The UK pensions market is experiencing an extended period of industry consolidation within Local Government Pension Schemes (LGPS) and Defined Contribution (and to a lesser degree Defined Benefit) Master Trusts. This has been a function of government policy with efficiency improvements via economies of scale, cost savings and better governance all contributing to the rationale. The Australian pensions market is often cited as a paragon of excellence to follow. We think it is important to examine, perhaps in a more abstract way than is common, the extent to which this trend should continue. Why? Because we have seen first-hand, in recent times, how systemic risk can cause havoc across the industry. We feel it is important to spend time imagining what other factors may cause systemic risk and how these could be managed. Indeed, as signatories to the UK Stewardship Code, it is part of our responsibility to consider potential systemic risks and collaborate with the industry where it makes sense.

Before we go on, we should address whether we have a vested interest in this topic as an asset management firm; this must be a natural question if you are reading this! In short, probably. We have a wide range of clients at Fulcrum – some small, some large. We have relationships with consolidated pools and we have relationships with standalone schemes. It is hard for us to assess if we will be more or less successful as a business if there is further industry consolidation, but there is no doubt that it is having an impact on the asset management industry more generally and we should be upfront about this. In a consolidated pensions system, there are fewer selection exercises and they represent bigger projects! Ultimately though, we must try to put to one side any commercial interest when we think about systemic risks and try to consider what is best for end savers when sharing our thoughts on the matter. So here goes…

There is no doubt, some smaller schemes were being over-charged

Many smaller DC schemes needed the benefit of improved governance and economies of scale. Master Trusts have helped with this challenge and we feel the endeavor should be applauded. Improved technology, better investment offerings and solid communications have been made accessible for many of these smaller employers, which is undeniably good for the respective members and their projected outcomes, in our opinion.

The case for further consolidation

We have seen a lot of research (e.g. this paper by the Resolution Foundation) that addresses the topic of consolidation in the pensions market. Whether UK schemes should be forced to invest in UK projects is beyond the scope of this article but we do agree with the Resolution Foundation that the UK has a deep-seated investment problem. However, in the hypothetical scenario of forced pension investment in UK assets, we are not convinced that substantial further consolidation is the way to fix it. We feel that this is a governance issue as opposed to a size issue. As an economy, ‘UK plc’ should aim to encourage innovative investment in small projects as well as large and there are far larger numbers of small projects that require investment. Smaller projects can also have higher potential returns.

Another key reason offered for consolidation relates to fees…

Fees are not the only thing you can control

There is no material evidence (that we are aware of) that suggests larger investors perform better than smaller investors. In fact, the paper of December 2004 in the American Economic Review entitled “Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organisation” by Joseph Chen, Harrison Hong, Ming Huang and Jeffrey D. Kubik presents some evidence to the contrary. Regardless, this is generally not used as the reason to justify consolidation – the argument tends to relate more to ‘what you can control and what you can’t control’. Fees are (at least to a certain degree) controllable and they will make a difference. That said, it is also possible to control the investment process, decision-making governance, the level of diversification/breadth in the investment portfolio and how much risk/return is being targeted (it is, of course, not possible to fully control the actual outcomes). These things will also make a difference, it is just harder to quantify them. Things that are harder to quantify represent the big challenge because they can also be the root cause of systemic risk.

Does the Australian model hold the answer?

We recently met a handful of very innovative smaller asset managers from Australia at a conference in London and part of the feedback we received in our conversations with them was that a mandate from one of the larger Australian Super funds would more than eat up all their capacity and that they were starting to struggle to find clients to work with in their domestic market (hence coming to visit potential investors here in the UK). A mandate would need to be that size from the perspective of the Super fund to move the needle at their total portfolio level. This was fascinating to us. There are clearly some fantastically well governed pension schemes in Australia with real depth of understanding of investment matters, but perhaps the market is starting to experience some side effects of forced consolidation?

An equilibrium state?

So, let’s try to think about this in a different way by imagining we work in the engine room of a very large, consolidated pension scheme. There must come a point at which your size means that certain investments are ‘off the table’. If you oversaw £100bn, there would be little point spending valuable due diligence time and governance on a £5m opportunity, because it doesn’t “move the needle”. Even if the investment were to double in value, the percentage gain at the portfolio level would be trivial. That same investment would be much more impactful for a £5bn scheme.

Now let’s extend the thought experiment. Imagine the whole market was comprised of a small number of very large £100bn schemes. There would be fewer buyers for the £5m opportunity. It wouldn’t necessarily mean that innovation dries up, but it would likely be focused on larger opportunities. It can also take longer to move money around when it is invested in bigger chunks, due to liquidity constraints.

We find it to be completely plausible that there is a threshold moment where systemic risk increases materially as the industry consolidates. This could be because of homogeneity in investment allocations or simply because it takes too long to move money around, impacting innovation and economic productivity. This is very difficult to quantify, but it must be a risk. Consequently, it is our contention that there is some equilibrium state for the industry where there is a ‘beautiful mix’ of smaller and larger schemes, some consolidated, some not. There would be good governance (in the small schemes too!) and as a result the schemes would be investing in different investment opportunities that suit their members; there would be heterogeneity.

We don’t know if we have gone through the threshold point. To consider this further, let’s try thinking about it differently again – there must have been some threshold moment in the UK LDI market (i.e. we reached some maximum industry-wide tolerance level for leverage in government bonds) prior to the events of late 2022. It is likely that the threshold moment was quite some time before late 2022, potentially years. We may have already gone through the equivalent moment for consolidation. When it comes to systemic risk, having a consolidated Australian pensions market is one thing; adopting a similar approach more globally is quite another.

Diversity in the ecosystem

There are clearly areas where industry collaboration is essential. For example, we would be supporters of consolidation in the range of ESG-related initiatives. Working together on the best methods for ESG data collection seems very logical. In contrast, independent thinking on asset allocation and manager selection is essential. We are not saying that this has always been good in a more fragmented market – there are plenty of historic examples of herding behavior across our industry.  We are just saying that excessive industry consolidation can create similar challenges (potentially worse) to lots of smaller asset owners investing in the same idea and that we could be shooting ourselves in the foot.

Summary (and what would this mean for Master Trust fees?)

There is a consensus that we will continue to see further consolidation amongst the Master Trusts (and potentially amongst the LGPS too) to ensure these businesses are sustainable for the future. The fee rates for Master Trusts are low and form part of the competitive dynamic in this marketplace. They necessitate large scale to become sustainable businesses, particularly given that there is a significant human resources requirement to operate such vehicles. We think the fee basis (both the basic rate and the budget for external managers) for Master Trusts should increase to improve the sustainability of the industry and lessen the need for further consolidation.

We recognise that we can’t just declare that ‘Master Trust fees should increase’. It is a very competitive market with the investment portfolio not necessarily being the top priority for the buyer. When considering what is in the best interests of end savers, our proposition may sound counter-intuitive and it is clearly linked to the Value For Money discussion. Nevertheless, we feel it is imperative it is solved. An industry with a diverse range of investors and asset managers provides vitality that reduces hard-to-quantify systemic risk. We believe our system would benefit from good, nimble governance across the board and education as opposed to never-ending consolidation.