Key Takeaways

• Unlike other areas of the asset management industry, pension funds experience economies of scale in both investment management costs and returns across asset classes.
• Large plans that can invest more in-house have stronger bargaining power over their external managers in negotiating fees as well as greater access to higher performing funds.
• Internal investment management offers significant benefits over external management, including cost reductions and improved gross and net-of-fee performance.

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Summary

Motivation. Defined benefit pension plans have increased significantly in size and have expanded their investment capabilities over recent decades. Against this backdrop, the paper analyzes how fund size impacts asset allocation, fees, and investment performance of defined benefit plans globally.

Methodology. The authors use a 29-year sample  period from 1991 to 2019 containing annual data   from 613 U.S. and 524 non-U.S. primarily defined benefit plans  from the CEM Benchmarking database. Through statistical analyses and econometrics, they examine the relationships between 1) plan size and the choice of investment style, 2) economies of scale and investment management costs, and 3) plan size and return performance.

Findings.

• U.S. pension plans have significantly increased their allocations to non-traditional asset classes, from less than 8% in 1991 to 28% in 2019. Meanwhile, allocations to broad-based U.S. stock strategies fell from 86% to 18% as U.S. plans shifted towards more specialized mandates within traditional asset classes. These plans have also expanded their non-U.S. investments, with allocations to international stock strategies increasing from 12% to 58% over the sample period.
• Costs of internal and external passive management have converged, suggesting that passively managed assets have become largely commoditized.
• Economies of scale are greatest for public asset classes and passively managed investments. They are smallest for private asset classes because of their more labour-intensive nature.
• Larger plans are more likely to utilize internal management for all asset classes except hedge funds and specialized strategies such as tactical asset allocation and risk parity . 
• Larger plans are less likely to use active management, especially for public securities. This is due to i) the diminishing  capacity of larger plans to capture alpha, and ii) economies of scale observed in passive management.
• Investment management costs decrease when plans switch from external to internal management or from active to passive management. However, benchmark-adjusted return performance does not significantly change when a plan switches between active and passive management due to strong competition amongst external investment managers .
• In terms of net return performance, the largest decile of plans (sorted by AUM) outperforms the smallest decile by about 20 basis points per year for public asset classes and 200 basis points per year for alternative asset classes. The most significant difference is seen in private equity, where the largest funds outperform the smallest funds by 419 basis points per year.

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