More U.K. funds likely to steer toward OCIOs

The impact of the coronavirus on markets and pension funding levels could push more U.K. trustees down the outsourced CIO route in the future, particularly as sources expect these funds to have outperformed non-OCIO arrangements in the quarter ended March 31.

Pension funds across the globe have suffered from falling equity markets, leaving trustee boards in a quandary about whether they should shift their portfolios to safety or take more risk. Trustees able to make and execute on decisions quickly and across the entire portfolio — largely through OCIO arrangements — would have done better than those depending on trustee board meetings and subsequent requests to third-party money managers to make such changes, sources said. There would also have been varied performance among OCIOs themselves.

"Performance-wise, it is almost inevitable that fiduciary management clients will have outperformed the advisory clients," said Roger Brown, founder and director at of IC Select Ltd. in Edinburgh, which helps retirement plans evaluate and choose investment consultants and OCIOs. "The reason is fiduciary management portfolios typically have higher hedging levels — at 90% to 100% — and they do have greater diversification. And equally, they can react more quickly than others; in early February when (investors) started to wake up to (the market situation), they made changes to the portfolio, which no advisory client could do so quickly. This first quarter, I'm pretty sure the impact on fiduciary management clients will have been much less" than on advisory.

OCIOs confirmed that they are hedging interest rate and inflation risk to high levels.

That's not to say that non-OCIO pension fund trustees did not respond on some level. "What did change in the last quarter, because trustees were having to make more rapid decisions, was that once they got into the swing of things they met more often. Everyone could find an hour to get together and have a quick chat on one of the virtual meeting platforms — and most trustee boards would never have contemplated doing that. It is probably a lasting change. Certainly on the investment side, I think we might see more frequent meetings, a change in the way advisory governance works," Mr. Brown said.

But the idea behind the OCIO arrangement is that trustees are able to spend their time on strategic issues, leaving day-to-day investment processes to the delegated manager.

Sources at OCIOs and third-party firms said they have continued to see interest in OCIO arrangements.

"Our view is it will lead to more schemes wanting to move to fiduciary management going forward. It's quite hard to think of a scheme that looks at their governance model on an advisory basis and considers 'that was the right governance model for these types of events.' We have seen an acceleration in the first quarter of fiduciary management searches. In terms of new searches we took on, it was our busiest quarter ever," IC Select's Mr. Brown said.

The stress on almost every aspect of running a pension fund — investments, the strength of the sponsoring employer, pension fund administration, business continuity and communication — may lead to trustees reviewing arrangements and making changes to the governance structure as a result, said David Rae, London-based head of strategic client solutions at Russell Investments.

"The increased use of outsourced arrangements to support the strategy development of trustees is a likely conclusion for many," he said.

The latest quarter was a good example of trustees needing to move quickly — whether they had an OCIO arrangement in place or not. The S&P United Kingdom index fell almost 24%, the S&P Europe 350 index dropped more than 22% and the S&P Global 1200 index fell about 20% for the quarter ended March 31.

Among the 5,422 pension funds covered by the Pension Protection Fund's 7800 index, liabilities grew 2.3% to £1.82 trillion ($2.26 trillion) while assets fell 3.4% to £1.68 trillion for the quarter ended March 31. The funded status of these plans fell to 92.5% as of March 31, compared with 98% as of Dec. 31.

"Certainly for funds on the advisory side (and so not using OCIOs), I don't think anyone anticipated we'd have a major dislocation in financial markets (requiring trustees to make investment decisions) at the same time as the governance model itself was impaired, in that they cannot meet face-to-face. That is going to come into people's thinking much more. There's no doubt that the governance around fiduciary management is easier in that circumstance," Mr. Brown said.

Fiduciary managers said they made a number of changes across the portfolios they run on behalf of U.K. pension funds, estimating smaller losses than among advisory clients.

"We've had very volatile markets, and that means that actually, you've needed to step in and do things in the portfolio — either to rebalance or recapitalize your (liability-driven investing) portfolios," said Tim Dougall, head of investment advisory at Legal & General Investment Management in London. The team provides OCIO services. Assets under management were not disclosed.

OCIOs and other sources either did not disclose actual portfolio returns for clients, or said it is still too early to put numbers on performance for the first quarter. One issue with overall portfolio numbers and returns comes with the time it takes to value illiquid assets, Mr. Brown noted.

While it is still too early to put exact numbers on client performance, "we know the falls haven't been as much as in (public) markets," said Tony Baily, partner at Aon PLC's investment team in London. "But where managers are only reporting on a quarterly basis (such as hedge funds) it is difficult. … But where we are talking to managers and extrapolating (from those conversations), we are seeing that we have cushioned the blow by not falling as much" as pure advisory arrangements, he said.

Preliminary figures show that, for full fiduciary management clients that have not set constraints, the absolute value of pension funds under Aon's OCIO arrangements increased in many cases over the quarter. And relative to their liability benchmarks, client assets were about 2.5% to 5.5% behind the liability benchmark — reflecting the fact that liability benchmarks increased more than assets, Mr. Baily said.

Aon's OCIO business had about $167 billion in assets under management as of March 31, 2019, according to Pensions & Investments data.

An unconstrained U.K. fiduciary management client's growth portfolio dropped around 3.5% in the first quarter, estimated Pieter Steyn, head of delegated investment U.K. at Willis Towers Watson PLC, based in London. The firm's OCIO assets under management totaled $122.2 billion as of March 31, 2019, according to P&I data.

However, there was also a clear difference between different OCIOs, said Paula Champion, director, investment advisory at retirement advice firm Isio Group Ltd. in Bristol, England. "In practice, in this environment, we have seen a significant dispersion in the performance of fiduciary managers."

She said most pension funds using an OCIO will have been "well protected against movements in interest rates and inflation" thanks to hedges.

"However, going through Q1, there is more dispersion in growth fund performance between managers than you might expect — not unsurprisingly, those with (the) most equity exposure have taken the biggest hit. Preliminary data for Q1 2020 suggests that some of the best-performing schemes using fiduciary management outperformed some of the worst by over 15% — in that quarter alone. So perhaps this tells us that the question is not simply 'fiduciary or not,' but 'which is the right manager?'" Ms. Champion said.

And how OCIOs invested once markets had fallen is particularly important. "The other point we try to make to our clients is that it's not just about the first quarter when markets fell, but how they manage the recovery. Even in recovery mode, it's not just about avoiding the size of the fall but if you can put risk back on quicker — which fiduciary managers can — this will be to their clients' benefit," Mr. Brown added.