teahen, president and CEO, said the principles that drove the board's interest in IMCO were its independence from government and strong governance policies, the control WSIB maintains over its asset allocation, enhanced risk management and reduced volatility, and the ability to invest in new asset classes more efficiently.

“Those principles aren't necessarily driven by the expectation of higher returns but by enhanced risk-adjusted portfolios, to be able to invest in asset classes like infrastructure but with moderate volatility,” Mr. Teahen said. “We have a conservative expectation of risk-adjusted returns but will have access to investments we otherwise might not have had.”

Messrs. Fuller and Teahen both said they expect to add 25 basis points of risk-adjusted return annually through the use of IMCO. “If that holds over 15 years,” said OPB's Mr. Fuller, “this plan is C$2 billion better off than it could have been. Also, our long-term view of the world is that we're entering a low-return environment. Small deltas in investment return are a big gain for us. We see this (moving to IMCO) as responsive, not just to internal management but also to what the markets will do. That makes sense to any institutional investor — if you can execute this properly.”

Indiana's Mr. Russo said the added return expected by combining assets was also a driver of its consolidation effort. “We came to the conclusion that the bigger the fund is, the better its performance, net of fees,” said Mr. Russo. “It wasn't so much how much we could cut our fees as much as could we get 0.2% better (in performance), that would give us $60 million net of fees each year.”

Keith Brainard, Washington-based research director at the National Association of State Retirement Administrators, said the Canadian model for external management of assets “does make eminent sense,” but he's unaware of any U.S. state where public pension funds cede control of asset management while still retaining control of asset allocation.

“In general, underfunding is not caused by poor investment management,” Mr. Brainard said. “That said, it's axiomatic that size matters, and larger funds can generate efficiencies and economies of scale that can lead to lower investment costs and greater access to consultants, money managers, asset classes and opportunities than with smaller plans.”

Mr. Brainard cited Massachusetts, Wisconsin, Minnesota, North Dakota and Indiana as states that have merged their public plan investment management but do not give member pension funds allocation control. But he said Illinois and Pennsylvania, with so many public plans — 4,000 in Pennsylvania alone — are good examples of states that could use pension management consolidation. The reason they don't is “a local control thing,” Mr. Brainard said. n