Why smaller public sector pension funds should consolidate to build scale

Why smaller public sector pension funds should consolidate to build scale

Market Views / Why smaller public sector pension funds should consolidate to build scale

Why smaller public sector pension funds should consolidate to build scale

BERT CLARK
CONTRIBUTED TO THE GLOBE AND MAIL
PUBLISHED FEBRUARY 11, 2022

Bert Clark is president and CEO of the Investment Management Corporation of Ontario.

Public-sector fund managers currently navigate a very uncertain investment environment: the Omicron wave of COVID-19, high inflation, significant central bank intervention in the markets and the start of a profound energy transition.

The outcome of any of these trends is difficult to predict. And public funds manage important liabilities and financial obligations, like pensions, so the societal stakes are high. The challenge for all investors is that, aside from diversification, there are very few reliable strategies to increase long-term returns without adding risk.

Unfortunately, most of these approaches require scale and many public funds are too small. For example, in Ontario, there are at least 80 public funds managing less than $1 billion in assets, including provincial agency funds and municipal reserve funds. The total value of the funds being managed by these organizations is over $23 billion.

There are several ways that scale contributes to better performance. It allows larger investors to reduce costs through internalization; to construct more diversified portfolios that better align with their liabilities, obligations, and investment horizon; and to build the necessary internal expertise to benefit from the opportunities associated with the energy transition and other structural market trends.

The idea that scale can lead to better returns is why regulators in the U.K. and Australia have pushed its smaller public funds to consolidate. In Canada, large institutional asset managers have been established in Quebec, Ontario, Alberta, and B.C. to enable public fund consolidation.

A new CEM Benchmarking report quantifies the benefits of scale in institutional investing – which has been rarely done before. CEM is one of the most authoritative pension fund researchers, with a database that includes 30 years of performance data from more than 1,000 funds exceeding US$11 trillion in assets under management.

The report’s findings are remarkable. In the long-term, most small public funds fail to achieve any net value add, or NVA: the amount by which the returns of an investor exceed the returns of the market benchmark, after applying related investment costs. Specifically, CEM found that, most funds with less than US$1 billion in assets achieved negative three basis points of NVA.

But bigger funds tended to perform better. Most funds with assets between US$1-billion and US$10 billion delivered 15 basis points of NVA, while most funds with US$10-billion or more assets achieved 29 basis points of NVA over the same period. What makes these findings even more noteworthy is that the bigger funds took less risk than the smaller funds to achieve better results.

To put these differences in performance in perspective: If a small fund was able to generate an additional 30 basis points in returns through consolidation, this would translate into $100 million in additional returns for a $1-billion fund over 30 years, or a 10 per cent increase in their funded status.

The CEM report looked more closely at the drivers of differences in performance and found that scale and internalization – strategies that do not increase risk – had about the same potential to increase NVA as pursuing active versus passive investment strategies. For most investors, this was 20 basis points.

Today, small public funds face a very challenging investment environment. But there are strategies available to some that should lead to significantly better investment performance. The conclusion that small funds should draw from CEM’s report couldn’t be clearer: They should consolidate to achieve scale before pursuing risky investment strategies in order to improve long-term returns for their beneficiaries.

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