Let us step back and recognize that many companies outsource a number of functions that are not core business activities for the organization. Motivations for outsourcing may include focusing internal resources on core business activities, accessing skilled talent related to the specific outsourced function, increasing efficiency or, at times, reducing costs.
For most organizations, defined benefit (“DB”) pension plan management is not a core business. The energies of the organization are focused on creating a great product or providing a superior service. Asset management is usually not their core competency.
In addition, as increasingly more companies close their DB plans to new participants or completely freeze new benefit accruals for all employees, the pension becomes a “legacy liability.” In other words, it may no longer be a key factor in attracting and retaining high-quality employees and is only related to employee services that had been rendered in the past. Yet, it remains a liability that the company will be responsible for managing for potentially several decades into the future.
Even though it may be a legacy liability, a DB plan may carry significant risk for the sponsor, including from a corporate finance perspective. Poorly managed DB plans can lead to the recognition of pension deficits on the balance sheet, increasing leverage ratios. Higher pension expenses may need to be recognized through the income statement, lowering net income or earnings per share. Contribution requirements may divert cash from other uses such as capex, M&A (mergers and acquisitions), stock buybacks, or dividend increases. In short, even a legacy DB pension liability can impact the balance sheet, P&L and cash flow of a sponsor, potentially negatively impacting its equity valuation, credit rating and cost of borrowing.
An OCIO (Outsourced CIO) partner may provide several potential benefits to plans and sponsors. First and foremost, it may help a plan achieve better investment outcomes through higher risk-adjusted returns and lower funded status volatility. At Goldman Sachs Asset Management, we are investors, in the markets every day. Our proximity to markets allows us to be nimble and capitalize on market dislocations, potentially adding excess returns through tactical and cycle-aware views. From a hedging perspective, we can help clients explore more capital efficient ways to match liabilities and reduce funded status volatility with a variety of LDI (liability driven investing) techniques.
Second, an OCIO provider may be able to lower external manager fees for a plan by leveraging the scale of its purchasing power. OCIO providers often have multiple clients invested in the same strategy with a particular manager. By aggregating the purchasing power of those mandates, lower fees may be able to be secured with those savings directly accruing to the plans.
Third, an OCIO model can free up internal resources for the sponsor. OCIO providers essentially become an extension of staff for the plan. Select investment decisions and operational responsibilities can be transferred to the OCIO partner, while the investment committee and staff can retain governance oversight with respect to the portfolio and strategic priorities.
Fourth, engaging an OCIO partner can provide the sponsor with a single point of contact for all aspects of plan management. This can streamline coordination of services and help support the plan investment committee at every level. Ultimately, this can drive greater scale and efficiency with respect to the management of the plan.
Finally, many DB plan sponsors are considering strategic changes, such as making a voluntary contribution to reduce PBGC variable rate premiums, shifting asset allocation to more of a fixed income/liability driven investment strategy, putting in place a completion program, investing in new asset classes as a means of diversifying the return-generating portfolio or transferring some of the liabilities to an insurance company through the purchase of a group annuity contract. Many of these changes involve taking actions that a sponsor may have never undertaken before. An OCIO partner can provide assistance with many of the new actions that need to be taken at the different stages of a plan’s life cycle.
Quite the contrary, global assets managed by OCIO providers across all investors have more than doubled since 2013 as an increasing number of plan sponsors have recognized the benefits of leveraging a strategic partner for the management of their plans (see below). As discussed earlier, this growth has been fueled by the recognition by many organizations that pension plan management is not a core competency for them and, in some cases, the reality that DB pensions are legacy liabilities where there may be less desire to continue to dedicate internal resources.
Source: Pensions & Investments. OCIO assets are reported as of March 31 of each year. Inclusive of discretionary and advisory assets.
Some of this growth is attributable to an increasing number of organizations that have outsourced their plans. However, the size of plans that have been hiring an OCIO provider has also been growing, further contributing to the increase in OCIO assets. Five to ten years ago, most outsourced DB pension plans were below $2 billion in plan assets. Over the past several years, larger plans have embraced the outsourcing model and, more recently, it has not been uncommon to see plans with assets in the $2bn - $10bn range hire an OCIO partner. We expect this trend not only to continue, but also to accelerate.
It certainly may. For smaller plans with limited internal resources and lack of scale, the main motivation may be better investment outcomes. Smaller plans tend to make less use of alternative asset classes such as private equity, hedge funds and real estate as well as satellite asset classes such as high yield, emerging market debt or alternative risk premia. Historically, inclusion of these asset classes has helped to both enhance returns as well as reduce risk.
Lack of internal resources and expertise related to investing in these asset classes may have prevented a smaller plan from including them in their portfolio. In addition, smaller plans may not have been able to access the best performing managers in many of these areas due to their inability to make sizable allocations. An OCIO partner can bring expertise as well as the purchasing power through allocations across its entire platform that may help to secure access and lower management fees.
For larger plans, another motivation may be potential cost savings and resource management. Larger plans generally have a greater amount of internal resources dedicated to managing and administrating the plan. As plans mature through closing and freezing, and as outflows increase with more participants moving into retirement status and/or through lump sum distributions and annuitization, the size and strategy of the plan may change. Some sponsors may have staff and infrastructure in place for a growing plan where the focus had solely been on beating asset benchmarks. As that potentially changes, it may be appropriate for sponsors to revisit the optimal resourcing and management of the plan going forward.
The answer to this question will generally be enlightened by the goals and objectives of the organization with respect to its plan management. For some plans, the goal may be to generate excess returns. For others, it may be to reduce funded status volatility through better asset/liability matching as well as the use of a liability completion manager. Still others may be looking for an OCIO partner to help with positioning a portfolio for an in- kind annuity purchase, and then to help reposition the portfolio again after such a transaction has been completed. In many cases, the goal may be all of these over time.
The differences in goals and objectives of different plan sponsors makes evaluations by comparison to other OCIO mandates somewhat challenging. It is important for a plan sponsor to outline what exactly it is trying to accomplish by engaging an OCIO partner and then examine the services and performance of providers in these specific areas.
We recommend setting key performance indicators, based on the unique circumstances of each plan, and then tracking them on an ongoing basis. Those indicators could include, for example, how closely an LDI portfolio tracks the liability, the performance of the strategic asset allocation relative to a simple market cap weighted benchmark, or how managers perform relative to their specific benchmarks.
In addition, many sponsors, when selecting an OCIO provider, are interested in partnering with a firm that has broad capabilities and can provide strategic advice and service as the plan’s needs change. A focus on growth of assets may transition to more hedging and then ultimately risk transfer assistance. Sponsors often want a partner that can help navigate all different phases.
An OCIO partnership may free up internal resources in two significant ways. First, by moving some of the day-to-day responsibilities for managing the plan to the OCIO partner, internal staff can focus on bigger-picture issues related to the pension, such as strategic asset allocation, glide path development or transfer of some of the liability to a third party insurance company. Second, by reducing the overall time spent on the pension, internal staff can allocate additional time to more value-added activities related to the management and growth of the organization’s core business.
In many ways participants are unaffected by a decision to outsource the management of the pension plan. The pension obligation is still the liability of the sponsor and participants are still entitled to receive their monthly pension payments. Some participants may not even know that an OCIO provider had been engaged to help with the management of the plan.
Nonetheless, bringing additional resources to the plan such as the expertise of an OCIO partner ultimately may be in the best interests of participants. Such resources can help enhance returns and reduce funded status volatility, which ultimately helps to secure the benefits accrued by participants.
Different providers take varied approaches when it comes to the use of internal or external management across asset classes. At GSAM, there are generally two instances where our clients may choose to use internal GSAM products.
First, our clients may use GSAM with respect to managing liability hedging fixed income where the assignment is more of an engineering exercise to match plan liabilities as opposed to generating excess return. In these cases, having the fixed income managed in house where the portfolio managers can work in tandem
with the OCIO’s liability strategists may result in a more efficient and coordinated process to ensure the hedge is functioning as expected.
Second, some clients may wish to tap into our tactical market views given we are investors, in the markets every day. Where this is the case, these positions tend to take up a relatively small portion of the overall plan. In all cases, any decision to use GSAM products would involve the client directly. Also, ERISA fiduciary and prohibited transaction considerations would apply.
An experienced OCIO provider can help effectuate all aspects of a plan’s de-risking strategy, such as increasing the plan’s hedge, reducing volatility in the portfolio or helping to transition liabilities to a third party. In addition, as sponsors increase de-risking activities, the exercise often calls for a much more customized approach, in particular with respect to an LDI program. An OCIO provider can provide that level of customization.
Part of implementing a de-risking program is ensuring that market events do not generate a large drawdown in funded levels that can essentially put a stop to any de-risking actions in place. Having a provider in the markets every day can help a plan navigate market volatility, such as what we experienced in the fall of 2018, and ensure that a de-risking program stays on course.
There is no one-size-fits-all answer. Some organizations might view the OCIO provider as replacing the investment consultant, albeit with a more enhanced service.
In other cases, a sponsor may wish to retain a consultant to help monitor the performance of the OCIO provider and as another set of eyes and ears on the plan. We have seen both models utilized in practice. Ultimately, the decision on whether or not to retain an investment consultant after hiring an OCIO provider is based on the circumstances and needs of the plan and sponsor.