Scale Economies In Pension Fund Investments: A Dissection Of Investment Costs Across Asset Classes by De Nederlandsche Bank

Dirk Broeders

De Nederlandsche Bank, the Netherlands, Maastricht University, the Netherlands

Arco van Oord

De Nederlandsche Bank, the Netherlands

David Rijsbergen

De Nederlandsche Bank, the Netherlands

1 June 2015


Using a unique dataset of 225 Dutch occupational pension funds with a total of 928 billion euro of assets under management, we provide a comprehensive analysis of the relation between investment costs and pension fund size. Our dataset is free from self-reporting biases and decomposes investment costs for 6 asset classes in management costs and performance fees. A pension fund that has 10 times more assets under management, has on average 7.67 basis points lower annual investment costs. These economies of scale are solely driven by management costs. Robustness checks show that this key finding does not vary over different pension fund sizes. Economies of scale do, however, differ per asset class. We find significant economies of scale in fixed income, equity and commodity portfolios, but not in real estate investments, private equity and hedge funds. We also find that large pension funds pay significantly higher performance fees for equity, private equity and hedge fund investments.

Scale Economies In Pension Fund Investments: A Dissection Of Investment Costs Across Asset Classes – Introduction

Investment costs are an important determinant of pension fund performance. High investment costs can significantly impact beneficiaries’ wealth and consumption, as they reduce the net rate of return on investments and subsequently raise the costs of providing pensions.1 This is even more relevant in recent years, as many pension funds around the world face significant challenges following the financial crisis and the ageing of society. As a result, pension funds face public and political pressure to operate more efficiently and show greater transparency to beneficiaries and the general public regarding their cost structure.2 Investment costs are also interesting from a broader financial markets perspective, as pension funds are among the largest institutional investors in the world. During 2013, pension fund assets in the seven countries with the largest (occupational) pension fund sectors – the U.S., Japan, the U.K., Australia, Canada, the Netherlands and Switzerland – amounted to $30.5 trillion, representing on average 105.6 percent of their GDP. By comparison, mutual fund assets in these countries aggregated to approximately $20 trillion during 2013.

Despite the importance of investment costs in pension fund performance, little empirical evidence is available on pension funds’ cost structures.4 This can largely be attributed to the absence of sufficiently detailed, unbiased and comparable data on investment costs. Several academic papers investigate pension fund costs and document a significantly negative relation with the size of a pension fund. These papers, however, concentrate on investment costs for U.S. pension funds (e.g., Bauer et al., 2010) and the aggregate investment cost level (e.g., Bikker and De Dreu, 2009). As a result, little is known about investment costs for European pension funds – that typically deviate from their American counterparts in terms of asset allocation – or what drives the observed economies of scale. Are they primarily driven by management costs or performance fees? Do economies of scale differ between asset classes that pension funds invest in? And to what extent are they stable over different pension fund sizes, types, and plans?

This paper aims to fill this gap by providing a detailed analysis of the relation between investment costs and pension fund size. For that, we have a unique and cross-sectional dataset containing information on fund-specific investment costs for 225 Dutch pension funds during the year 2013. The dataset is free from self-reporting biases, and is to our knowledge the first to distinguish between two components of investment costs, namely management costs and performance fees. Furthermore, we have detailed information on the asset allocation of pension funds for six asset classes, namely fixed income, equities, real estate, private equity, hedge funds, and commodities. We can further decompose this into thirteen sub-asset classes (e.g., for equities between mature markets and emerging markets) and different credit ratings for fixed income securities. This allows us to correct the investment cost analysis for differences in asset allocations and other pension fund investments’ characteristics.

As a case study, we examine pension fund investment costs in the Netherlands. The Dutch occupational pension system provides an interesting case study for several reasons.5 For one, the Dutch system is well-developed and relatively large in terms of size. This results from an important feature of the Dutch pension system, namely its mandatory nature. Due to this, large collective pools are created and participants of occupational pension funds benefit from economies of scale (Bikker and De Dreu, 2009). Another key characteristic of the Dutch pension system is that pension funds face no quantitative investment restrictions.6 They are free to invest in any asset class in any currency denomination. As such, the Dutch pension system offers an interesting case study, as the pension funds allocate money to a wide variety of asset classes.

Pension Fund Investment

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