The Pros and Cons of Consolidation

Ashby Monk

Two weeks ago, Ontario was abuzz over a blog post by Mark McQueen suggesting that the Canadian Province scrap its five large defined benefit pensions (HOOPP, OMERS, OPB, OP Trust and OTPP) in favor of a single, larger fund that could take better advantage of economies of scale and keep costs low. Here’s a blurb:

“But you’ve got to ask yourself: why a London firefighter, a London teacher, a local OPP officer, a local MTC employee and a nurse at St. Joseph’s Hospital might all be served by different pension plan managers with seemingly different strategies and risk tolerance levels? That can’t be the most efficient way to manage scarce financial resources in wild stock and credit markets, particularly when the same taxpayer winds up funding the shortfall if things don’t go as hoped. Which has been the case for at least the past three years…Each fund also has its own approach to public market management, as well. Some do most of it in-house, while others farm out the stock and bond picking to external managers. Invariably, these costs all wind up coming out of the pockets of the employer and employee in the form of the fund’s own unique investment management expenses and pension admin expenses, which amounted to $959 million in 2010…Just think: five different actuaries; five different audits; five different custodians; five different IT departments managing multiple offices…”

It’s an interesting point that definitely merits consideration. That being said, $959 million of costs on $320 billion of assets (which is the total AUM for the five funds) still only represents around 30 basis points, which is quite cheap (especially when you consider all the exotic assets that these funds are into). As you can imagine, then, the blog post above provoked quite a bit of debate in Ontario, including this letter from HOOPP CEO John Crocker, who argued that:

“Our view is that bigger for the sake of bigger alone, isn’t necessarily better. There are risks – for workers, retirees and taxpayers – when consolidating hundreds of billions of dollars of assets into one “mega fund”. In Quebec, the Caisse de Depot et Placement houses all the pension fund investments for public sector plans – yet in 2008, that “mega fund” lost more money than the five separate Ontario plans combined…Moreover, our CIO Jim Keohane notes that once a fund grows beyond $75 billion in assets the real risk is diseconomies of scale – costs can actually start to go up.”

In short, this back and forth has revived the persistent question of whether an enormous and powerful fund is better than one that is small to medium size and dynamic. Personally, I can see both sides of this argument.

I thought we could consider Norway for a moment. The NBIM, which has close to $570 billion in AUM, will have all the economies of scale that a mega Ontario fund (that McQueen is lobbying for) could ever hope to have…and probably all the problems that go with it.

Let’s start with pros: The NBIM is remarkably cost efficient; total cost of management in 2010 was 11 basis points of AUM. This is very low but perhaps reflects the fund’s focus on indexing and its lack of exposure to illiquid markets as much as the benefits from size. The NBIM, for its part, explains these low costs as a result of the fact that the fund makes “less use of external managers than its peer group.” Indeed, the NBIM believes (and has found) that the cost of internal management is lower than the cost of external management and, moreover, that the NBIM’s internal management costs are lower than its peers. So in short, NBIM has the scale to do things that a smaller fund might not, which is a real positive.

Now let’s consider the cons: The sheer size of the fund means that a small error or event can have significant financial consequences for the country. This is why the NBIM is so focused on internal compliance and controls and has a keen focus on countermeasures to prevent fraud or ‘unwanted events’. While laudable (and necessary), this can lead to institutional sclerosis that prevents innovation or dynamism (i.e. too many rules). But, to give the NBIM credit here, what choice do they have? You can’t manage $570 billion without rigorous and heavy-duty systems to ensure that all operational risks are well managed. But, again, these systems impose a real cost on the fund in terms of innovation, in my view. For example, the NBIM is only now (after decades of operations) moving into real estate and has no other real assets to speak of. My personal opinion is that a long-term investor should be investing in infrastructure, timberland, agriculture, and real estate. But the size of NBIM makes any of these allocations very slow in coming (if they ever come).

In short, there are arguments that go both ways. I can see how being too large can constrain innovation and lead to conservatism. Moreover, being large can drive funds away from some interesting deals; I happen to know some large funds that miss out on fantastic deals that are “too small to move their return needle” because, given that internal resources (i.e. fixed costs) necessary to source and vet don’t change much by deal size, these funds focus on the large deals even though the small deals offer considerable upside. But I can also see that being large can bring considerable benefits. Large funds have the ability to manage assets in house, make direct investments in real assets, and impose a sort of monopsonistic leverage in their negotiations with potential asset managers, all of which offer considerable return potential.

And, so, I think the ultimate decision as to whether a sponsor should ‘go big’ or ‘go dynamic’ depends on the local economic and political geography of the sponsoring authority. In other words, it may make sense for Norway and Japan to have single large funds, while it may also make sense for Ontario and Sweden to have a handful of smaller funds. There’s really no one-size-fits-all solution.

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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