Guide to Choosing Delegated Investment Management Services for Corporate Pensions

Delegating fiduciary responsibility for key investment decisions to an external provider has emerged as a significant trend in the world of corporate pensions. This approach is known by many names – e.g., delegated investment services, outsourced chief investment officer (OCIO), fiduciary management services, discretionary asset management. There are dozens of providers and, seemingly, as many different investment philosophies, execution strategies and approaches to client service.

Delegated investment services provided to a pension plan sponsor are distinguished from the traditional investment consultant service model by the additional level of responsibility and fiduciary accountability taken on by the investment advisor. In this new model, investment committees give the provider full discretion over certain investment decisions. The delegated investment service provider, rather than the sponsor or its investment committee, sets the asset allocation and chooses managers.

This works due to a previously obscure section of the Employee Retirement Income Security Act of 1974 (ERISA). This section of code – §3(38) – allows a plan sponsor to delegate control and authority for certain investment management functions, thereby transferring those fiduciary obligations. However, a plan sponsor who chooses the path of delegated investment services cannot rid itself of the fiduciary responsibility related to selecting the delegated investment service provider and monitoring the continuing appropriateness of the chosen provider.

Why do pension plan sponsors hire an OCIO?

There are several key advantages to a plan sponsor of delegating responsibility to an OCIO:

• These external providers generally have extensive expertise and experience with liability-driven investing (LDI). Liability-driven approaches can be a challenge for the typical investment committee to implement.
• Selecting managers and the handling of any tactical asset allocation are put in the hands of experts with significant experience and resources dedicated to making these kinds of decisions. See the chart on the following page that shows the results of a study illustrating how challenging it is to choose managers effectively.
• Investment committees encounter issues such as lack of expertise, “groupthink,” or the hurdle of simply getting the whole group together on a regular basis. Delegating decisions to an outside expert can mitigate or eliminate these common problems.
• Lower investment fees are achieved via economies of scale resulting from the OCIO’s overall asset base.

The right kind of delegation will free up time for the investment committee. The committee will spend less time making decisions such as manager selection, where studies like the one summarized in the chart show that committee decisions can detract from performance. With the right OCIO arrangement and provider, the committee can spend more time focusing on oversight and strategic asset allocation.

Additional considerations

There are some issues that should be weighed carefully before delegating investment authority to another party:

• The extent to which fiduciary responsibility for investment decisions can actually be transferred is not clear and has yet to be tested in litigation.
• There is potential for conflicts of interest to arise in some OCIO arrangements.
• OCIO providers may be subject to some of the same decision-making biases and problems that are issues for the typical investment committee.
• Plan sponsors with expert resources on staff and an investment committee and decision-making process that are working well may feel better about retaining responsibility for all investment decisions.

Type of firms offering delegated investment services

OCIO providers generally come in three flavors:

• Actuarial consulting firms These firms have long had investment consulting practices that leverage their knowledge of pension liabilities and have recently invested in infrastructure, such as trading software and custody relationships, to be able to take on delegation.
• Investment consulting firms These firms, too, have set up the infrastructure that allows them to take on delegation. Some of these firms have been in the delegated investments business the longest and many of them have beefed up their actuarial and liability-driven investment (LDI) capabilities in recent years.
• Asset managers These firms already have the resources and infrastructure for delegation readily available. Many of these firms have also strengthened their actuarial capabilities in order to effectively design and implement LDI solutions.

Each firm has strengths and weaknesses, some of which spring from their origins, but these do not lend themselves to simple metrics. Because investment perspectives and approaches to implementation are different at every OCIO, choosing a firm is not so much about identifying strengths and weaknesses as it is about finding a firm with an investment philosophy that matches the plan sponsor’s.

Considerations when evaluating OCIO providers

The following provides an overview on factors to consider when evaluating the different OCIO providers.

Investment performance

Past performance is not a key factor on which to base your choice of OCIO provider. Investment philosophy and cost are more important.

Although past performance should be examined, historical investment returns should not be the primary focus for evaluating an OCIO. Most delegated solutions will be customized to the needs and perspectives of that particular sponsor and not easily evaluated in a vacuum. So, comparing investment performance track records for OCIO providers will always be a challenge and is probably not a particularly useful factor in making a decision about which OCIO firm will make the most sense for the organization.

Investment perspective

On the other hand, the OCIO’s perspective on such issues as active versus passive management, use of derivatives and alternative investments, and approaches to strategic and tactical asset allocation are all important. Perspectives on these issues should ring true with the sponsor. There are not necessarily right and wrong answers that clearly lead to better results, but a sponsor won’t have success with a firm that doesn’t share its views.

Types of investment management

There are several variations on investment fund management offered by OCIO providers:

• Proprietary funds, managed internally This is most commonly found at asset management firms that naturally use their own funds to implement solutions. Use of proprietary funds should not necessarily be viewed as a problematic conflict, especially for index funds. If fund management fees are reasonable, proprietary funds at a large asset manager can be a sensible way to implement a delegated arrangement.
• Proprietary funds, managed externally In this arrangement, the OCIO firm creates a fund and hires one or more external managers to make the investment decisions for the portion of the fund for which they are responsible. The OCIO firm negotiates a fee with the fund manager and passes that cost on directly to its clients.
• Proprietary fund of funds Under this approach, the OCIO firm purchases shares in funds managed by other managers and combines them together into a single fund vehicle for their client plan sponsors. In some of these arrangements, the OCIO has negotiated favorable fee arrangements based on the entirety of their business with the manager. In some arrangements, the OCIO can make tactical decisions about moving money between managers based on market conditions.
• External funds The OCIO firm simply purchases shares in funds or sets up a separately managed account on behalf of the pension fund. Fees for the external manager may be based on the full level of business from all the OCIO’s clients.

“Open architecture” is prevalent.  There are typically few restrictions on keeping favored managers.

Many OCIO firms offer a combination of these types of investment management vehicles. Most arrangements these days are “open architecture,” meaning that a plan sponsor can use most any investment fund from any investment manager as part of the delegated solution. Almost any OCIO firm allows any investment fund to be included in a client sponsor’s portfolio. This can occasionally cause reporting challenges for the OCIO, especially if daily valuation of a portfolio is desired, e.g., for glidepath management.

Paying for OCIO services

Most firms in the business of providing OCIO services are highly cognizant of the potential for conflicts of interest to arise in the way they are paid for their services. It is not typical for OCIOs to have revenue sharing arrangements with fund managers. Transparency should be expected in that OCIOs tell their clients how they make their money and how much the total relationship, including fund management expenses, costs.

For OCIOs who have proprietary funds that are managed internally, the potential exists to profit more from an allocation to a higher-priced fund. For example, an actively-managed fund may have a higher profit margin than an index fund. However, this is not a reason to automatically eschew OCIOs with internally managed funds. One simply must be aware of the issue and ask the right questions when choosing or monitoring a provider.

Level of delegation

There are various aspects of the investment process that can be outsourced:

• Strategic asset allocation While this function can be outsourced, the vast majority of arrangements involve a consultative and cooperative approach to determining the right strategic asset allocation.

Most OCIOs will look to add value with their approach to tactical asset allocation.

• Tactical asset allocation Tactical asset allocation is usually delegated, but some arrangements may call for consultation with the plan sponsor before making changes.
• Manager selection This is the essential function of delegation. The investment committee is freed from the process of searching, interviewing, hiring, monitoring and firing investment managers.
• Contracting with managers Outsourcing this legal function is a natural extension of outsourcing the selection of managers.
• Certain asset classes only An outsourced solution could include, for example, only the liability-matching portfolio or only hedge funds or private equity.
• Custody, brokerage and trustee services Most OCIOs allow their plan sponsor clients to maintain their own custody and trustee relationships. Some offer these services with preferred vendors, and package pricing may be available when these services are bundled with other aspects of delegation.

Derisking glidepath management 

A derisking glidepath gradually replaces, as funded status improves, equities with liability-matching fixed income investments.

Many corporate pension plan sponsors have adopted some kind of glidepath approach to gradually implement a lower risk portfolio as funded status increases, and sometimes based on interest rates as well. There are as many different approaches to glidepath implementation as there are OCIO configurations. Most adapt their approach wholly or at least partially to a client sponsor’s preferences.

Similar to tactical allocation changes under an OCIO arrangement, asset allocation adjustments based on a glidepath approach to derisking are often delegated, but some sponsors want to confirm these moves by phone or e-mail, while others delegate this completely and are only informed after the fact. Some sponsors still gather their entire investment committee together to confirm these changes, but this may defeat the basic purpose of the glidepath approach.

For some plan sponsors who have adopted a glidepath, it is important to be able to monitor funded status on a daily basis and make asset allocation changes within a matter of days after a funded status trigger is reached. Not all OCIOs have developed the capability to monitor funded status on a daily basis, so this may be an important distinction between OCIOs. For sponsors with portfolios containing illiquid assets that are hard to value daily, or for those sponsors that just aren’t comfortable with such quick timing, this may not be an issue.

Glidepath strategies are like snowflakes – no two are exactly alike.