To read the first part of Pensions: To Merge, or Not to Merge, click here.
(January 17, 2014) — The risks identified by the Dutch include the Australian concerns about whether the merger is value for money, whether there is enough alignment between the two firms’ administration systems, and how they can mitigate any transition risks. But there are other issues to overcome too.
Return on investment has become a key battleground when making the decision to merge, or not merge.
“Smaller pension funds have shown better return on investments than the larger ones,” says Zaghdoudi. “If you make 10% more on your investment of €600 million, that’s €6 million more than another pension fund who’s much larger. We don’t address that as an industry though, we only look at what it costs. It’s what the DNB concentrates on too: cost, cost, and cost.”
The consultant is also alarmed by how the biggest pension funds will protect themselves against interest rate risk.
And without mentioning names, Zaghdoudi claims some of them are already unable to hedge their interest rate risk because they are unable to find an insurer willing to take on that much risk.
“From a risk perspective, if a €500 million pension fund does nothing about its interest rate risk, the DNB asks them ‘Are you mad? Why haven’t you hedged 60% or 70% of your interest rate risk?’ But if a larger pension fund does that, there’s no-one in the market to get that level of insurance. If pension funds get larger, that risk enlarges.”
Zaghdoudi also predicts pension administrators will get hurt if consolidation in the Dutch market increases, as they will lose clients and be forced to merge with each other. He predicts just three or four will remain in five years’ time at the current rate of mergers.
A&O’s Eelens has a different set of concerns. “The risks I see are mostly related to concentration risk, which if it isn’t managed properly could lead to systemic risks,” she warns.
With fewer people responsible for more assets there will be a greater key person risk, not only if a person leaves, but also if a person makes the wrong decisions, she said.
“Secondly, a concentration risk in the asset allocation may also arise. You don’t want to over diversify, which doesn’t add much to the portfolio, but you don’t want to have an unmanageable concentration risk in your portfolio either.”
Larger funds will also struggle to invest in less liquid assets, Eelens continues, and will be uncomfortable with large allocations to them in case they are too big to adjust or redeem.
Forcing together different demographics will produce suboptimal results too, Eelens argues. This point can be clearly seen when looking at social responsible investment (SRI) ideas. “As SRI policies mature we’ve seen pension funds aiming to match their SRI policies to the backgrounds and goals of their participants.
“As the group of participants becomes bigger and more diverse through consolidation, SRI policies will have to become more general and less personal again,” she warns.
Further consolidation appears likely in the Dutch market, given the increased pressure on employers from the DNB and forthcoming regulations.
The UK
In the UK, the majority of talk around pension fund mergers has occurred in the public sector. To date, no major mergers have taken place.
Cambridgeshire and Northamptonshire local authority pension funds have come close with its shared services platform called LGSS, which they were both part of by 2011.
This combines professional and transactional services for local authorities, including HR, finance, IT, and legal services. It has also combined on some of its investment decisions, such as signing up to Russell Investments’ foreign exchange execution platform earlier this month.
But other local authorities have come up with an alternative option, collective investment vehicles (CIVs).
Continues on page two…Similar to joint vehicles, these platforms allow pension funds to pool assets without having to merge everything to do with the fund. The complications, costs, and time delays which would be caused by consolidating administration, IT functions, staff, communications and more are simply swept away.
A proposed merger between Berkshire, Buckinghamshire, and Oxfordshire pension funds is now believed to be heading down the CIV route.
In November 2013, Nick Greenwood, pension fund manager at Berkshire Pension Fund, told aiCIO it “was possible” that the Berkshire/Buckinghamshire/Oxfordshire union could take place next summer, but stressed there were many more steps needed before any sort of merger was secured.
The main driver of this CIV is the perceived savings from investment management fees, Greenwood said. “We also think it makes for a more resilient structure on the strategy side, it will lessen our key man risk,” he added.
In January this year, following months of rumours of a possible merged fund, aiCIO discovered that London boroughs were also moving away from the idea of a full merger in favour of a CIV.
Hugh Grover, director of fair funding, performance, and procurement at London Councils, told aiCIO he wanted the CIV to be up and running within nine months, with at least £25,000 committed by each of the 21 boroughs signed up to the platform.
Speaking more recently, Grover says the idea of a CIV was more appealing because, as far as he can see, it won’t require any complex legislation or regulatory changes.
“Merging funds probably will [require them], although I’m not a legal expert on pensions,” he says. “There’s a timing issue around that too—if it’s just regulatory, it can be resolved relatively quickly, but if it needs any primary legislation, then that will have to go through parliament, which would take some time to do.
“The other issue is some of the complexities around merging funds together: how do you balance off the differentials between current performance and funding levels? How do you bring a high performing fund and low performing fund together in a way that doesn’t penalise the high performer?”
Grover adds the borough members were also extremely keen to retain the local democratic accountability. “There needs to continue to be a level of democratic input and decision making as they’re the representatives of council tax payers. If you merge, how do you continue to get that local democratic input?” he ponders.
At this early stage in negotiations, little has been nailed down in terms of the structure of a London CIV, but Grover is confident most risks will be overcome.
“Members have asked us to go back to them with a more detailed business model, so we’re starting to think about governance issues. We’re just working through those issues at the moment. In so far as issues have been raised, all of them seem to be surmountable,” he says.
CIVs may not be all they’re cracked up to be however. John Finch, director at JLT Investment Consulting, told aiCIO in September the savings investors thought they could get by scaling up often aren’t as big as they had hoped.
“Within deep, liquid markets, there is a strong element of truth to the argument that you can get lower costs by merging funds,” he said. “Asset classes such as UK and US equities with large cap stocks would work.
“But at the smaller end of caps, you will hit problems because there simply isn’t enough volume. And in more niche areas of investment, such as frontier markets, there comes a point where you have limited capacity.”
Looking at frontier markets as an example, Finch cited HSBC Asset Management’s current drive to place £600 million in frontier equities.
“If you’re sitting there as an asset manager, do you want £600 million all from one merged client, who will put pressure on me to lower my fees? Or should I take smaller amounts of several clients at the normal fee rate? And I can charge more for the manager research I will have to do for each client,” he explained.
For pension funds still contemplating whether or not to merge, there’s one analogy which might assist their decision making.
Towers Watson’s Zaghdoudi says when his clients come to him to ask his opinion on mergers, he advises them to be careful about choosing their life partners.
“Be aware you can go into this marriage, but there is no chance of divorce. You can’t say after two, three, or five years, ‘let’s pull out’ or ‘let’s go to another pension fund’, and that is a risk. You don’t know if you’ll be satisfied in 10 years’ time.”
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