Key Take Aways

Any pension fund must have an individual or appoint an entity that is responsible for the actual implementation of the investment strategy. In a very small pension fund, this may be a trustee or an administrator who buys a few mutual funds and monitors these investments. A larger pension fund can appoint an external organization to carry out the investment strategy. This can be done in many forms, e.g. the Outsourced chief investment officer (OCIO) or fiduciary manager models. As funds grow in size and complexity, they tend to add their own professional investment staff, developing an internal investment management organization (IMO) or committee. Dedicated investment staff can add value to the investment process at any level of the operation. Funds make their own individual choices, incorporating portfolio construction, selection and monitoring of mandates or even the internal management of mandates. However, the role of the in-house IMO must be clearly defined.

We begin this chapter with a discussion of the different types of IMOs, ranging from fully outsourced to fully insourced. In this section, we also address the important question of the size of the “governance budget” for managing and overseeing the IMO from the perspective of the pension fund, i.e. the budget in terms of allocated time, resources, and knowledge. The board decides on this. In practice, this budget is often seen as a given, so the question becomes “What can we do we given the budget?” In reality, the more relevant question is “What governance budget do we need in order to be fit for purpose?”

Governing the investment management part of the fund is no easy task, regardless of whether this is done internally, partially externally, or fully externally to the pension fund. Therefore, in the later parts of the chapter we zoom in on the critical instruments the board possesses to make this structure, which often has elements key for a partnership to work well, such as delegation, the service level agreement (SLA), monitoring, and evaluation.

THE ROLES OF THE INVESTMENT MANAGEMENT ORGANIZATION

In order to be of most value to the fund, the board has to be clear about the roles and responsibilities of the IMO. The following roles can come into play:

1. To execute the investment strategy or policy set by the board;
2. Optionally, there might be a requirement from the fund to add extra value beyond a reference or benchmark portfolio;
3. The IMO may in turn be in charge of the external agents; i.e. the investment managers it selects and monitors for individual mandates on behalf of the pension fund;
4. The IMO is also likely to have an advisory role for the staff and board of trustees of the fund.

The first and most fundamental role of the IMO is to execute the investment strategy or policy set by the board, within the specified parameters. This often appears in the investment policy statement in the form of a set portfolio with boundaries for asset weights, in combination with a risk budget. The execution should be cost efficient, and operational risks should be managed. The board normally also sets a cost range beforehand, and is aware of when costs could change reflecting performance or growth in assets. Regarding the operational risks, the board is likely to have conducted a risk due diligence, identified the most important risks of outsourcing to the IMO, and discussed with the organization what sort of mitigating measures have been taken.

Secondly, there might be a value-added requirement from the fund that the IMO should, at a specified horizon, realize added value over and above a reference portfolio or strategic benchmark when carrying out the policy portfolio of investments. The board of trustees would quiz the IMO as to why it believes there is an opportunity to create extra added value, usually in the form of discussing the organization's beliefs and set up. The board of trustees needs to make sure that these beliefs at least do not contradict the pension fund's values and beliefs. If possible, they should be fully aligned, which is of course easier when the pension fund controls or owns the IMO. Next, the fund has to make sure the IMO has the skills and resources needed to add value.

Thirdly, the IMO can in turn be expected to be in charge of external agents. Execution of the investment strategy requires the selection and monitoring of mandates and developing hedging strategies for interest rate or currency risk. If the pension fund were to deal directly with the individual parties carrying out these mandates and derivatives transactions, information asymmetry would arise. Among other things, the board would face the high cost of information collection. After their purchase, the board would have to monitor its investments in a timely and complete fashion. Failure to monitor would expose the fund to agency costs, i.e. the risk that the asset managers will take actions contrary to the promises made at the start or as stipulated in the covenants or agreements. This is especially relevant when the manager as party to a financial transaction has information the board does not, and when control and enforcement of contracts is costly. The IMO should therefore play a valuable role in intermediating between the board of trustees and individual asset managers, controlling the outsourced activities and making sure that there are no incentives for the asset managers to manage the investments other than in the interests of the pension fund. Combining internal fund management with external management leads to potential agency issues where the IMO may be biased towards internal management.

Fourthly, the IMO is likely to play an advisory role to the staff and board of trustees of the fund: given the objectives of the fund, it can advise on asset liability management (ALM), strategic asset allocation (SAA), the implementation forms within asset classes, and discussions on investment styles such as active vs. passive. This advisory role is important for a board. Because the search and transaction costs of switching to another IMO are high, it is desirable for a long-term relationship to develop, where the IMO builds up intimate knowledge about how the fund and board works, enabling it to provide tailor-made advice. The IMO will know the risk appetite, preferences in implementation, and particular dislikes that board members might have where investment management is concerned, all very helpful insights for drafting the right proposal. On the other hand, the IMO does have to balance both the goals of the board, and the goals of its own organization. The challenge for the board is to recognize that the IMO has a difficult role to perform. On the one hand, the board expects the advisory role to be aligned with the fund's goals insofar as possible, and not solely reflect its own particular views or investment solutions. On the other hand, the IMO has assets under management and profitability targets, so the advice cannot be entirely disinterested.

Finally, the IMO needs to be alert to developments in financial markets and be adaptive. While the pension fund sets out the long-term strategy and the set of asset classes or investment solutions in its most simple form, to reflect its return objective and risk appetite, the role of the IMO is to critically monitor this set of asset and investment solutions. This includes envisaging how it will evolve and develop, and looking out for better alternatives for achieving the fund's goals. Investment classes that fit well in the portfolio today might not do so in a couple of years, due either to the economic cycle that affects the return/risk assumptions, or to in or outflows in the investment class reflecting increasing or decreasing popularity. To be an effective manager of external agents, the IMO needs to develop insights on how the value chain can best be organized—starting with the fund and ending with external managers—to deal with a changing set of opportunities and threats, and to develop strengths. If the IMO itself has no innovative skills, it will have to monitor developments in the asset management industry and adopt innovations at an early stage.

FUNCTIONS AND TYPICAL EVOLUTION OF THE IMO

The size and development of the IMO is a function of the size and complexity of the pension scheme.¹ As a general rule, when the size of the fund grows, more resources become available to make informed decisions on where to allocate policymaking, execution, and monitoring in the investment management process. During the process, the fund acquires more and more intellectual property on its own. Three types of investment organization models emerge (see Exhibit 12.1), which could be tied in to the governance budget that a board wants to spend.

The first model concerns the smallest pension funds. These are funds with less than $500 million assets under management. Due to the scale, these funds are usually price takers in the investment management industry, having little or no bargaining power to drive down costs, or resources to allocate to investment solutions that create a higher expected return. Cost minimization, focus on the strategy at hand, and eliminating all elements that detract from achieving the goals or where the fund has no influence or bargaining power, such as active management or illiquid investments, are key driving factors for the IMO. These funds will generally employ an external investment manager to recommend and implement both strategy and selection decisions through a few generalist funds or a selection of specialist funds. The investments in this model are all-in funds, comingled with the assets of other institutional investors that have similar objectives. The external manager may use funds from their own organization, where the preference is for mutual funds that combine different assets to diversify effectively, and/or investment strategies that are passive in nature, thus reducing the monitoring pressure on trustees to invest in depth in the monitoring of the funds and focus on the strategic choices instead.

Trustees of such small pension funds may have little investment experience and rely entirely on the judgment of the chosen asset manager. A consultant may help to establish a strategy, recommend an investment manager, and monitor the results. The manager will make tactical asset class decisions. There might be an in-house staff or executive office. But their prime responsibility is administration, and the monitoring of policy and investments is just a part-time role.

The second phase in size and complexity is when the pension fund moves from generalist to specialist management. This process involves adding other funds or managers, either to expand diversification by adding new asset classes, or by gaining investment styles and strategies within the asset classes. Comingled or generalist mutual funds become less important in portfolio construction, as more and more specialized strategies are added. Within the pension fund, the selection and monitoring process as well as the portfolio construction will require more attention. The executive office will have one or more investment officers for the overall coordination, supported by an investment consultant. An investment committee is established, composed of a few board members, and several external members. The committee is charged with monitoring the execution of the investment policy, providing countervailing power to the advice from the IMO and, at times, the committee is used in an advisory capacity on investment issues. If the assets are large enough, the fund will opt for one or more segregated mandates.

What separates the first phase from the second phase is that the fund internalizes strategy formulation, as well as parts of the selection and monitoring policy. In some cases, the fund also internalizes tactical asset allocation decisions. The executive office must be able to aggregate and prepare effective information for the investment committee to be able to make tactical decisions or have enough investment experience to do themselves. The investment committee, on the other hand, must contain sufficient professional experience to make judgments in that area and have enough seniority to remain focused on the long-term goals of the fund, rather than engaging in day-to-day financial markets. The role of the investment consultant also changes. In the first phase, the consultant normally educates as well as directs the board of trustees, laying a large proof of burden on the consultant to give the right advice. In the second stage, the investment consultant encounters financially educated investment staff and the investment committee. Their job is now to convince the staff and committee on specific pieces of advice. In this phase, funds run the danger of receiving and discussing overly technical material, trying to get to grips with it rather than setting the course based on the information.

The third stage is the development of a full in-house capacity. This involves a full time, in-house group of asset managers and portfolio strategists. Pension funds managing $5 billion or more have the suitable scale to start considering this model. The scope and form of the in-house capacity depends on the following decisions:

• Does the board see any value in a full in-house capacity? For example, is there a strong case that the pension scheme's characteristics cannot be served adequately in standard administrative systems; does the board hold distinguishing views towards financial markets, requiring tailor made investment solutions not easily available or does the board hold a view which skills and capacities should be retained within the fund to provide maximum adaptability for future developments?
• Within the investment management process, should the fund manage strategic investment policy and portfolio construction as well as implementation, managing the mandates in-house?
• Should the staff concern itself with setting the strategic policy, the management of the balance sheet on a higher level? Or should the fund be involved in the in-house management of segregated mandates? In other words, where in the value chain could be the most value added by insourcing?
• In terms of business model, should the fund consider a separate investment management company, or consider a separate asset management arm?
• Related to the previous question, should the pension fund incorporate staff and executive office within the asset management arm, or keep it as a function close to the board?

Jumping from an external to an internal IMO is not a forgone conclusion. Pension fund boards have a wide range of organizational forms to execute their investment management function. The relationship can have one of the forms in Exhibit 12.2.

Outsourcing

The board basically outsources investment management. It transfers the investment function from the pension fund to a (commercial) IMO that is not owned. In turn, the IMO can (and often will) outsource a number of functions to third parties, a form of subcontracting.

Outsourcing can provide a number of substantial benefits.³ For example, it may permit boards to obtain necessary expertise at a lower cost than might be possible by hiring internal staff, and allows boards to focus on their core business: strategy formulation and monitoring.

With outsourcing, the board decides to have services provided by an IMO, without any financial ties other than the stipulated in the contract. The relationship is for a specific period, after which the services can be tendered in the market or renewed with the existing IMO. The board has to draw up an investment management agreement and an SLA.

Outsourcing poses a number of challenges for pension fund boards. Transferring investment functions to an IMO may have a detrimental impact on the board's understanding of how the function is performed, with a consequent loss of control. There is a risk that the inappropriate selection of an IMO may lead to a business disruption, with negative consequences for the pension fund's participants and, in certain instances, the potential for systemic risk to the market as a whole. The external organization will serve more masters and will be a for-profit organization, which may distract from the priority of serving the pension fund. Finally, the board runs the risk that due to inadequate internal process with the IMO, mistakes or gaps in oversight arise, causing reputational damage for the fund.

Outsourcing also creates important challenges for the integrity and effectiveness of the regulator. First, where outsourcing takes place by regulated entities, a firm's control over the people and processes dealing with the outsourced function may decrease. Nonetheless, regulators require that the outsourcing firm, including its board of directors and senior management, remain fully responsible (towards clients and regulatory authorities) for the outsourced function, as if the service was being performed in-house. Second, regulators expect that they will have complete access to books and records concerning an outsourcing firm's activities, even if such documents are in the custody of the firm's service provider. Regulators must also take into account the possible operational and systemic risks that may exist in the event that multiple regulated entities use a common service provider.

The mentioned risks and benefits need to be on the board's mind when entering the outsourcing relationship.

The connection with the external investment manager can range from strictly transactional (client–provider) to relationship- or partnership-based (partner–partner). In the first case, services are clearly defined in terms of deliverable, price, and monitoring; and investment services are predominantly seen as interchangeable components. In the second case, the board views outsourcing mainly based on relationship. The more proprietary information is shared between the pension fund and investment organization, the more tailor-made the investment function can be designed for the pension board. This, is turn, should result in a higher alignment with the board's goals and better outcomes in the short term and in the long run. For the IMO, the relationship-based model has pros, such as a potentially long and deeper relationship with the client, and cons, such as potential higher cost of customization, as is shown in Exhibit 12.3.

ISSUES IN DEALING WITH AN INVESTMENT ORGANIZATION

In dealing with the investment organization (whether external or proprietary), the board has to consider the following issues: delegation, compensation, alignment of interests, and potential differences in culture. We further detail these issues in the following paragraphs.

Delegation. The board assigns specific tasks or authority to the IMO, specifically one or more of the activities described at the beginning of the chapter: execute the investment strategy or policy set by the board, adding value beyond implementation of the policy portfolio, be demonstrably in control and in charge of the mandates and investment managers they select, and monitor on behalf of the pension fund. This delegation is one of the core concepts of board leadership. However, the board remains accountable for the outcome of the delegated work: board responsibility cannot be delegated. In addition, delegation always requires countervailing power, understanding, and probing. If that isn't done right, problems will arise.

Delegation empowers a subordinate to make decisions, i.e. it is a shifting of decision-making authority from one organizational level to a lower one. There is no simple answer to the question of what is the right level of delegation of the fund to the IMO. The following points must be taken into account:

1. A necessary ingredient for delegation is trust. Trust requires maintenance and understanding.
2. Delegation always introduces agency issues. The right level of delegation is a balancing act between the added value of specialization and the cost of delegation.
3. The more material a decision is for the realization of its objectives, the more the board should be involved and own it; therefore, crucial decisions about the SAA should always be owned by the board, and the implementation can be delegated to the investment organization.
4. The more technical knowledge and know-how are required for a task, the more it should be delegated to the part of the chain of the investment process in which this is available. This should be done in such a way that the board sets the policy and the parameters. While the board cannot predict the outcome (nor should it necessarily have the knowledge to predict it), it can determine in advance the acceptable bandwidth of the outcomes. Hiring and firing of individual external asset managers should be within the realm of the IMO. When the strategic parameters on investment style, type of mandate, and horizon are set, the actual selection and monitoring come down to operational decisions and are skill intensive.
5. If the board of trustees wants to build a culture and DNA for the long term, it has to invest a lot of time in developing a shared set of beliefs and a shared culture. It has more control over the IMO when this is done in its close proximity.

Compensation. Another complex issue with which trustees are currently struggling is the manner in which investment organizations are being compensated for their services. Given that trustees are responsible for negotiating fees or salaries, they can exert significant influence on the way people work and collaborate, provided of course that a properly designed compensation framework is in place. However, experience demonstrates that the conventional and widely used model of pay-for-performance is often in conflict with long horizon value creation.

Alignment of interests. There are a number of significant implementation issues regarding the investment organization that currently dominate an industry-wide debate among trustees. “Alignment of interests” is such an issue, because the interaction between the investment committee (representing the interest of the fund) and the IMO is regarded as probably the most important factor in creating investment success. If this discussion is not dealt with from the beginning, a lack of understanding and trust increases between fund and IMO. It is not always clear who is in charge: the pension fund or the IMO. Since by nature the IMO has more resources, experience, and continuity in the investment field than the board, it should help the board in a subtle way to ask the right questions. When asked, both board members and executives state that trust is the most important ingredient between a fund and the IMO.

THE SERVICE LEVEL AGREEMENT

Delegation of responsibilities is the basis for a board to draw up an SLA, setting out in detail the services to be provided and the mutual obligations of the partners and attendant parties. In other words, the expectations of a working relationship between the board and IMO are dealt with. In our view, the SLA is a valuable tool regardless of whether the investment management is outsourced or owned.

A pension fund should be able to rely on the integrity of its IMO manager and on the solidity of their contract to guarantee an effective partnership, but when it comes to the management of specific tasks, a clear, concise, comprehensive and unambiguous SLA is a must. This is without a doubt one of the most important prerequisites for entering an effective, surprise-free, long-term fiduciary relationship. Transparency is the key to an SLA and detail is its best servant: it is better to spend extra time in definition and dialogue up-front than to find out that the partners don't agree on things when an emergency appears.

A fair and effective SLA can only be based on clearly defined mutual obligations between the partners. A pension fund board should also indicate its responsibilities in the SLA so that the fiduciary manager can be confident it will be called upon to deliver its services at the desired level and on a fair playing field.

To monitor the effective delivery of the services described, an SLA should contain guidelines for assessing the performance of a fiduciary manager per service. Each service is then represented by a set of agreed-upon performance indicators, which are a just reflection on the core of the service. Agreeing on fair measurements up-front will help providers stay on top of their game and the pension fund assess its partners' performance.

The SLA is a valuable framework to evaluate the IMO, where the executive office and the board discuss and monitor the progress on a regular basis. This is only part of the story in the long-term relationship. The board should be aware of the elements that are more difficult to capture in SLAs. Assessing how the investment management scores on them and tracking this over time will provide valuable insights on whether the relationship is more transaction-based or relationship-based. A board could also ask the IMO to reflect on these issues and indicate how the board scores on them.

The delegation of responsibilities requires a board to draw up an SLA, setting out the services to be provided and the mutual obligations of the partners and attendant parties in detail. In other words, expectations of a working relationship between the board and the IMO are enshrined therein.

MONITORING AND EVALUATING THE INVESTMENT MANAGEMENT ORGANIZATION

The investment management should be monitored continuously and evaluated regularly—at least once in three to five years—both when it is outsourced to an external or to a proprietary IMO.

The SLA should form the basis for these activities: it should clearly outline what is expected from the investor, in terms of goals and acceptable outcomes, but also in terms of behavior and deliverables such as reporting and communication to the board. Ideally, the SLA contains a multidimensional scorecard that forms the basis for monitoring and evaluation. This should be acceptable and fully understood by both parties beforehand, so that no ambiguity arises during the execution. The more the relationship resembles a partnership, the more the monitoring and evaluation will be two-sided; the board, and especially the board investment committee, are very important parts of the value chain and should therefore be open to monitoring and feedback.

Of course, every now and then there will be very tough conversations between the parties. In a learning system between fund and investment manager, we feel the primary objective should be to learn and improve from the ongoing monitoring and evaluation process. The more long-term the relationship is, the more attention there can and should be paid to the learning part; this is where the collective intellectual property of the fund and the investor will increase.

Whereas the monitoring is an ongoing process, the evaluation should in principle take place on a regular basis, unless there is a specific reason for more immediate action. It may be valuable to have an external party such as a consultant involved in the process. On the basis of the scorecard mechanism in the SLA combined with observations by the parties involved in the process, it should be possible to draw up an agenda for the evaluation. The outcome could be that some of the aspects of the services will have to be upgraded or improved. Often, an evaluation will result in a new version of the SLA containing the new insights resulting from the evaluation process.