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Optimizing Outcomes for Portfolio Transitions
As portfolio allocations change and market volatility increases, institutional investors benefit from working with the right transition management partner to optimize outcomes.
Amanda Willams, Regional Practice Lead, Transition Management – North America
There are multiple factors currently impacting institutional investors and their portfolio allocation decisions. Some of these may drive an organization to make significant changes to their portfolio. For example, a move to Environment, Social and Governance (ESG) investing or a desire to consolidate pension plans in order to reduce costs and gain scale may prompt institutional investors to overhaul their portfolio allocations.
However, in an uncertain environment, time and expertise are crucial components to making significant changes. Working with a transition management partner is key to a successful outcome.
Perhaps one of the most notable investment trends in recent years is the rise of ESG investing. Now emerging regulations are putting asset owners and managers under more pressure to focus on ESG.
In Europe, ESG has been at the forefront of investment trends for years, and the EU is taking steps to broaden its reach. In November 2022, the European Parliament approved The Corporate Sustainability Reporting Directive (CSRD), which requires large firms to disclose data on how their business practices impact people and the environment plus any climate-related risks. 1
Slated to take effect in 2024, the requirements apply to all EU-based companies, plus large corporations with a significant presence in the EU.
In the U.S., the Securities and Exchange Commission (SEC) proposed new climate-related disclosures for investors in 2022. If the regulations are enacted, investors would be required to disclose “climate- related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements.” 2
As institutional investors overhaul portfolios to align with ESG regulations, the transition could be a large-scale under taking. In this case, asset owners benefit from the expertise of a transition manager. And since adherence to ESG policies is a priority, investors should seek out an organization with the following:
- Focus on transparency and integrity
- Solid track record of risk aversion and ethical behavior
- Commitment to diversity, equity and inclusion
- Strong corporate governance, internal audit and counterparty review
- For clients domiciled in the U.S., seek a provider serving as a co-fiduciary, compliant with ERISA
Across the globe, the trend toward plan consolidation and fund pooling continues to gain traction as public pension plans and healthcare systems seek ways to reduce costs, gain scale and increase efficiencies.
Australia has one of the world’s largest pension pools, due to significant growth in its superannuation funds.3 As a result, smaller funds are faced increased pressure and scrutiny. The Australian Prudential Regulation Authority, the nation’s largest regulator for the financial services industry, said that funds with assets less than A$30 billion are “uncompetitive”.4
In the U.K., occupational DC pension plans decreased by nearly 40% from 45,150 funds in 2011 to 27,700 in 2021.5 On the DB side, more than 80 local government pension funds pooled their assets in 201867 into eight separate pools and are expected to consolidate to three pools by 2030.89
In continental Europe, the Netherlands is a pioneer in pension consolidation with the total number of pension funds decreasing from about 1000 in 2000 to less than 200 in 2022.10 Over the past few years, the nation has been shifting its largely defined benefit pension system into two new types of defined contribution contracts, allowing pension funds to choose which framework to adopt. The vast majority11 (94%) of the country’s pension participants are in defined benefit (DB) schemes, but in 2023, they are starting to make the transition to two new types of defined contribution (DC) contracts.
Pension consolidation has also been picking up momentum in the Middle East. Saudi Arabia merged its General Organization of Social Insurance (GOSI) with the existing Public Pension Agency, creating a massive fund worth over $250 billion at the time of the merger in 2021.12 Aiming to cut costs, help investment returns and increase efficiency, the move made GOSI one of the largest pension plan investors on earth. Just next door, Oman merged eight pension funds into two: designating one for public and private sector employees and one for the military.13
As pioneer of the large public pension funds model, the Ontario Teachers’ Pension Plan is emulated by many consolidated funds. With approximately $242 billion in net assets as of 2023, the plan is one of the world’s largest institutional investors. It’s no surprise that with such a successful local example, 72% of Canadian pension funds surveyed in 2021 were considering consolidation. More than half of the respondents are planning on consolidating within five years.14
Pension consolidation is just starting to gain traction in the U.S. The State of Illinois has merged all its municipal fire and police pension plans, except for the City of Chicago, into the Illinois Firefighters’ Pension Investment Fund and the Illinois Police Officers’ Pension Investment Fund.15
And in the U.S. healthcare sector, increases in merger and acquisition activity led to additional consolidation. From 2016 to 2021, there was a substantial increase in health system consolidation with more than 1000 announced hospital and healthcare system M&A transactions.16
Pension funds and healthcare systems that pool or consolidate assets and change investment strategies as a result will find themselves in need of an organized portfolio transition manager to guide the process. There are many advantages to this approach.
- Transition managers add project management expertise, ensuring coordination between legacy and target investment managers, custodians and trade desks, saving the pension fund time and energy.
- Transition managers can act in coordination with the custodian to execute transitions as assets move, to migrate from legacy to target real time.
- Transition managers can also bridge the gap between the previous investment strategy and the new. Options include utilization of ETFs, optimized index replication or futures to maintain market exposure against a benchmark and ensure the portfolio remains invested in the interim.
While certainly not a trend, market volatility is a factor to consider in any portfolio transition. From political unrest to economic uncertainty, market volatility can wreak havoc on investment portfolios.
2022 was tumultuous for investors with the S&P 500 dropping by 19% and the Nasdaq declining by 33% over the course of the year.17 Trying to fight rampant inflation, the U.S. Federal Reserve hiked interest rates seven times in 2022, ending the year with the highest federal funds rate in 15 years.18 Despite the steady increases, the Fed is expected to continue to raise rates in 2023.
In an uncertain environment, particularly when investors need to act quickly due to increased volatility, having a seasoned transition manager at the ready is crucial to be sure that execution is handled in an expert manner and that risk is managed properly.
The portfolio allocation decisions that institutional investors make are always changing, as recent trends show. Some of these decisions may mean major investment strategy shifts. Transition management is a key service to manage the process and the inherent risk of such a big change. An experienced transition specialist can help navigate risk, complexity and market volatility to make the process run more smoothly and effectively.
To learn more about Northern Trust Transition Management, reach out here.
1 Sustainable economy: Parliament adopts new reporting rules for multinationals | News | European Parliament (europa.eu)
2 SEC.gov | SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors
3 Australia's top pension fund warns against tapping savings to fix economy | Reuters
4 Australian Pension Fund Chairman Urges Caution on Consolidation - Bloomberg
5 Defined contribution pension market consolidation continues, TPR’s latest figures show | The Pensions Regulator
6 https://mycouncil.surreycc.gov.uk/documents/s73145/14%20-%20Annual%20Report%202019- 20%20-%20Annexe%201.pdf
10 Netherlands: Pension transition drives consolidation | Country Report | IPE
11 https://www.thinkingaheadinstitute.org/content/uploads/2021/02/GPAS 2021.pdf
12 New giant Saudi pension fund ready to rival world's largest investors - Arabian Business
13 Pensions, sovereign wealth funds, and industrial policy in the Gulf: A look at fund consolidation | Middle East Institute (mei.edu)
14 72% of Canadian pension funds considering consolidation options: survey | Benefits Canada.com
15 Illinois consolidates 649 police and firefighter pension funds | Pensions & Investments (pionline.com)
16 2021 M&A in Review: A New Phase in Healthcare Partnerships | Kaufman Hall
17 Stocks Drop in Final Trading Day of Year - WSJ
18 Fed Raises Rate by 0.5 Percentage Point, Signals More Increases Likely - WSJ
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