Is big really beautiful? The limits of pension consolidation Many governments are thinking about merging their disparate systems. New research finds real benefits, but capturing them is difficult. Eser Keskiner and Robin Matthias SEPTEMBER 2018 • PRIVATE EQUITY © Yongyuan Dai/Getty Images Pension systems face a tough road. Long-term arguments, economies of scale do not automatically economic growth is slowing, pulling down returns, translate to “economies of consolidation,” as and political uncertainty is high. Funding levels numerous pitfalls can let the benefits slip away. have deteriorated, and despite recent improvements, Pension systems that want to achieve synergies pension funds will continue to be under pressure as through consolidation need to integrate funds beneficiaries live longer. Regulators are sharpening carefully, using a few essential best practices: develop their focus on achieving greater efficiency and a clear target model that articulates the drivers of effectiveness for the industry. value, don’t let politics interfere with a focus on value creation, ensure effective decision making, keep the While defined-benefit (DB) and defined-contribution integration moving quickly, and reduce uncertainty (DC) schemes around the world are forming different for employees and members as quickly as possible. responses to these challenges, there is a common theme in many countries: consolidation. The United Argument 1: Scale drives better investment Kingdom is pooling the investments of its local returns pension schemes. The Productivity Commission Some believe that larger pension funds should in Australia is reviewing the competitiveness and generate higher gross investment returns, reasoning efficiency of the country’s pension funds, with ongoing that larger funds have better access to the most focus on subscale funds with poor performance. The attractive opportunities, many of them in illiquid Netherlands has already seen the number of its funds asset classes and available only through preferential fall by 60 percent from 2005 to 20151—and there may treatment by the most successful external managers. be an additional 20 percent reduction in the coming With more investors and capital rushing into private years.2 In several other parts of Europe, governments equity (PE) and other private markets, access to are thinking about merging smaller pension schemes these attractive investment opportunities (and the into larger plans. most successful external managers) will become increasingly difficult to achieve. Already, investors The simplicity of the consolidation argument is find it “hard to get [their] money in the door.”3 The appealing: bring smaller funds together and achieve most successful managers can afford to work only economies of scale, from the back office to investment with the largest investors that can make significant activities. Everybody wins—or so it would seem. After commitments, thereby reducing their administrative all, some of the largest pension funds tend to have burden and saving costs. high investment returns as well. For example, the Canadian Pension Plan Investment Board (CPPIB), Our recent research shows some evidence for the which manages $350 billion, has achieved average theory that investors are gravitating toward the returns of 12 percent annually over the past five years. biggest managers. The largest private-market firms And the Dutch pension fund ABP, with $550 billion are beginning (but only just) to claim a larger share under management, has achieved average returns of of fundraising (Exhibit 1).4 8 percent per year over the same period. Our research also finds that the largest funds In this article, we test the three most common have recently outperformed smaller funds, with arguments made in favor of consolidation: that it will less variation between top- and bottom-quartile result in better investment performance, lower costs, performance than that observed among smaller funds and stronger governance and organizational health. (Exhibit 2). It seems that if a pension successfully What we find is that while there is merit to all three places its capital in one of these megafunds—which is 2 McKinsey on Investing Number 4, October 2018 McK On Investing Number 4 2018 Pension Consolidation Exhibit 1 of 8 Exhibit 1 Big firms’ share of fundraising has increased since 2015. Fundraising market share across all asset classes, top 20 private-market firms, 55 50 45 –2% per +24% per annum annum 40 35 ø 32 30 25 Top 20 firms 20 15 10 5 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Source: Preqin; McKinsey analysis not easy to do—it will gain access to a better collection How do they do it? If returns are similar for smaller of deals, ones that, for the moment, are generating and larger pension funds, it seems that they have equal superior returns. access to the asset classes that have performed well— which has often meant alternative assets. An analysis But other research suggests that smaller pension funds of the PE allocations of large and small pension funds, can do just as well as larger ones. CEM Benchmarking for example, shows no indication that large “ticket (a strategic partner of McKinsey & Company) analyzed sizes” are a must for participation in this asset class. the investment performance of 49 US pension funds The PE allocations of the smallest funds (those with from 2010 to 20155 and found almost no correlation total assets under management [AUM] between $1 between fund size and achieved gross investment returns billion and $5 billion) are not significantly different (Exhibit 3). In fact, differences in scale explained only from those of the largest funds (those with total AUM 4 percent of the difference in gross returns. It appears more than $50 billion) (Exhibit 4). Even at ticket sizes that smaller funds can hold their own, despite their as low as $50 million, smaller pension funds are able lesser ability to place capital with the largest managers. to gain access to this diverse and competitive asset Is big really beautiful? The limits of pension consolidation 3 McK On Investing Number 4 2018 Pension Consolidation Exhibit 2 of 8 Exhibit 2 Measured by pooled returns, megafunds have outperformed since 2008. Global private equity pooled returns by fund size relative to public-market Top- and bottom- equivalent, percentage points quartile variation from the average, percentage points 6 Megafunds ±3.2 4 Large-cap funds ±5.0 2 Mid-cap funds ±5.5 Small-cap funds ±7.3 0 Public-market equivalent –2 4 –6 2007 2008 2009 2010 2011 2012 2013 Source: Cambridge Associates; Thomson One; McKinsey analysis class.6 (And in the future, the advent of new liquid and is open only to pension funds of a certain size. alternatives products should make it even easier for But investing with a small set of highly reputable PE small funds to gain entry.) managers requires fewer resources and is easier to do, even for smaller funds. This may seem odd, as entering any new asset class requires a minimum level of commitment that will So, it appears that both large and small pension funds make the required investments for research and enjoy access to illiquid asset classes whose returns building a new team worthwhile. And such a minimum have been greater than those in public markets. commitment will always be easier for funds operating And analyses by CEM Benchmarking suggest that at larger scale. However, the answer lies in the pension size differences explain only a very small part of fund’s preferred implementation style (or the choice the observed differences in investment returns. If between internal and external management) and current trends continue, and larger private market the scope and complexity of the planned investment funds outperform smaller ones and access to these strategy. Building an internal team of investment outperforming large funds becomes increasingly professionals to make direct investments in global complicated to secure, our findings might change. But infrastructure, say, will require a sizeable investment at the moment there seems to be little merit in the 4 McKinsey on Investing Number 4, October 2018 McK On Investing Number 4 2018 Pension Consolidation Exhibit 3 of 8 Exhibit 3 Gross returns show no correlation with fund size. US pension funds,1 gross returns vs fund assets 10 9 8 Gross returns,2 20101, 7 6 Data-point concentration Low High 5 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 Fund assets, 2015, $ million, log10 Note: The proportion or percentage of variance explained by a regression is 4%. 1 n = 49. 2 y = 0.30x + 6.42. argument that greater scale per se drives higher gross participant for both administration and investment investment returns. management. Again, the logic is intuitive, and the underlying reasons also sound compelling. Across the Argument 2: Scale lowers costs whole business system, greater scale should allow for The second key argument for consolidation is more efficient operational processes, and scalable IT that larger scale will drive down average costs per platforms should save money. Greater scale should Is big really beautiful? The limits of pension consolidation 5 provide stronger negotiating power with third parties, returns. But can they do so in a cost-efficient way? Or such as pension administrators, fiduciary managers, do they end up with lower net investment returns than investment consultants, and external asset managers. their larger competitors, because they incur higher costs? Many proponents of consolidation claim that Even more powerful, at-scale pension funds can move bringing investment management in-house will yield some of these third-party activities, notably investment significant savings, particularly in private markets. management, in-house and thus significantly reduce McK On Investing Number 4 2018 their costs. That idea has gained particular prominence Does scale lower costs? Here, our findings are more Pension Consolidation with investors’ increasing allocations to alternative and conclusive and encouraging than they are in the Exhibit 4 of 8 illiquid investments.