Investment outsourcing means insourcing pension management best practices

Investment outsourcing means insourcing pension management best practices Joseph Gelly, Jr., Managing Director & Head of Institutional Canada Adam Hornung, CFA, Senior Consulting Analyst EXECUTIVE SUMMARY: Plan sponsors are seeking strategic providers who can offer professional expertise, share fiduciary responsibility and improve governance. As McKinsey notes, institutional investors have begun to dramatically adjust their thinking around portfolio construction, as the nature of the industry is shifting from alpha to outcomes. Dramatic growth in investment discretion In this environment, many plan sponsors have been seeking extra help from professionals outside their organization. One of the most visible trends is widely known as outsourcing. In a recent report, The Asset Management Industry: Outcomes Are the New Alpha, McKinsey describes solution providers as those who cater to the needs of sponsors and others who are looking for more wide-ranging strategic advice, customization and support that span the spectrum of asset classes. 1 McKinsey remarks that fiduciary solutions, a term synonymous with outsourcing, is one of the key approaches for success in the solutions space. In the report, the firm draws on their North American annual benchmarking survey to reveal that institutional investors, particularly plan sponsors, are actively seeking outcome-oriented solutions as they attempt to cope with worsening plan deficits and liability management. 1 The Asset Management Industry: Outcomes Are the New Alpha, McKinsey & Company, October 2012. Russell Investments // Investment outsourcing means insourcing pension management best practices AUGUST 2013

Enhanced fiduciary solutions To put this trend in context, it s useful to include a historical perspective. Russell Investments began managing multi-asset mandates with discretion in 1980. At that time, one of Russell s consulting clients requested a fully diversified investment solution for a middle-market subsidiary whose pension program had to be managed separately. In response, the firm began providing a fully implemented investment solution, complete with sophisticated portfolio strategies similar to those recommended by Russell s consulting group. Today, the successors of these early groundbreaking vehicles typically include strategic advice and implementation with customizable discretionary services that range from simply hiring and firing managers to full investment responsibility encompassing strategic asset allocation as well. Because of the variety and complexity of these relationships, many use the term "enhanced fiduciary solutions," as it is a more accurate description than outsourcing. Russell s expanding investment outsourcing solutions has more than $108 billion 2 in institutional outsourced assets around the globe. In this article, we would like to offer plan sponsors the benefit of our 30 (and counting) years of experience in the field of investment outsourcing. These insights can help pension plan staff and their committee members set realistic expectations, and identify effective strategies and practices that apply to their respective investment objectives. Today s plan sponsors are seeking to improve their performance as fiduciaries In any discussion about investment outsourcing, it helps to stay focused on the plan sponsor s objectives. During the extended bull-run from 1982 through 1999, plan sponsors took advantage of the secular upward trend by hiring consultants to search for top-performing managers. As absolute returns remained strong, plan sponsors seemed content to work with consultants for their investment manager decisions. However, as witnessed in 2008, absolute returns did not hold up in adverse market environment. This led to a shift in focus from asset class performance to total plan objectives. While the market environment has improved considerably since the severe recession faced in 2008, the issues facing plan sponsors today have not gone away. They continue to struggle with the burden of being underfunded, the significant volatility in funded status, and the apparent inability to take advantage of de-risking opportunities. In this environment, plan sponsors are turning to providers who can help them with their fiduciary duties in the broadest sense. In fact, the plan sponsor is insourcing a provider to help shoulder the burden of fiduciary responsibility. Desirable capabilities include: professional expertise in risk management, effective implementation, and good governance. The challenges facing plan sponsors are most pronounced for those whose resources may not match their aspirations. This strain on resources may lead to ineffective governance structures, higher expenses, and slow decision-making. As a result plans may face unnecessary risk exposure or miss the opportunity to dynamically take advantage of changing market conditions. By providing a customized approach to implementing the sponsor s overall strategic plan, the outsourcing provider remains focused on the full-time issues, such as providing meaningful advice, developing strategies for asset allocation, structuring the portfolio, selecting and monitoring investment managers, rebalancing, staying current While an outsourcing provider may still look like a gatekeeper to investment managers, the plan sponsor perspective is really to insource a provider to help shoulder the burden of fiduciary responsibility. 2 As of March 31, 2013 Russell Investments // Investment outsourcing means insourcing pension management best practices 2

with regulatory requirements, and coordinating the operations of multiple parties involved in a plan sponsor s investment program. Because the fiduciary solutions provider is focused on these issues, the pension committee can concentrate on their fiduciary duty to plan for and address long-term strategic issues. An effective fiduciary provider should increase access to managers on the plan sponsor s teams When choosing a fiduciary solutions provider, it s important to consider three factors: The range of investment options available The degree of objectivity and ability to provide qualitative, forward-looking insight Past experience negotiating manager access on favorable terms First, today s investment managers are more specialized than ever before. A fully diversified portfolio may include equities, fixed income, real estate and alternative assets, with each asset class subdivided by geographic region, capitalization, style, sub-style and among alternative assets, the various types available (hedge funds, private equity, infrastructure, commodities). The wide range of investment choices provides unprecedented opportunities, but also means that considerable experience is required to manage them. An effective fiduciary solutions provider needs to have considerable resources dedicated to researching and evaluating the managers available in each category. In addition, sophisticated analytics and years of hands-on experience are required to construct and manage a well-diversified portfolio that manages risk and performs well in a variety of market environments. Second, in its role as the fiduciary responsible for manager selection, the provider must recommend the investments that best meet the needs of the client. In the process, it must demonstrate how it is managing potential conflicts of interest, such as the willingness to use non-proprietary products or to recommend asset mixes that may generate lower fees. The need for objectivity extends to the criteria the provider uses to select managers. This is a difficult undertaking: On the one hand, quantitative criteria are not adequate to assess a firm s ability to perform well in the future. Data reflect past performance only, and as such are an unreliable predictor of future results. To be effective, a manager evaluation process must include qualitative assessments of each firm s professional staff, along with its management and incentive structure, investment process, and the resources available to support that process. This process requires personal knowledge based on face-to-face interviews. Yet the outsourcing firm must take care not to grow too closely tied to the managers it recommends. In effect, the investment outsourcing provider must demonstrate that it has an effective sell discipline in place. In addition to its range of assets and objective scrutiny, the third important element for an investment outsourcing firm is its ability to provide scale on behalf of its clients. This is a case where bigger is better. As an aggregator of assets, the solutions firm can be an extremely attractive client for top-tier managers. Tangible results can include access to products that might be closed to new investors; the ability to work with a manager to customize a product for its clients special needs; and, of course, receiving the most favorable fee structure that the manager has available. An effective fiduciary solutions provider needs to have considerable resources dedicated to researching and evaluating the managers available in each category.. Russell Investments // Investment outsourcing means insourcing pension management best practices 3

Plan sponsors can leverage the professional expertise of the outsourcing provider Russell Investments founder, George Russell, invented the pension consulting business when he performed the first manager search for JCPenney in 1969. After that, the professionalization of the pension function developed quickly. As George Russell notes in his 2010 published memoir, Success by Ten: In 1969, only the treasurer was paying attention to the pension plan. Now these corporations all have major teams of highly sophisticated investment professionals. Our clients increasing ability to perform more of the work themselves changed the dynamic of our relationship. We knew Russell had to develop new capabilities that were of value for them or we d never have a job. Enumerating those new capabilities provides a fairly accurate summary of the scope of work that is required in modern pension fund management. If the plan sponsor doesn t have the expertise to manage these functions in-house, then the following list is a basic job description for a fiduciary solutions provider: 1. Governance. Clear and actionable governance advice should be the starting point for the provider. The sponsor will then be in a position to assign clear roles, responsibilities and accountabilities, and ensure that decisions are allocated to those who have the expertise and time to make them. The focus of the plan sponsor remains in setting the overall strategy of the portfolio, and delegate the other important decisions to those in the best position to achieve the desirable outcome. 2. Strategy. The provider will focus not only on specific outcomes for the plan but also achieving these outcomes within the context of the overall corporate strategy. This requires personnel who are well versed in compliance, asset/liability modeling, corporate finance, analysis of contribution policies, and ongoing reporting against objectives. Investment guidelines are established at this point, including planned deviations from the policy that allow the provider to dynamically alter the investment portfolio when plan and market circumstances change. Today s environment dictates that plan sponsors focus on funded status and total plan return. Liability-driven investing (LDI) strategies like immunization and duration matching are emerging as important tools for managing risk. Plans seeking higher returns need to consider alternative assets and portfolio engineering techniques. Incorporating LDI and alternatives along with traditional asset classes requires sophisticated approaches to asset allocation, so it s important to work with professionals who have the required expertise in all of these areas. 3. Implementation. It s clear that the transition from a consultant recommending managers to a full-service fiduciary solutions provider involves an extended learning curve. It requires significant adjustments to credibly assume the level of liability that comes with fiduciary responsibility. Implementation of a complex, well-diversified portfolio is a task requiring significant resources. Oversight must be continuous: each manager needs to maintain its style discipline in order for the total portfolio to maintain its designated level of residual risk. If manager replacements are needed, they must be implemented in a timely fashion. For instance, transition management should be carried out cost-effectively. Cash drag should be minimized using stock index futures. And a rebalancing policy needs to be developed and maintained. A single outsourcing provider can also identify opportunities and risk factors at the total portfolio level, and should have the trading and execution services to achieve additional sources of return and enhanced risk management. Having a full implementation platform with services that include hedging and overlay capabilities are key components to achieve the most efficient and cost-effective portfolio. Professional competence is the key in all three areas: governance best practices, strategic and investment expertise, and implementation. The fiduciary solutions provider needs to have a deep bench with experience across all these capabilities. By managing risk on the portfolio level, the outsourcing firm frees the individual manager to focus on return potential rather than diversification.. Russell Investments // Investment outsourcing means insourcing pension management best practices 4

Good governance means running your pension fund like a business A simple working definition of good governance is the establishment of a structure where every decision will be made by the people who are in the best position to do so. In a pension plan, good governance exists when the trustees are allowed to focus on issues that impact the long-term objective of the fund and its impact on corporate financial goals, rather than being responsible for investment decisions. At the other end of the spectrum, security selection decisions should be made by investment managers who have very specialized expertise in their particular area. In between those two layers resides the outsourcing provider, who is in charge of making sure the trustees orders are executed as effectively as possible. By managing risk at the portfolio level, the outsourcing firm frees the individual manager to focus on return potential rather than diversification. A well-governed pension plan functions like a well-run business. In their regular meetings, trustees should note whether the volatility of contributions is within expected ranges, costs are under control, liabilities are manageable, and the plan is on track to fulfill its promise to employees. Keep asking questions Ideally, this discussion will inspire plan sponsors to think of their pension programs in new ways. It is always tempting to define success in terms of investment performance, or alpha; but that would be mistaking the means for the end. Of course the end depends on each fund s particular situation. That s why it is so important for plan sponsors to keep asking questions when considering working with a fiduciary solutions provider: This is a close, comprehensive and long-term relationship, so it s critical to get the right fit. Russell Investments // Investment outsourcing means insourcing pension management best practices 5

ABOUT RUSSELL INVESTMENTS Russell Investments (Russell) is a global asset manager and one of only a few firms that offers actively managed multi-asset portfolios and services that include advice, investments and implementation. Working with institutional investors, financial advisors and individuals, Russell's core capabilities extend across capital market insights, manager research, portfolio construction, portfolio implementation and indexes. Russell has $250.3 billion* in assets under management (as of 6/30/2013) and works with over 2,500 institutional clients, independent distribution partners and individual investors globally. As a consultant to some of the largest pools of capital in the world, Russell has $2.6 trillion in assets under advisement (as of 12/31/2012). It has four decades of experience researching and selecting investment managers and meets annually with more than 2,200 managers around the world. Russell traded more than $1.4 trillion in 2012 through its implementation services business. Russell also calculates approximately 700,000 benchmarks daily covering 98% of the investable market globally, which includes more than 80 countries and more than 10,000 securities. Approximately $4.1 trillion in assets are benchmarked to the Russell Indexes. Russell is headquartered in Seattle, Washington, USA, and has offices around the world including Amsterdam, Auckland, Beijing, Chicago, Frankfurt, London, Melbourne, Milan, New York, Paris, Seoul, Singapore, Sydney, Tokyo and Toronto. For more information about how Russell helps to improve financial security for people, visit www.russell.com or follow @Russell_News. * includes US$69 billion of derivative overlay assets under management not included prior to June 30, 2013 FOR MORE INFORMATION: Call Russell at 866-737-2228 or e-mail Joe Gelly at jgelly@russell.com Visit: http://www.russell.com/ca/institutional Important information Nothing in this publication is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This information is made available on an "as is" basis. Russell Investments Canada Limited does not make any warranty or representation regarding the information. Unless otherwise stated all index data is sourced from BNY Mellon Asset Servicing. All rights reserved. Russell Investments and the Russell Investments logo are either trademarks or registered trademarks of Frank Russell Company, used under license by Russell Investments Canada Limited. Russell Investments Canada Limited is a wholly owned subsidiary of Frank Russell Company and was established in 1985. Russell Investments Canada Limited and its affiliates, including Frank Russell Company, are collectively known as "Russell Investments". Copyright Russell Investments Canada Limited 2013. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. First used: August 2013 INST-2013-07-20-0195 (EXP-07-2014) Russell Investments // Investment outsourcing means insourcing pension management best practices 6