Insourcing has emerged as an important strategy for pension funds to reduce costs while maintaining a tight grip on risk and performance across their portfolios. In a recent State Street survey, four out of five pension funds said they intend to increase the proportion of their portfolio that is managed in-house.
The savings achieved by insourcing can be substantial. Another study revealed that pension funds spent, on average, 46 basis points on external management compared with 8 basis points on internal investment capabilities. As well as cost benefits, pension funds also see insourcing as an opportunity to reduce agency risk through increased oversight. The principle is clear: if pension funds can get closer to the underlying assets, they have an opportunity to save money and get a better grip on risk and performance.
Insourcing can deliver significant benefits, but most pension funds will want to use this strategy selectively. Many start by focusing on areas such as government bonds or domestic equities where they typically have extensive in-house expertise.
However, pension funds’ investment portfolios are becoming increasingly complex and still need specialist support. State Street’s survey shows many pension funds are increasing their allocations to alternatives in a bid to deliver much-needed upside performance. Private equity is a priority, with 60 per cent of survey respondents saying they will increase existing allocations to this asset class. Other alternatives are also attracting more investment from pensions, including hedge funds, property and infrastructure.
Funds need to be clear about where their in-house teams can add value. Most will need to retain a range of external partners to help them leverage more specialist investment strategies. Those that decide to bring some areas of asset management in-house need to plan carefully. Insourcing in today’s investment environment requires new skills and capabilities.
Basis points pension funds spend on external management
Talent is high on the agenda and in demand. To manage a broad range of assets in-house, pension funds will need to attract people with specialist skills. Those set on an ambitious insourcing path may need to increase headcount substantially.
Insourcing demands operational expertise in areas such as risk and compliance management. Attracting talent will require pension funds to design competitive packages. For funds that set up different specialist teams, it is important to maintain consistency and transparency across employment contracts. Otherwise, a generous deal designed to attract new talent may be resented by existing employees.
Basis points pension funds spend on internal investment management
Technology is another piece in the puzzle. As they insource, funds will need to build a coherent picture of risk and performance across multi-asset portfolios. This requires technology that can provide full-scale integrated risk analytics. This is difficult to achieve using traditional risk software, which is often engineered around a single asset class. It is another reason why insourcing is likely to require an overhaul of operating models and data infrastructures.
As funds use a mix of in-house capability and external asset management of more specialist classes, they are looking for a new relationship with asset managers. Managers will have to be able to work as fully fledged investment partners: understanding funds’ investment goals intimately and delivering solutions tailored to their long-term objectives.
As pension funds may also pursue a parallel outsourcing strategy and try to outsource critical operational functions, such as data management, to specialist partners.
The ambition and degree of insourcing will be a strategic decision, more often than not resulting in a mix of internal capabilities and external partners. To make this strategy work, funds will require a new relationship with their external asset managers and smart operating solutions for their in-house plays.
William Slattery is an executive vice-president of State Street Corporation and head of the Global Services business in Europe, the Middle East and Africa
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