A Guide To Delegated Investment Management by Willis Tower Watson
What is delegated investment management?
Delegated investment management combines strategic advice and implementation. Typically, a mandate involves the ongoing management of most or all of the assets of a pension or endowment fund, managed to an objective and risk level set by the plan sponsor or pension committee.
Research has demonstrated a connection between investment governance and investment success. Keith Ambachtsheer suggests that the good/bad governance gap could be worth 1% to 2% of additional return each year.* (Figure 1)
So it’s logical that governance should guide the investment process. While some pension funds have adopted simple, passive equity and bond portfolios that require a lower level of specialist knowledge and time to maintain, others have attempted to build more sophisticated portfolios in pursuit of better risk-controlled returns.
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Either approach may be appropriate, but to maximize the chances of success, the governance approach must match the fund strategy.
Closing the governance gap: To build or buy?
For those who want to improve the risk/return trade-off from their equity and bond portfolios, there are generally two options to enhance investment governance: build or buy. Pension funds can either build an in-house team or delegate to a specialized third party.
Building an internal team can offer attractive benefits. However, for many, it is simply not a realistic solution, as only the largest pension funds have sufficient scale to make this a genuinely viable option.
For pension funds that can’t build internally, delegated investment management can close the gap between the need for efficient investment strategies, real-time decision making and the typically constrained governance budget of a pension fund committee.
Benefits of delegated management
While it may seem that plan sponsors that opt for delegated investment management are taking a step back, this is not the case. In fact, one of the most frequently cited benefits of delegated investment management is that plan sponsors or committee members have more time to focus on key strategic issues and long-term goals for their endowment or pension plan. The plan sponsor retains accountability for the investment strategy (overall risk and return) and works with the delegated manager to determine key parameters, such as the time horizon, return and risk. The delegated manager, working with the plan sponsor, then executes the investment strategy separating the governance and execution functions.
Monitoring also becomes less of a burden on the plan sponsor as the delegated manager relationship replaces numerous relationships with investment managers and potentially other service providers.
Roles and responsibilities
Delegated investment management turns over certain functions to a third party, but it isn’t a simple outsourcing solution. Rather, it should complement the strategic responsibilities of the plan sponsor.
The model is the same as when a management team acts upon a corporate board’s strategy. Clear guidelines are needed to reflect the significant decision making delegated to the investment manager.
The plan sponsor remains in control of high-level strategy, defining the pension plan’s long-term funding objectives and determining return requirements relative to the liabilities, while the delegated investment manager implements the daily aspects of that strategy, including portfolio construction and operations.
Figure 2 shows the range of investment decisions and activities, and which function they fall under.
Typical delegated manager functions
- ??Allocation to different asset classes, within the plan sponsor’s guidelines
- ??Monitoring the funding level and implementing changes based on market conditions and de-risking triggers
Delegation frees the plan sponsor to devote more time to strategy and, more important, to focus on high-quality oversight.
- ??Hiring and firing investment managers
- ??Negotiating investment manager fees
- ??Negotiating legal investment management and related agreements
- ??Executing documentation
- ??Managing cash flow
- ??Monitoring investments at a detailed and higher level
- ??Liaising with the custodian
The appointment of a delegated investment manager can significantly increase governance effectiveness if there are up-front, clear guidelines based on the plan sponsor’s mission, objectives, and carefully defined roles and responsibilities.
Pension funds evolve over time, so it is important that a delegated investment manager has the full suite of skills and expertise to work to any set of objectives.
At the highest level, plan sponsors strive to have sufficient assets available to meet the pension promises. Exactly what this means in practice changes over time. In fact, this has changed remarkably over the last two decades as we have moved from a purely long-term approach to an increasingly mark-to-market approach driven by legislation and accounting standards.
The youthful pension plan
Although now rare, in the past pension plans were more commonly open to new entrants with participants earning additional benefit accruals with each year of employment. The time horizon created was to all intents and purposes infinite and replenished with new entrants to pay contributions, which indirectly paid pensions.
In this type of plan, a sponsor may adopt an approach akin to an endowment fund with objectives set in real terms (e.g., risk and return targets relative to inflation). A long-term investment horizon can be sought, and the plan can outperform shorter-term investors that may find they are forced sellers when short-term market shocks occur.
The midlife pension plan
Over the last few years, an increasing number of pension plans have been closed to new members — and in some cases, to new accruals for current active members. With no increase in membership and no new benefits earned, this is a fundamental change. Gradually, as the time horizon for payment of the liabilities shortens, management of this liability assumes greater importance, eventually dominating the investment strategy.
Many pension plans acknowledge this trend with well-defined journey plans (also known as glide paths) that state their long-term funding objectives expressed relative to liabilities. Pension plans will also define the time horizon over which they expect to achieve their objectives and their acceptable level of risk.
The importance of implementing this framework increases as the pension plan’s liabilities mature and there is less room to maneuver if investment performance is poor.
The mature, self-sufficient pension plan
Some pension plans are fully funded on both a going concern and solvency basis. At this stage, assets may be invested mostly in fixed-income and other low-risk assets (relative to liabilities), as it is highly probable that benefits can be provided without recourse to the sponsor.
During early self-sufficiency, cash-flow management and liquidity tend to be less of a concern than mark-to-market management, as cash flows may only be 1% to 2% of assets each year. The focus is on managing mark-to-market interest rate and inflation risks. Diverse, return-seeking assets will still have scope if they have sufficient liquidity. Indeed, liquidity management becomes increasingly important as a pension plan transitions through the self-sufficiency stage.
As benefit payments become a material draw on assets, the focus moves to cash-flow management. Bonds are held because they will generate cash flows that match the yearly predicted pension fund outflow.
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