Bigger Might Not Be Better for Pensions, Dutch Regulator Claims

Performance fees wipe out larger pension funds’ scale advantage in private equity and hedge funds, research from the Dutch financial regulator has shown.

“Size is an important driver for economies of scale in fixed income, equity and commodity portfolios, but not for real estate, private equity and hedge funds.” —Broeders, van Oord, and RijsbergenThree staff from De Nederlandsche Bank (DNB) co-authored a paper—“Scale Economies in Pension Fund Investments: A Dissection of Investment Costs Across Asset Classes”—analysing 2013 performance, asset allocation, size, and cost data from 225 pension funds based in the Netherlands.

Authors Dirk Broeders, Arco van Oord, and David Rijsbergen found that larger pensions typically received better deals in fixed income and equity, but private equity, hedge funds, and real estate investments did not become cheaper as investors scaled up.

The research contrasts with the wave of consolidation that has shrunk the number of pension funds in the Netherlands dramatically in the past few years. The DNB has supported consolidation within the country’s pension system in a bid to increase efficiency, particularly among smaller funds.

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The report noted “diseconomies of scale” for pension funds allocating more than €400 million ($450 million) to private equity “primarily driven by performance fees”. A ten-fold increase in assets under management corresponded with a 41.49 basis points increase in performance fees paid out.

“A possible explanation for this finding could be that larger funds are better able to select the best-performing private equity funds and therefore pay significantly higher performance fees,” the authors said.

For hedge funds, a ten-fold increase in a pension’s assets corresponded with a 33.36 basis points rise in performance fees.

In real estate, Broeders, van Oord, and Rijsbergen also found evidence of diseconomies of scale. “A tenfold increase in real estate investments raises total investment costs [by] 14.55 basis points,” they wrote.

The writers put this increase in costs down to different reporting requirements for listed and unlisted property assets.

Overall, the report said a ten-fold increase in assets under management corresponded with a 7.67 basis point decrease in investment costs, including performance fees.

Pensions achieved the greatest economies of scale with commodities investments, the authors found, although this advantage disappeared for allocations above €300 million.

With mainstream equity and fixed income allocations, the authors reported that “size appears to be an important driver for economies of scale”. A ten-fold increase in assets corresponded with a 4.76 basis point decrease in fixed income costs and a 7.75 basis point decrease in equity costs.

Download the “Scale Economies in Pension Fund Investments” paper.

The Pension Benefit Guaranty Corporation (PBGC) is searching for fixed income managers to run mandates on its Smaller Asset Managers Pilot Program.

The US’ lifeboat for bankrupt company defined benefit plans has issued a request for proposals to relatively small managers who wish to run active US fixed income portfolios.

“The Smaller Asset Managers Pilot Program creates new opportunities for such firms by reducing the required amounts of the assets they manage and their mandates,” the PBGC said.

Allocations will range from $50 million to $250 million, and only companies with more than $250 million already under management will be eligible to apply.

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“Before the pilot program, these contracts were out of reach to the firms because the minimum amounts of the investments, often in the billions, were too large for the firms to accommodate,” the agency said.

The lifeboat announced the programme earlier this month and hosted a pre-bidder’s conference to help smaller asset managers understand the process it uses to select funds.

It is expected to award two or three contracts this year, with a maximum of five being allocated as part of the pilot programme.

The pilot follows several emerging manager programmes initiated by large US public pensions in recent years.

Across its various funds and portfolios, the PBGC manages around $80 billion and each year pays out more than $5.6 billion to members of pension funds it has taken under its auspices.

Details of the mandates to be issued can be found on the Federal Business Opportunities website. Proposals are expected by August 18.