Ceri Jones delivers an update on developing transition trends in the US across pension funds, asset managers, and life and mutual fund companies.
Transitions in the US this year continue to be driven by long-term risk mitigation as pension funds move to liability driven investment (LDI) structures or to outsource investment responsibility. With increased focus on performance, there are continued efforts to manage costs down, in manager selection and asset allocation decisions, and in the use of transition management (TM) itself.
There has been an increase in OCIO (Outsourced Chief Investment Officer). “Initially this was something that targeted smaller clients who did not have sufficient resources to build out internal staff,” says Rajeev Ghia, Americas head of transition client strategy at BlackRock. “It was typically targeting clients under $1 billion but bigger clients from $2 billion up to as much as $15 billion are now doing it. It is not really about governance or regulatory pressures but back down to what is most cost effective and whether they want to build out the internal staff.”
Many of this year’s largest transitions have involved a shift away from US-specific components, towards combining international equity mandates with US equity mandates under a global portfolio, and there has also been greater activity in emerging markets, and particularly China A shares.
“Most events are still driven by clients making shifts primarily from active to active managers, with only about 20% of transitions in Q1 moved into passive,” adds Ben Jenkins, global head, transition management at Northern Trust.
Pension plans continue to shift from equities to fixed income, typically for LDI matching purposes, with pension funds buying 20+ strips and other long duration assets.
Many defined contribution (DC) schemes are looking to limit fund choice for members to seven-to-eight core options, including target date funds, in place of the 50 or 60 investment choices typically offered in the past. Demand for TMs has also been boosted by changes to existing target date managers for cost or performance reasons, compounded by an unusually high number of corporate mergers.
Asset managers and life and mutual fund companies have also stepped up their use of TMs, often to reduce the cost of implementing changes in sub-advised funds on multi-manager platforms. “A global equity mandate may have three or four underlying funds so the operational considerations can be challenging,” says Kevin Byrne, senior vice president at Macquarie Group. “Reporting requirements can be more bespoke; and there may be opportunities not to transact, because the first consideration is, how do we get from one legal entity to another without incurring additional costs.”
The complex multi-asset class nature of these events requires project management skill, combined with portfolio management and trading capabilities in all asset classes.
“Similar to the DC segment, these clients need support around the project management component of on-boarding and off-boarding assets and are looking for a transparent and risk-reduced manner in which to do this,” says Jenkins. “Like the asset owner community, asset managers are facing increased cost pressures and are looking at methods to effectively and efficiently outsource aspects of their process which are more episodic and more heavily cost-based, including TM activity and even elements of the front office.”
While the priority for all clients is to achieve an optimal outcome, the resources available to plan sponsors are particularly stretched, owing to their additional legal obligations, and more complex investment portfolios.
“This is an era of ‘do more with less’ and plan sponsors are under pressure to produce results with fewer and fewer resources,” says Travis Bagley, director, transition management Americas at Russell Investments.
Fair and equitable treatment for all pension scheme members is a pressure point for plan sponsors, particularly as in most DC events, only a certain set of participants actually require the restructure. Creating a transition structure that isolates transaction costs to the participants causing the change is a key consideration in developing a transition strategy.
Commingled funds and DC account structures can present particular challenges. “These commingled products may hold securities that can be transferred in-kind to the target manager resulting in lower transaction costs for the participants,” says Bagley. “The underlying portfolios in the commingled products involved should be analysed to access the best implementation strategy; in-kind securities or cash and potentially derivatives. With the application of in-kind transactions, the custodian must have accounts available to hold securities, not just pooled funds. This all becomes part of the planning process to ensure that all needed capabilities are available at the time of implementation.”
Exchange Traded Funds (ETFs) are widely used to gain interim exposure because of their specific, targeted returns, and tight pricing, so where there is an exposure mismatch or liquidity constraints an ETF can reduce the risk cost effectively. In addition, tactical exposure to an asset class, such as corporate fixed income exposures, may not be so efficient via futures. ETFs can also be used to circumvent particular problems such as while awaiting a custodial account for a country such as India, which could take six months or more to complete, notes BlackRock’s Ghia.
However, Bagley suggests that in a scenario where a client needs to terminate a mandate but maintain market exposure until a new mandate can be funded, interim portfolio management can minimise total costs relative to ETFs, futures or swaps, allowing the sponsor to focus on higher value-add functions and ultimately deliver better outcomes for members.
“An interim portfolio manager will simply take over management of the existing mandate, optimise it to a tracking-error level with a benchmark index and maintain that tracking error for months or even years with minimal trading and at a very low management fee,” he says. “This interim management strategy can avoid the higher management fees of staying with the unwanted legacy manager and the cost of the alternative strategy.”
Against the backdrop of improving funding status, pension buy-outs have become more prevalent in recent years, nearly always involving just a portion of the defined benefit (DB) plan. Most plans that seek a risk transfer have already de-risked their plans, holding a large percentage of long-duration bonds which can be transferred in-kind to the insurer.
“The main drivers include rising PBGC premiums, administrative costs, investment management fees, and funded status risk/ volatility,” says Steve Fenty, managing director, transition management, US at State Street. “For larger transactions, insurance companies have moved toward accepting assets in-kind (AIKs) as ongoing securities in their portfolio instead of 100% cash. AIKs are attractive as they reduce cash drag and transaction costs incurred by insurers, who will often offer a discounted buy-out price.
“Plan sponsors and investment consultants are engaging transition managers to consult on strategies aimed at minimising the overall cost and risk of a pension buy-out. For example, building out a liability-matched fixed income portfolio in advance of a pension buy-out can serve the dual purpose of managing risk leading up to the transfer and reducing the insurance premium.”
This article features in the Transition Management Guide 2019. Download the full guide here.