UK review highlights potential savings from fund mergers

A just released UK report into public sector pension fund costs also highlights the potential for Australian super funds to achieve cost savings for members via mergers.

The report, which can be found here, was prepared in respect of the UK Local Government Pension Schemes – 89 separate but sub-scale local government funds – to identify how savings could be made in investment costs.

The report has been sensational because of its main finding that the best way to make savings is to abandon active management of public market assets, in favour of passive management.  It concludes that active management adds no value over any material time frame, even before fees.  Moving from active to passive would save fees at no cost to returns, because there have been no positive active returns after fees and costs.

This will be even more controversial in Australia where most institutional investors believe it remains possible to add value for members via active management.  The conclusions are unlikely to find much support at REST, for example, but will find sympathy at QSuper, already has already adopted such themes.

The report has also gained interest in Australia, but the situation is not entirely analogous.  The UK funds involved are public sector and defined benefit, so for the UK, this is essentially about cost to taxpayers rather than fund members.  That said, without getting into the active vs passive debate, there are observations which provide useful contributions to the debate over super fund mergers.

The report explores 3 implementation options:

– Creating a central pooled investment platform, with a single, passively managed pool for each asset class.  All 89 funds would have to use the platform, but would otherwise continue to exist as independent entities, with their own services, and able to choose their own asset allocation by assembling the asset class exposures as they deemed fit.

This is essentially a fiduciary management model, where funds retain their independence and identity, but merge their investment platforms.  We haven’t seen this model in the Australian market, although is it well known in Europe.   

– Creating 5-10 investment platforms; essentially a variation on option 1, which would provide the 89 funds with more latitude.
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– Merging the 89 separate local government funds into 5-10 much larger funds – presumably regional funds – each of which then have its own passive investment platform.  A bit like option 2, but delivering mergers of funds as well as investments.

Interestingly, the report does not highlight fund internalization as one of its cost reduction strategies; it focuses on passive management and the scale benefits from pooling.

Given this emphasis, it’s perhaps unsurprising that the report identifies maximum savings being delivered by option 1.  It would create an investment platform of ~$325bn, with ~90% in passively managed public asset class pools.  The remaining 10% would be a series of alternative investment pools, removing the costs of fund-of-funds.

Savings under option 1 were estimated at ~60% (which at an average of 44bps are not exactly high as a starting point), derived from a combination of removing active fees, cutting costs on alternatives, and lowering turnover costs.

Option 2 and 3 savings were ~90% and ~70% respectively of those projected for Option 1, reflecting reduced pooling gains.

The report does not consider costs or benefits other than investment management (ie such as those which would be derived from merging fund entities), so it is not a complete view of potential fund merger gains.

However, for Australian super funds, it highlights some important issues:

– Fund mergers which create single, scaled-up investment platforms are likely to achieve cost savings.  Even if funds remain committed to active management, increased scale offers more bargaining power, and more structuring flexibility to take out investment costs.  That said, the evidence suggests that super funds do in fact increase allocations to passive management as they scale up, offering further fee savings.

– There should be room for a fiduciary management model in the Australian market, where large funds would allow smaller funds to merge their investment platforms (and perhaps other parts of their operating model) while retaining their independence, brand, board, etc.  It may not be as efficient as a full fund merger, but in the face of sometimes intractable board politics, it may be better than nothing.   And of course, it can function as a first step; it does not have to be the last word. 

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