Governance and Investment management of Dutch pension funds in times of rapid asset accumulation

Diploma in Financial StrategyKatherine KucherenkoFebruary 2016

Governance and Investment management of Dutch pension funds in times of rapid asset accumulationA broad look at strategic decisions, challenges and lessons learned

from the trustees’ perspective during the merger wave

GOVERNANCE AND INVESTMENT MANAGEMENT OF DUTCH PENSION FUNDS IN TIMES OF RAPID ASSET ACCUMULATION 3

“It’s not that there’s an optimal solution to the market under realistic assumptions, and people deviate away from it. It’s a shift from assuming that there’s an objective world out there to saying

that the world is created subjectively.”

Brian Arthur

4 GOVERNANCE AND INVESTMENT MANAGEMENT OF DUTCH PENSION FUNDS IN TIMES OF RAPID ASSET ACCUMULATION


Abstract

This paper digs deeply into the governance and investment management decision process of consolidating pension funds from the perspective of trustees of growing funds and presents findings Based on twenty one in-depth semi-structured interviews with chairmen and members of the board of trustees, CIO’s, industry professionals and researchers. The findings confirm the existing economies of scale for asset management and administration costs, but suggest that evident diseconomies of scale should be taken into account when a fund pursues infinite growth. Furthermore, the author presents the lack of relation between size and investment belief and sheds light on the shifting nature of the belief in the post-GFC era towards investing in passive mandates, followed by a number of major considerations as to why active management is losing ground. Furthermore, this paper documents not only evidence of large pension funds investing more in illiquid assets, but also the reasons for smaller funds to stick to the traditional, liquid asset classes. Additionally, the paper reports on transparency, sophistication of transition management and bargaining power as key factors in the selection of a pension executor. Lastly, the author analyses the main challenges to the consolidation processes thus far and argues that transition of administration and assets, difference in funding ratio and unexpected procedures from stakeholders are most important.


Table of Contents

I. Introduction 8

II. Methodology 11

III. Optimal Size 12

IV. Investment Belief 14

V. Asset Mix 16

VI. Selection of a pension executor 19

VII. Challenges and lessons learned 20

VIII. Conclusions 22

List of Interviewees 25

References 26


I. Introduction

“ Chaos is when the present determines the future, but the approximate present does not approximately determine the future.” Edward Lorenz

The Dutch pension system is relatively large compared to the size of the domestic financial market. At the end of the second quarter of 2015, the value of assets under management amounted to 1,247 billion euro1.

The Dutch pension system is based on three pillars. The first pillar is state pension, which is financed on pay-as-you-go basis. Occupational pre-funded pension plans form the second pillar. The third pillar consists of the private savings of retirees, undertaken on their own initiative. The second pillar, which is the focus of this paper, consists of two types of schemes: an industry-wide scheme or BPF (Bedrijfstakpensioenfonds) and a company-wide scheme or OPF (Ondernemingspensioenfonds). The mandatory nature of the occupational system has resulted in a significant accumulation of assets. The extent to which a pension fund can meet its liabilities is reflected by the funding ratio, which measures financial wealth relative to the liabilities.

The stock market crash in 2008 and the fall in interest rates took away a significant portion of accumulated pension wealth and raised the value of liabilities, which resulted in a deterioration in funding ratios. As the system struggles to distribute the shocks in a post global financial crisis (GFC) environment, Dutch pension funds also have to deal with challenges of a more structural nature, such as exposure of defined benefit pension plans to interest rate risk and demographic trends such as an ageing population and declining proportion of younger people in the workforce. On top of that, the on-going sophistication of financial markets and urgency to meet funding requirements has challenged the competences of trustees and uncomfortably revealed the limitations of boards’ investment expertise.

At this juncture no one can say with certainty what will happen in the future. The speculations regarding the disappearance of the mandatory nature of occupational pension plans and the switch from defined benefit to defined contribution schemes, deters funds to rethink their governance and investment policies from the ground up. Furthermore, not only the pension funds with an alarming underfunding, but the system as a whole has

1 Dutch Central Bank, Q3 2015

to deal with a structural deficit, due to the longevity risk that is materializing. Driven by the low interest rates, the outlook for the portfolio returns in the coming decennium is less comforting than before the GFC. Although for the time being there are enough buffers and instruments with dampening effects in the system to keep the clock ticking, some pension funds succumb to the urge to gamble their deficit in more risky investments, as they sail off into the deep waters of structured finance.

In the light of these developments, the Dutch Central Bank (DNB), which is the pension funds regulator, has emphasized the need for competent trustees and has questioned the need for 600 (2010) funds; a rapid consolidation would make it easier to find competent trustees and the industry would benefit from economies of scale along with sophistication of investment policies. To move from words to actions, the regulator suggested 100 funds as a distant goal and urged pension funds to formulate a long-term strategy, which should include a strategic choice of growing through a merger with, or an acquisition of, another pension fund or of transferring the assets and liabilities to another fund or the insurer and subsequently liquidating itself. As many industry professionals put it, the trustees should decide whether their fund will be the predator or the prey. The sense of urgency to do so differs, since the larger funds are considerably safer than small and underfunded ones, which have received a personal note from DNB questioning their licence-to-operate and urging them to come up with a plan. The constant pressure of bureaucratic complexity stemming from the regulator is fuelling the consolidation process, which resulted in 278 funds by the end of 2015. After this 50% drop in 5 years, it is now being said that consolidation is now in a stage of acceleration and that, in disregard of DNB’s point on the horizon, the common wisdom is that around 50 pension funds will survive this merger wave.

To date, all pension funds have set up their own ‘Future Commission’ to investigate their options in more detail. According to industry professionals, the route of transferring pension plans to an insurer – because of the historically low interest rates – has largely ‘dried out’, forcing the clustering of occupational pension funds. While some funds are looking into a merger with another one of equal size, it is being said that acquisitions of small funds by larger ones will account for the gross of consolidation activities.


This means that while some members of the board of trustees will have to navigate their pension fund through the process of liquidation, others will have to manage theirs during the period of rapid asset accumulation.

When it comes to the latter, in a process, the members of the board of trustees are fully responsible for the governance and investment strategy of the pension fund and are required to make a number of strategic decisions. This paper seeks to contribute to the greater understanding of considerations faced by trustees when the pension fund significantly increases in size and major strategic decisions are being made in order to give substance to governance and investment policy in these turbulent times. The governance related decisions involve questions such as: should the pension fund pursue growth through acquisitions in order to take advantage of economies of scale and which market player is the best partner for managing of assets and liabilities? The investment strategy related decisions involve the choice for an active or passive investment belief, followed by the composition of the portfolio. Although the enumeration of these milestones is not exhaustive, these ones are considered to be of great significance. The focus of this paper is limited to a study of these decisions. Last but not least, it is important to investigate and document the lessons learned from the previous mergers and acquisitions, in order to reduce the ambiguity for the less experienced trustees and help them to make better, more informed decisions during any future mergers and acquisitions.

The following questions shall be addressed:1. Should pension funds pursue infinite growth in order to take

full advantage of economies of scale or do diseconomies of scale exist?

2. Should pension funds critically examine and adjust their investment belief during the period of rapid asset accumulation in order to optimize their performance?

3. Should pension funds critically examine and adjust the asset mix as their portfolio increases?

4. What factors play a key role in the selection of a pension executor responsible for asset management and pension administration activities?

5. What major challenges have members of the board of trustees encountered so far and what lessons learned can be distilled from the previous mergers and acquisitions?

Merger waves in the pension fund industry occur on such a large scale that for many countries they are once in a lifetime events. To the author’s best knowledge, these five questions (especially numbers 4 and 5) haven’t yet received significant academic attention and are not extensively documented. This paper aims to fill this gap. Although this paper concentrates on the Dutch occupational funds, most findings are not unique to the Dutch situation and have broader applications. The study is not a deep or quantitative exploration of the decision-making process and its impact, but rather a broad, high-level qualitative summary of professional perceptions. The drive behind the relatively large number of questions that the author seeks to address within the constraints of this paper reflects the perceived importance of making a snapshot of collective knowledge and experience of the current merger wave from a broad perspective, by interviewing a number of key players, who find themselves at the heart of on-going consolidations.

The remainder of this paper is organized as follows. Chapter 2 will describe the methodology and will elaborate on the shortcomings of the research method and its execution. Chapters 3, 4 and 5 are analytical and address the first three questions; respectively the size of the pension fund in relation to its cost efficiency, investment belief and the asset mix. Within these chapters, the author reviews the existing relevant literature, presents research findings and offers an analysis of the outcome in relation to existing theoretical ideas. Chapter 6 focuses on the factors which influence the selection of a pension executor. Chapter 7 sheds light on challenges and lessons learned by the members of the board of trustees. Due to the relevance of the local context and the limited academic attention questions 4 and 5 have received, these two chapters will only offer the findings from this study and will not be placed in an existing academic context. Chapter 8 recapitulates, draws conclusions and puts forward recommendations.


II. Methodology

“ A study of the history of opinion is a necessary preliminary to the emancipation of the mind.” John Maynard Keynes

The empirical strategy of this study utilizes the knowledge and experience of industry professionals to address the questions formulated in the previous chapter. Due to the highly qualitative and subjective nature of the required data, the author has chosen for in-person interviews with professionals, which can elaborate on questions concerning their governance or investment management background, or both. This approach has resulted in 11 in-depth interviews with the chairmen and members of the board of trustees and other key figures in pension funds, which were directly or indirectly involved in the decision process during the consolidation process or have inside information which can contribute to answering the five questions formulated in this paper. As the majority of the interviewees are involved in multiple boards, the outcome was a discussion of the governance of 19 funds, which account for approximately 45% assets of the total sector.

Furthermore, because a number of questions require a sophisticated investment management expertise, which in some cases lies beyond the knowledge and experience of the trustees, the author interviewed 3 investment management experts. These professionals are among the key figures at top pension executors, which manage the assets of 3 of the top 5 Dutch pension funds and over 40 smaller ones (700 billion euros pension assets combined, which account for approximately 55% assets of the total sector) and can provide detailed information on the investment strategy and execution.

In addition to this, the author interviewed 7 researchers and industry experts to elaborate on literature findings, verify the gaps, reflect on the findings and/or shed light on the questions from a different perspective, in order to avoid missing essential elements in the process of compiling the whole picture.

Based on the list of the interviewees and findings from their interviews, the author assumes it to be safe to draw conclusions for the top 5 largest pension funds and the majority of the middle-sized and small ones. Despite the fact that a large portion of trustees and investment management professionals of the Dutch pension funds were not interviewed, as the interviews proceeded, the number of additional insights, minor details notwithstanding, declined almost proportionally, leaving the author with a condensed impression, one which had essentially been boiled down to its essence.


III. Optimal size

“ When the accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals.” John Maynard Keynes

Should pension funds pursue infinite growth in order to take a full advantage of economies of scale or do diseconomies of scale exist?

Literature reviewAn insight into cost structure and pension fund’s performance related to its size is necessary in order to answer this question from an academic perspective. The pension fund’s cost structure mainly consists of investment and administrative costs.

Investment costs can be sliced into management and performance based fees and differ between asset classes, namely fixed income, equities, real estate, private equity, hedge funds, and commodities. A significant amount of empirical work has been done on the relation between the fund size and investment costs. Bauer et al (2010) provided empirical evidence that large pension funds have much lower investment costs than smaller funds, however, the study only focused only on US pension funds, which face different regulations and operate in a different context.

Similarly to investment costs, numerous studies documented a negative relation between pension administration costs and the size of a pension fund; in particular pension industries in Australia, the US and Latin America have been studied extensively and report significant economies of scale.

In the Dutch context, a growing amount of papers confirm the existence of economies of scale for both types of costs. Bikker et al (2010) observe strong evidence of economies of scale for administrative costs: “a 1% increase in the number of participants would increase costs by 0.76%”. Broeders et al (2015) find significant evidence of economies of scale in investment costs; “a pension fund that is ten times larger, in terms of assets under management, has on average 7.67 basis points lower annual investment costs.” However, size appears to be an important driver for economies of scale only for equity, fixed income and commodities (under 300 million euro) asset classes, suggesting that economies of scale do not exist for illiquid asset classes.

The effect of scale on the performance of a pension fund has received little academic attention thus far. Furthermore, the

evidence of the existence of diseconomies of scale, which suggest the optimal size for a pension fund is not that clear-cut. Andonov et al (2012) argued that “while larger funds have lover investment costs, this does not lead to better performance” and exhibits substantial diseconomies of scale. However, apart from the fact that reporting was voluntary and was a subject to self-reporting bias, the study focused on US pension funds and analysed components of active management, which might not be representative for the Dutch pension funds with passive strategy. Similarly, Chen et al (2004) find strong evidence that fund size erodes performance, however, the focus group were the US mutual funds, which are largely actively managed and are less regulated. In contrast, Huang and Mahieu (2011), which studied the Dutch pension funds, find evidence that the largest pension funds outperform the smallest ones, but do not suggest an optimal size. To the best knowledge of the author, only Bikker (2013) provides this insight, suggesting that the optimal scale for a pension fund is 40,000 participants, but that administrative costs decline without limit. In terms of a portfolio size, the optimum is reached at 690 million euro “without a clear shift over time and without diseconomies of scale”.

Based on previous academic work, the author concludes that there are economies of scale for liquid asset classes and infinite economies of scale for administration costs and seeks to reflect these findings with industry professionals, who are aware of the change in the cost structure at their funds after one or multiple mergers and acquisitions. Furthermore, although the majority of academic work which provides evidence of diseconomies of scale has focused on pension funds in other countries and less regulated industries such as mutual funds, the author seeks to fill this gap by documenting the scale disadvantages for pension funds in the Netherlands.

Findings and discussionEconomies of scaleAll interviewees who had a view on the changing cost structure after consolidations, did confirm that administration and asset management costs do decrease. Trustees argued that their funds did become more cost efficient after various consolidations, but the savings differ from negligible to substantial, both on administrative and asset management sides, although the


decrease of the administration costs was more substantial. Additionally, the decrease of investment management costs is subject to heated negotiations with asset managers, and strongly depends on whether the fund is managed actively or passively and whether the fund choses to do business with high- or low fee/service providers. However, Interviewee 7 was sceptical about economies of scale for investment management costs and argued that their fund has no economic reasons for acquisitions of smaller funds, the cost level is already optimal: “Economic reasons for a transaction are put on paper to convince the regulator, but after a couple of consolidations, despite our steady growth, the cost savings of investment management are not substantial”.

Investment management experts do confirm literature findings that economies of scale of asset management costs for liquid asset classes are infinite. Interviewee 12 admitted that at some point the cost savings become marginal, but the economies of scale are evident: “Small funds can better outsource their asset management to the different aggregators that charge the lowest fee per asset class.”

In general, there is a consensus that the return is more important than the cost structure and, when it comes to costs, the question is not ‘how low can you go’ but ‘is it market-conform’. However, the majority of the interviewees confirm that there is enough room for more efficiency for both types of costs in the system, endorsing the existing theoretical ideas.

Diseconomies of scaleDespite the acknowledgment of economies of scale for liquid asset classes, which confirms the literature findings, among the majority of the interviewees there is a consensus that the optimal size related to performance of a pension fund follows the hockey-stick curve, suggesting that diseconomies of scale do exist. To validate this opinion, three arguments have consequently been put forward.

First, the interviewees argue that large pension funds, given their scale, should be able to operate more efficiently and negotiate lower fees in order to have lower administration and asset management costs than it happens to be the case. As Interviewee 7 observed: “You would expect pension funds which are ten times bigger than ours to have the costs which are ten times lower, but the difference is not significant and in some cases we pay even less than they do.”

Second, it is said that very large funds are inflexible and too bureaucratic. Despite the lack of economies of scale, small funds are able to gain higher returns because of the higher flexibility in the market and speed of asset mix adjustment. This finding endorses Chen et al (2004), who addresses hierarchy costs at large mutual funds that erode fund’s performance. Although this paper does not present the evidence that the smaller funds are taking advantage of their flexibility and translating it into higher portfolio returns, the majority of interviewees confirmed that this factor is largely seen within the industry as major disadvantage of large funds. However, the advantages of stronger bargaining power and access to additional asset classes and high-level service providers might overweigh the disadvantages of being inefficient as a large organisation.

Third, the majority of the interviewees agreed on difficulties for large pension funds to hedge the interest risk as an important factor of diseconomies of scale; smaller funds can decide to hedge the interest rate for 100% and they don’t have to cut the transactions in order not to unbalance the market or to wait until the derivative contracts of required size will be available. However, Interviewee 10 argues that limited possibilities of interest rate hedge is not only a problem for large pension funds, but of the industry as a whole: “The Dutch pension sector manages 1,200 billion assets, but the market for European AA+ securities is around 400 billion, so it is not just the problem of large pension funds, there is just not enough market volume to hedge the interest risk for all of them.” However, the Interviewee does admit that, in contrast to small pension funds, large ones do not hedge it for 100% and the process to hedge the risk for a smaller part can even take years. Although in academic literature much is being written on the possible sources of diseconomies of scale, this insight modifies the existing work. To the author’s best knowledge, in the literature the constraints related to risk management haven’t been put forward as a source of diseconomies of scale. The author takes a balanced view whether pension funds should pursue infinite growth in order to take a full advantage of economies of scale. While some pension funds argue that they have an optimal cost structure and that acquisitions wouldn’t optimize the cost substantially, others admit that there is enough room for further reductions. In the end, the performance is of greater significance. However, in a process of rapid asset accumulation, pension funds should acknowledge the trap of becoming less flexible and efficient and the limitations related to risk management that come with the scale.


IV. Investment belief

“ There are hundreds of theories of inefficient markets. There’s only one theory of efficient markets.” Merton Miller

Should pension funds critically examine and adjust their investment belief (passive or active) during the period of rapid assets accumulation in order to optimize the performance?

The board of trustees of a pension fund is responsible for the choice of the investment policy and its implementation. The belief of the board of trustees is a pillar of the investment strategy and determines whether the pension fund will pursue a lower risk - lower cost strategy or will take a path of active asset management, expecting that the additional cost and/or risk will be justified by additional portfolio return (Ambachtsheer, 1994). In the context of rapid asset accumulation of pension funds, it is important to estimate whether the increased size of a pension fund should result in a change of an investment belief. More specifically, when the fund is experiencing growth in terms of assets under management, which investment belief will be of a greater benefit for an increased portfolio? The fundamental question is: is there a relation between size of the fund and the type – passive or active - of asset management?

Literature review The choice between passive and active investment management boils down to whether the board of trustees believe that buying index funds will provide the best returns as opposed to pursuing alpha and trying to beat the market; the intellectual debate which can be illustrated by the conflicting views of Fama and Thaler. The decision for an investment belief involves philosophical and practical preferences of the board of trustees. Although an extensive review of the academic literature within this domain is beyond the scope of this paper, the conclusion is that, in general, active management shows little evidence of significant outperformance and, after transaction costs and fees, is even a negative-sum game. Hanke and Schredelseker (2010) made an attempt to examine what happens if investors switch from active investment to index funds, and concluded that analysis cannot provide a definitive answer as to which type of investment strategy should be pursued. However, Shankar (2007) supports a role of active portfolio management by providing evidence that performance of actively constructed indices is superior to that of passively constructed. To make it even more complicated, Randalo and Häberle (2007) go deeper into passive asset

management and distinguish between all-inclusive and exclusive i.e. selective types of indices; the authors argue that the latter outperform inclusive ones in an upward market and by no means should be regarded as synonymous with passive management. Furthermore, numerous studies on the mutual fund industry in the U.S. cause confusion by contradicting each other by documenting the lack of skill of the average manager (Fama and French, 2010) and providing evidence that skill does exist, justifying the choice active asset management (Berk and Van Binsbergen, 2015). In addition to this, Ambachtsheer and Farrell (1979) argue that unless the active-passive debate switches from technical issues such as market efficiency to process and organisational design consideration, “active management will continue to lose ground to passive management in the years ahead.” Last but not least, Andonov et al (2012) distinguish between small and large pension funds and argue that, “While smaller actively managed pension funds obtain higher returns, the larger pension funds would have done better if they invested in passive mandates”.

Although this summary of literature findings is far from exhaustive, a number of conclusions can be drawn. However, the applicability of the findings also has its limitations. First, the data mainly comes from the pension and mutual funds in the U.S., which have a different context and operate in a different regulatory environment. Second, in the aftermath of the financial crisis and in light of an on-going evolution of financial markets, institutional investors might have rebalanced their views on efficient market hypothesis and adapted their risk management strategies, making many of the pre-crisis empirical studies less representative. Third, to the author’s best knowledge, none of the studies has focused on the performance of passively and actively managed pension funds during the period of rapid asset accumulation or documented out- or underperformance related to the size of the pension fund.

Followed by the literature review, this paper examines whether the industry professionals can - from their own experience - support the finding that active management shows little evidence of significant outperformance. Additionally, it investigates whether pension funds have changed their investment belief after significant increase of assets under management (AUM) and so whether there is a relation between passive and active management and the size of the fund.


Findings and discussionAll interviewees that were involved in consolidations of pension fund portfolios confirmed that, even after a substantial growth through mergers and acquisitions, the change of the investment belief didn’t take place, moreover, it was not even considered. And if it was considered or it did change, it was not related to a growing asset base. There is a consensus among all interviewees that the choice of an investment belief is not related to the size of a pension fund, suggesting that as the fund grows, there is no necessity to examine a switch from passive to active asset management or vice versa.

However, the size does serve as a natural barrier for active asset management. Three interviewees argued that the fund requires a minimum of 2 to 3 billion euros of AUM to justify the costs of insourcing. So, the size serves as limitation for small pension funds which would like to pursue an active strategy. To the author’s best knowledge, this is a modification to the existing academic literature.

Furthermore, the polarisation of findings in academic literature is fully reflected in the conflicting views on investment beliefs of the interviewees. In addition to the academic literature, the outcome of the interviews offers an insight into the shifting nature of the investment beliefs in the post-GFC era. As interviewee 12 observed: “There are various investment strategies. One extreme is traditional passive, followed by smart beta, factor investing, and quantitative investing, with traditional active (stock picking) at the other end of the spectrum. We see that in the aftermath of the financial crisis our clients, pension funds, are moving from a range of strategies to one or both extremes.” Other interviewees argued that the shift towards passive management is more dominant and traditional active is decreasingly popular, with cost efficiency and lack of evidence of value creation as the key decision drivers. One of the top-10 largest pension funds switched to passive management, as interviewee 19 observed: “We believe that you should be passive when you can, and active when you have to be. For us, the switch has resulted in a significant decrease in investment costs. We have switched not because of the increased portfolio, but because our philosophy at this point is that you cannot beat the market.” Interviewee 4 confirmed this view: “Our pension fund - despite repeated advice from our pension manager that we are missing higher returns - does not believe in active management. We have been looking for empirical evidence that active management pays off, but we just can’t find it. Many studies have documented that it is a zero-sum game, so pension funds with an active management are the ‘thieves of their own wallet’.” According to interviewee 12, large funds have a longer haul and deeper pockets and can afford costly active management and dispersion of the returns more than small ones can. “However,” – he argues – “you would expect that they also have higher returns, but so far the evidence within the Dutch context is not convincing.” In summary, the common wisdom is that active asset management is more expensive and index investing is cost-savvy and the choice is not related to the size of the pension fund. However, until now, the quantitative evidence on investment belief in relation to performance is still absent.

Although the collective acknowledgment of the shift towards passive management (even at the large funds) is obvious – supporting the prediction of Ambachtsheer and Farrell (1979) that passive strategy would keep winning ground - not all interviewees are supportive of this trend and the arguments they offer go beyond cost efficiency and out- and underperformance factors extensively discussed in the literature. Interviewee 2: “Armed by the prophecy ‘it is better to fail conventionally, than to succeed unconventionally’, pension funds are switching to passive management, to avoid a peer group risk. But it is a dangerous development. The idea that passive management is safer is flawed, you don’t know what you are investing in, and you should put your brains to work.” Interviewees 1 and 3 have emphasized that investing based on Environmental, Social and Governance (ESG) criteria becomes increasingly important and it cannot be put in practice with traditional passive strategy. Interviewee 14 takes it even further: “ESG investing will have a significant impact on the return of the pension funds in the long-term. The biggest risks at this point are all related to climate change. Your impact on society grows proportionally with the growth of your fund, so should the responsibility you take.” Interviewee 17 largely criticized the pension funds that have or are switching to passive management: “Absence of evidence is not an evidence of absence. Studies that document the lack of value creation of active management have a short-term focus. In the long term – over 10 years period - active portfolio management does have higher returns and the costs of quarterly rebalancing the portfolio weights are negligible. But most important, the fund is able to give a substance to the ESG policy. Our extensive research shows that on average, 30% of the shares on the Western markets and majority of the once in emerging countries should be excluded, because they do not satisfy the sustainability criteria as we have formulated them. In the light of rising environmental consciousness in our society, traditional passive strategies are not sustainable”.

Based on the findings, there is not enough evidence that a fund’s performance is related to size and investment belief; growing funds do not necessarily examine their belief after increased assets. However, they do this for other reasons. In the aftermath of financial crisis, pension funds, including large ones, have been switching to passive management to optimize their asset management costs, because they are subject to group pressure, and because the trustees were not able to find quantitative evidence of value creation with active management. However, during the period of rapid asset accumulation, the pension funds should examine their belief in the light of other factors which are becoming increasingly important, such as ESG investments.


V. Asset mix

“ Don’t look for the needle in the hay-stack. Just buy the hay-stack.” John C. Bogle

Should pension funds critically examine and adjust the asset mix as their portfolio increases?

The investment belief, described in the previous chapter, serves as guidance for the board of trustees, which are responsible for the composition of their portfolio. The selection of asset classes reflects the return ambitions and risk tolerance of the pension fund and is constrained by the implicit and explicit requirements of the regulator. Asset classes can be categorized as liquid (fixed income and equity) and illiquid or alternative (private equity, hedge funds, commodities, real estate and other ‘exotic’ assets). In the context of rapid asset accumulation of pension funds, the fundamental question is whether the asset mix should change as the fund grows in order to find a new optimum performance. More specifically, is there a relation between the size of a fund and the asset mix and so should rapidly growing funds consider other asset classes?

Literature reviewThe academic literature on portfolio management finds it fundament in Markowitz’s portfolio selection and it’s model of balancing risk and reward is still considered a starting point (Markowitz, 1952). Since then much of the academic debate, which is beyond the scope of this paper, has been focused on the portfolio composition of mutual and pension funds, the risk level of asset classes and their performance. As an illustration, Fraser-Sampson (2008) argues that bonds are not necessarily a safe investment for pension funds and a traditional view of private equity as ‘high risk’ is totally wrong. In contrast, Kimyagarov and Shivdasani (2013) document that, over the past decade, companies have “de-risked” their pension asset portfolios by rebalancing the asset mix towards fixed income investments. Davis (2005) studied the portfolio composition of pension funds in a global perspective and has linked those to performance.

To the author’s best knowledge, empirical studies have so far ignored the performance of asset classes in relation to the pension fund size and haven’t drawn any conclusions concerning the portfolio composition for small and large funds. However, Broeders et al (2015) studied the asset classes of the pension funds in relation to the investment costs and observed that the large Dutch pension funds invest more in asset classes with higher investment costs, which in the sample represent illiquid

asset classes. It can be concluded that small pension funds invest much less in illiquid assets classes.

Furthermore, in order to adjust the asset mix as the fund grows, evidence of a better performance of asset classes at different stages of growth is required. The limited availability of academic work on pension fund’s asset mix related to size when compared to the topic’s importance at the heart of this merger wave, seriously limits the solidity of any drawn conclusions. More intensive study would give a better understanding of evolving market realities.

Findings and discussionThe interviewees, who were involved in various mergers and acquisitions, argued that the asset mix hasn’t changed significantly since their assets substantially increased. However, interviewee 19 did argue that they are now looking into a merger with a 2.5 billion pension fund and it might result in adding new, illiquid, asset classes to the portfolio.

Apart from the lack of evidence from previous acquisitions that changes of the asset mix do occur, the views on the relation between the size of the pension fund and its portfolio composition are mixed.

The minority of the interviewees – 3 in total – argued that there is no relation and that the doctrine that size offers more investment opportunities is out-dated; these days even small funds can access all kind of asset classes. Among the rest, the common wisdom is that size does matter; the larger the fund, the more illiquid asset classes the fund can add to the balance sheet. However, the majority of the interviewees that support this notion, placed a remark that in theory the size shouldn’t matter, but it practice, it does. And it does for several reasons.

First is accessibility. It is said that less than 5 billion euros is too small for private equity investments (Interviewee 20) and even the funds in the range of 20 billion are too small to have access to respected private equity firms that generate satisfactory returns (Interviewee 19). Interviewee 16 argued that at least 100 billion AUM is required for a fund in order to be seen as a serious player in global illiquid markets and to be granted an access to prestigious and lucrative deals. Interviewee 18 pointed out that even if small pension funds would have access to best


performing private-equity firms, their low bargaining power wouldn’t be enough to negotiate a satisfactory return, so it would almost be a zero-sum game.”

Second is the lack of required knowledge and time to manage illiquid asset classes, such as selecting the right service provider and devoting resources for close monitoring. When pension funds invest in private equity, hedge funds and real estate asset classes, DNB requires them to understand these classes fully, quite a challenge for many of the smaller funds. Interviewee 3: “If you splinter the portfolio, you are asking too much of yourself.” Furthermore, changing regulatory requirements deters from the easy addition of these asset classes to the portfolio. Interviewee 6 explained: “If you have lots of illiquid asset classes, you can be sure that DNB will ask you lots of questions. As your portfolio becomes more complex, the requirements get tougher.” As Interviewee 4 illustrated: “At some point we were spending 50 per cent of our time on management of two smallest asset classes, it is just not worth it.”

The majority of interviewed members of the board of trustees of small and midsize pension funds confirm that in the past, pension funds, albeit under peer group pressure, have diversified into the illiquid asset classes without sufficient knowledge, but the trend is now reversing. Firstly because they just can’t manage them. Secondly because some of them, especially hedge funds, haven’t met the expectations. Interviewee 4 explains: “These days, there is an implicit threshold of 10 per cent for ‘exotic’ assets on the balance sheet and it doesn’t change with size, but there are exceptions. Mainly the pension funds of banks exceed this amount, but I guess they understand their own products better than we do theirs.”

Thirdly is the lack of evidence at small and midsize pension funds that illiquid asset classes serve diversification well and generate substantially higher returns, justifying the illiquidity premium they require. Interviewee 7: “Alternative investments work well for diversification only on paper, in practice, the dampening effect is not significant.” Interviewee 4: “Within the board, we have continuous discussions whether we should invest or stay in private equity, it’s illiquid, the fees are high and it is difficult to manage. The return is higher, but not more than 2% on top of those of equities. With only 10% of the portfolio the extra return is negligible, but you introduce considerable risk to

your portfolio.” In contrast, large funds in the sample (above 50 billion AUM) that do invest in private equity and hedge funds are satisfied and confirm that returns are satisfactory.

Following on from these findings it can be concluded that, in practice, the size does matter, illiquid asset classes have generated disappointing results for small and midsize pension funds, management of those asset classes require a substantial amount of time and knowledge and only large funds have an access to respected market players that can offer profitable deals. In general, the findings support the existing academic idea that illiquid asset classes are considered higher risk and that a certain scale for a fund is needed to exert the bargaining power and devote resources in order to fully take advantage of the illiquidity premium these assets classes potentially can offer. Furthermore, besides the bargaining power and resources, this study also adds pressure from the regulatory environment as an important factor in portfolio composition.

Last but not least, Interviewee 18 offered an interesting perspective on portfolio composition to ponder: “In the long-term, as prosperity, fuelled by the growth in emerging markets, grows, investments will flood into liquid markets and it will become increasingly difficult to have sufficient returns on your portfolio. Moreover, liquid markets represent a relatively small share of countries’ wealth; not all assets are publicly traded. In the future, the funds should think beyond the liquidity factors of assets and seek access to sustainable cash flows, no matter the type of the asset class.”

Results from the interviews does not give a unequivocal answer to whether pension funds should critically examine and adjust the asset mix as their portfolio increases by, for example, adding whole new asset classes. However, there is enough food for thought. As the large pension funds (>50 billion AUM) confirm that the illiquidity premium is worth devoting resources to and additional risk, as funds grow in size and are confident enough about their knowledge and bargaining power, they can consider looking into other cash flows rather than sticking to traditional asset classes, which might create value. In contrast, given the continuous sophistication of financial markets, limited resources and increasing pressure from the regulatory environment, small funds should stick to traditional, cost-efficient and manageable investment products.


VI. Selection of a pension executor “ The investor’s chief problem – even his worst enemy – is likely to be himself.”

Benjamin Graham

What factors play a key role in the selection of a pension executor, who is responsible for asset management and pension administration activities? In pursuit of lower asset management and administration costs, growing pension funds are restructuring their ecosystems and evaluating options for various in-house and outsourcing activities. The choice whether to keep the asset management and administration in-house or to outsource it is a strategic decision and is beyond the scope of this study. However, when a pension fund does decide to outsource its activities to a pension executor, a number of factors play a role in the decision making process. This study examines the most important factors according to the trustees, which have a significant influence on the choice of an executor.

The first is transparency. The perception of how transparent the executor is, is fundamental for trust and approval of the trustees. As an example, Interviewee 4 mentioned that their pension executor was chosen because in their proposal they mentioned the need for transparency regarding mistakes that are made; how every failure is extensively reported. Admittedly, for a pension executor it is crucial to craft the perception of full transparency and subsequently meet expectations.

The second is experience with and the sophistication of transition management. The transfer of pension administration is an IT-intensive and complex process. The smoothness of the transition process is an important factor for the trustees. The interviewees articulated that while being in a transition process, other trustees at pension funds approached them and questioned about their experience so far. And also the other way around: trustees at pension funds approached other clients of pension executors in advance to hear recommendations.

The third is reputation and negotiating power on local and global markets. Small and midsized pension funds lack bargaining power in a global financial arena. The reputation of a pension executor is considered an important factor. The underperformance of a custodian at one of the pension funds resulted in a 400,000 euro loss for the fund. Interviewee 4 argued: “Because our executor is an eminent and notable financial institution on a global financial arena, we got our money back without a second word. For a relatively small fund as ours it would have resulted in a long-term legal process.”


VII. Challenges and lessons learned “ If I have seen further it is by standing on the shoulders of giants.”

Isaac Newton

What major challenges have the members of the board of trustees encountered so far and what lessons learned can be distilled from previous mergers and acquisitions?

This paper examines the most common hurdles members of the board of trustees face during the consolidation process. The challenges are outlined in order of the number of times the issue was brought up by interviewees.

1. Transition of administrationPension funds and their executors have been cooperating with each other for decades and there is – as trustees put it – a lot of noise in the administration, such as incorrect or missing personal data and invalid financial assumptions and allocations. The database update is a costly and time-consuming process. In some cases trustees decide to turn a blind eye in order not to delay the M&A transaction. But often the process is thorough. Interviewee 4 pointed out that random database quality testing procedure revealed significant inaccuracies in several thousand of cases.

Another hurdle is the information technology (IT) infrastructure where the data is being stored and processed. Transition processes expose the incompatibilities of IT systems of merging funds or transition to an executor: proper data transfer is an extremely time consuming process. The majority of the interviewees argued that the process takes on average one and half years and almost always longer than anticipated in advance.

In this process, the goal of trustees is to identify as many skeletons in the cupboard as they can and for each fund develop their own strategy to deal with them. As interviewee 8 put it: “We acquire only assets and liabilities and afterwards the fund liquidates itself with all the unknown unknowns.”

2. Difference in funding ratioManaging the difference in funding ratio is seen as one of the biggest hurdles in the consolidation process. For DNB, which needs to approve the transaction, too big a funding ratio difference is a show-stopper. In other cases, the funds should come up with a solution in order not to disadvantage any of the participants. For an acquiree to have a higher funding ratio

is not considered a major concern; the participants receive a single surcharge. It is more complicated when the funding ratio of the acquirer is higher. The solution is often a result of heated negotiations where instruments such as one-off payments, advantages and disadvantages of age differences in the scheme, number of active and passive participants among others are used to smooth the difference.

The stipulation of the funding ratio during negotiations is a challenge as well. The interest rate determines the value of the assets and liabilities. As the market fluctuates, timing becomes the most important factor. It is seen as extremely difficult to make the right choice regarding the moment of transfer and the value of assets and liabilities often turns out to be different from what was put forward in advance. Interviewee 7 mentioned that during the merger, the negotiation process took too long, the market was moving a lot and it resulted in too big difference in funding ratio between the funds and so the loss in value was substantial.

3. Transition of assets Although the common wisdom is that the transition of administration is far more challenging than the transition of the assets, there are also hurdles to be overcome on asset management side too. After many mistakes in early mergers, trustees of pension funds admitted that the majority of the learning costs belong to the past; for many of them the M&A process has already become routine. Below are the most important lessons learned.

The key question is whether the assets will be transferred in-cash or in-kind; the decision is a result of intensive negotiations between the boards. Most acquirers demand cash to avoid valuation risks; the acquiree has to face the loss in value and transaction costs as the acquirer doesn’t want to bear the risks of valuation.

The valuation of liquid assets is manageable, although the small cap is considered a bit more complicated. However, the complexity increases, as the assets that need to be valued, get more illiquid. On average, funds have no more than 25% of illiquid assets which as it turns out to be, is an implicit requirement of the DNB, but there are exceptions. A number of interviewees argued that after a merger, the real value of the assets turned


out to be lower than the book value, and devaluation takes place quite often. Due diligence and structuring of a new investment fund usually takes longer than initially anticipated. In this process, some asset classes are more challenging than others. Certain derivative contracts introduce complexity. Interviewee 5 stated that, when it comes to real estate (which trustees respectfully call ‘stones on a balance sheet’), the valuation of newly built assets is slightly more complicated, because the market value is not so clear and there are no existing rental contracts.

In general, private equity is considered to be the most complex. According to Interviewee 10, the valuation of private equity assets is highly subjective; you only get to know the value when you exit. Interviewee 8 explained that pension funds have a long-term horizon and often commit themselves to a project with 15 to 20 years duration; selling these ‘secondaries’ in order to transfer the assets in-cash, can result in a 40 to 60 per cent loss in value. If the fund decides to transfer these assets in-kind, they are being held as the satellites of the portfolio until they can be sold without significant loss. A number of interviewees emphasized the disadvantage of small funds in valuation processes. Interviewee 16: “Large pension funds and their executors have resources and know-how to value illiquid asset classes, such as private equity. If we have to value investments such as agricultural land somewhere in South-America, our dedicated team will personally inspect the assets and provide an accurate valuation. However, for many small and mid-sized pension funds, this sophisticated valuation process is unaffordable.”

Additionally, a number of interviewees admitted that, after a merger, they came to know that a vast amount of transaction costs were avoidable; the transfer of assets is not always done in a most cost efficient way. Interviewee 21 elaborated extensively on three major types of avoidable costs: “First, unnecessary transactions are being made. For example, when the assets are transferred in-cash, the acquiree sells its equity portfolio and afterwards, the acquirer invests in the same securities; simply transferring these securities saves costs compared to first selling and then buying them. Second, the avoidable costs are often associated with poor portfolio exposure- and risk management. During the transition of assets, when the market is static, only transition costs are incurred. But when it is moving, the portfolio becomes exposed to the market risks. If the market goes up, the acquirer makes profit. If it goes down, it has a negative impact on the value of assets; in that case, the pension fund would be better off if the risk was managed using different instruments,

such as derivative contracts. The goal of the transition manager is to reduce the difference in movement and get the price as close to the benchmark as possible. Third, a substantial portion of asset management costs is avoidable and scale is an important factor. Large service providers have a stronger bargaining power and pay the lowest possible fees to asset managers; pension funds can save asset management costs by outsourcing to the market players with the strongest bargaining power. So, solid transition management is considered extremely important.”

Last but not least, those responsible for the transition of assets at the pension fund are often surprised with the amount of work that has to be done, Interviewee 21: “There are various stakeholders involved: the acquirer and the acquiree, old and new asset managers, the auditor and the custodian. The transition manager should speak with everyone at least once and make a timeline with milestones. The devil is in the details. For example, some equities and bonds pay dividend, so the moment of valuation of assets (before or after the dividend payment) has influence on the value of portfolio. These discussions plus stakeholders’ operations and decisions take a lot of time. Nothing may be forgotten or overseen.”

4. Unexpected procedures from stakeholders

A merger with, or an acquisition of, a pension fund is a complex process that comes with different unforeseen events. Although the enumeration of the challenges in this paper is not extensive, these are the most noteworthy. On top of the challenges previously described, the M&A process is being delayed by unforeseen procedures coming from stakeholders such as other funds, executors and participants in the scheme. Interviewee 8 can look back on a dozen acquisitions and argues that internal procedures are one of the biggest problems: “The value transfer is never 100 per cent commensurate, the participants can object and unfortunately they do that quite often. It is considered a big problem.” Interviewee 3 confirmed the existence of the possible argument with stakeholders: “We anticipated that the liquidation of the fund would take three months, but, because of the procedures with one of our stakeholders, it took us seven years.” Proper stakeholder analysis in advance, sound transition strategy and implementation and open and intensive communication with stakeholders can avoid unforeseen fall-backs.


VIII. Conclusions “ The future is already here. It’s just not evenly distributed.”

William Gibson

This paper seeks to contribute to the greater understanding of considerations faced by the trustees when a pension fund significantly increases in size and major strategic decisions are being made in order to navigate it through rapid asset accumulation. That is why this paper digs more deeply into the M&A process of pension funds and investigates major decisions related to governance and investment management. Lastly, the paper outlines the execution of related challenges and presents lessons learned from numerous previous consolidations, which have been managed by the interviewees. The data was collected from the semi-structured interviews with the help of a set of open questions and afterwards analysed by looking for the overlapping and contradicting views. In the process, the number of peripheral views and experiences offered by the interviewees diminishes; this paper presents the key findings.

Firstly, the author finds that trustees and industry professionals confirm that consolidation results in lower administration and asset management costs, although the financial benefit is being dampened by avoidable transaction costs and the loss of value of assets during transition. Although at some point the savings tend to become marginal, the paper confirms the presence of economies of scale for asset management and administration costs, supporting existing academic literature. Moreover, this paper documents the major sources of the diseconomies of scale of Dutch pension funds, namely, inefficiencies related to size, hierarchy and inflexibility costs and constrained portfolio risk management. Academic literature which addresses these matters does so in the context of U.S. based mutual funds. In the Dutch context, academic papers reject the existence of diseconomies of scale, albeit their primary focus is asset management and administration costs. This paper offers a modification by putting the optimal size for a pension fund in a broader perspective. However, despite the disadvantages, large pension funds utilize their stronger bargaining power on the global financial arena and so are able to attract the resources so they can benefit more from the illiquid asset classes.

Secondly, this paper finds no evidence of pension funds questioning their belief in the context of rapid asset accumulation; the findings suggest that there is no relation between size and belief. However, the size does serve as a limitation for small (>3b euro AUM) funds which would prefer their assets being managed actively. Furthermore, the academic debate on active and passive management couldn’t be any more relevant and visible than now

in the current Dutch pension fund industry. Interviewed trustees have poked many holes in active asset management; for many of them there is enough empirical evidence to suggest that the only sensible idea to start with is that the market is smarter than their asset managers and that successful investment strategy can rarely be scaled up to their size without the disappearance of arbitrage. The minority of interviewees did argue that the trend of index investing – for group pressure and cost-saving reasons – is worrisome, as other factors that require active management, such as ESG investing, are becoming increasingly important. In that sense, the investment belief is related to size, because – as they argue – the responsibility of the impact of pension funds’ investments on the society grow proportionally with their size. Given the importance of this topic in the years to come, the field of study related to the performance of ESG investing and its costs – which pension funds care a lot of these days - is wide open.

Thirdly, this paper supports the findings in the recent academic literature that large pension funds invest more in illiquid asset classes. However, after various consolidations so far, there is no clear evidence of a shift in asset mixes towards more illiquid asset classes. Overall, growing and yet still relatively small pension funds are exiting their investments in hedge funds and questioning private equity ones to save costs, reduce risk and avoid regulatory pressure. On the contrary, large funds (>50b euro AUM) are satisfied with the returns of their asset classes. This study modifies existing academic views by adding access to profitable deals, bargaining power and resources to withstand the pressure from regulatory requirement, as the main reasons why large pension funds invest more in illiquid asset classes and claim to be satisfied with returns.

Fourth, this paper, although not being put in an academic context, documents the factors which play a key role in the selection of a pension executor. In the light of the acceleration in the restructuring of ecosystems, this topic has certainly deserved attention during this study. Although this topic, in contrast to the first three, was not discussed with all the interviewees, the insight into the driving factors behind decisions regarding which pension executor should manage their assets, is of value. As it turns out, transparency, experience with and the sophistication of transition management and reputation and bargaining power on local and global markets are among the most importance ones.


Fifth, the author investigated the most common hurdles trustees faced during the consolidation processes. Broadly speaking, three major challenges were mentioned repeatedly, these were: challenges related to the transition of administration and assets, those related to dealing with the difference in the funding ratio and unexpected procedures from stakeholders. Based on described experiences, the recommendations that can be put forward are: critically assess the acquiring database, do not underestimate the duration of the transaction and invest in a proper asset valuation and transition management in order to avoid misevaluation and unnecessary transition costs. Conduct a sound stakeholder analysis in advance and formulate

a comprehensive communication strategy in order to avoid unforeseen and time-consuming legal procedures.

• • •

Within the foreseeable future, industries assets will end up in the hands of fewer trustees than before. Ones that are competent, knowledgeable and prudent enough to manage the pensions of millions Dutch workers. Perhaps this is the main real benefit of this merger wave. Hopefully, after reading this report, these trustees will be better informed as well.


List of Interviewees

The author is grateful to all interviewees for their time and openness. The views expressed in this paper remain anonymous, are opinions and personal experiences and do not necessarily represent those of the organizations. The order of

the interviewees presented below is alphabetic and does not correspond with the numbers the interviewees were referred to in the text, neither does the chronological order in which the interviews were held.

Name Function Organisation Interviewed

Alwin Oerlemans ChairmanChief Strategy Officer

Opf APGAPG

8 Jan 2016

Benne van Popta ChairmanTrustee

PMT Bpf Detailhandel

6 Jan 2016

Bruno de Haas Head of Strategy and Research MPD 24 Nov 2015

Dirk Broeders Senior strategy advisorSpecial Professor of Pension Finance and Regulation

De Nederlandsche Bank (DNB)Maastricht University

11 Dec 2015

Dick van Haaster TrusteeChairman (till 1.1.2016)

Bpf WaterbouwBpf Schilders

11 Dec 2015

Eloy Lindeijer CIO PGGM 10 Dec 2015

Eric Uijen Chairman PME 4 Dec 2015

Gerard Roest ChairmanChairmanTrustee

Bpf Bloemen en PlantenBpf LandbouwOpf Forward (Unilever)

8 Dec 2015

Hans Betlem CIO IBS Asset management 8 Jan 2016

Hijke Hijlkema Chairman Chairman

Bpf KoopvaardijBpf Rijn en Binnenvaart

9 Dec 2015

Johan Eeken ChairmanTrustee

Opf BrocacefPMA

9 Dec 2015

Jos van Ophem Senior ConsultantActuary

Ortec FinanceBpf Landbouw

5 Jan 2016

Kees de Vaan CIO Syntrus Achmea 13 Nov 2015

Leo de Haan Senior Research Economist De Nederlandsche Bank (DNB) 9 Dec 2015

Mark Rosenberg Member of the Investment CommitteeTrusteeTrusteeTrustee

Opf DuPontBpf Schilders Bpf SPWBpf Landbouw

11 Dec 2015

Peter Loehnert Managing director BlackRock Transition Management 25 Jan 2016

René Upperman Managing Director Bpf Detailhandel 19 Nov 2015

Ruben Laros Associate Supervision Officer – Pension funds and insurers

The Netherlands Authority for the Financial Markets (AFM)

13 Nov 2015

Thijs Aaten Managing director Treasury & TradingMember of the Investment CommitteeExternal Investment Advisor

APGBpf SchildersOpf ING

27 Nov 2015

Wim van Zwol Head of Institutional Sales Western Europe Vanguard 17 Dec 2015

Xander den Uyl ChairmanTrustee

PWRIABP

7 Dec 2015


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University of OxfordSaid Business SchoolPark End StreetOxford, OX1 1HPUnited Kingdomwww.sbs.oxford.edu/dipfinance

Diploma in Financial StrategyFinal project February 2016 Katherine KucherenkoThe [email protected]

Governance and Investment management of Dutch pension funds in times of rapid asset accumulation

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