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2 OCTOBER2014 CONTENTS SPONSOR DIRECTORY 3 Overstretched and Under-resourced: Asset Owners Embrace Outsourcing 9 Outsourcing Is Making Inroads into Defined Contribution Plans 10 The Complexities of Fiduciary Responsibility 12 The Cost Equation 14 Measuring OCIO Success Northern Trust 50 S. LaSalle Street Chicago, IL Margret Duvall Margret_Duvall@ntrs.com PFM Asset Management LLC Two Logan Square, Suite 1600 Philadelphia, PA John Spagnola Managing Director spagnolaj@pfm.com SEI Investments 1 Freedom Valley Drive Oaks, PA Paul Klauder Vice President and Managing Director, Institutional Group pklauder@seic.com Strategic Investment Group th Street North 16th Floor Arlington, VA Deborah D. Boedicker, CFA Managing Director dboedicker@strategicgroup.com This special is not created, written or produced by the editors of Pensions & Investments and does not represent the views or opinions of the publication or its parent company, Crain Communications Inc. 2

3 Overstretched Under-resourced: &Asset Owners Embrace Outsourcing More pension plans, endowments, foundations and other institutional investors are considering the fiduciary management solution I t can be called outsourcing, outsourced CIO, fiduciary management or delegation. But although there s no consensus on what to call this business, there is a noticeable trend among institutional investors to use these services to cope with a more complex and time-sensitive investment environment. For those responsible for significant pools of capital, usually invested on behalf of others, the challenges are only increasing. Any time the fiduciary requirements of the assets can be optimally delegated, they should be, says Brian Murdock, Chief Executive Officer at Strategic Investment Group. Absent strong professional in-house staff, all asset owners should hire a partner as a co-fiduciary. Why wouldn t you? Today, there are huge headwinds. There s global investment complexity. There s a very low opportunity set to make even nominal returns. And there are increasing regulatory pressures that make managing money and fiduciary governance increasingly daunting. There s no question that boards and investment committees are finding the task more difficult. Plan sponsors consider outsourcing because of the trifecta of fiduciary, regulatory and investment risks, says John McCareins, Practice Lead and Senior Client Investment Officer at Northern Trust Asset Management. Investment committee members are overwhelmed by the complexity and time commitment of tracking those three various buckets. The governance practices that exist today are often insufficient and/or are not executed on a consistent enough basis. Further, portfolio decisions are often not timely because of the governance structure. The traditional quarterly meeting schedule clearly makes investment decision making inadequate in many portfolios. Stop-gap measures that many have adopted in times of crisis more frequent meetings, phone calls place burdens on committee members that impinge on their other responsibilities often other jobs. Oversight committees have a lot on their plates, says Jim Link, Chief Marketing Officer at PFM Asset Management. Many of these committees are saying that they need to get back to their strategic mission and move away from making tactical investment decisions that may not be the best use of their valuable time. The question of what committees focus on is critical. All too often a committee has been spending too much time on manager selection and not enough time on asset allocation, says Paul Klauder, Vice President and Managing Director, Institutional Group at SEI. Arguably, studies show that the asset allocation decision is more impactful over time. And committees need to make decisions faster. Typically, committees only get together once a quarter, and even with a good investment consultant, many feel that they cannot react quickly enough either in making manager changes, or allocation decisions. Ebbing skill set Outsourcing provides an opportunity for better performance, says SEI s Klauder. It s not a guarantee of better performance, but the fact that someone is accountable for manager decisions on a daily basis means that the outsource provider can act more decisively, and the asset owner can focus more energy and time on asset allocation. Another issue that asset owners face is the ability to properly staff an internal resource. Retirement expertise in the U.S. is retiring, says Margret Duvall, Senior Solutions Specialist, Outsourced CIO Solutions at Northern Trust Asset Management. It s harder to find people who really know how to run a pension plan to replace someone who has been there for 30 years. And even if you could find that person, can you get them to move to the job? It s a skill set that s ebbing and will continue to ebb. So it makes outcontinued on page 4 3

4 continued from page 3 sourcing look more attractive. Even if you can find staff, can the portfolio support the diversity of internal skills required today? Asset owners have an overall concern about the level of expertise they can manage to hire internally, given the volatility of the markets, higher regulatory scrutiny and the new laws that govern fiduciaries, says John Spagnola, a Managing Director and Head of Multi-Asset Class Management at PFM Asset Management LLC. Because of these and other issues, we see more and more asset owners transitioning over to OCIO services like those offered by PFMAM. Outsourcing providers also provide market perspective. One of the risks of an inhouse structure is a certain insularity, says John O. Keshner, Managing Director, Multi- Manager Solutions at Northern Trust Asset Management. Outsource partners will have assets that they are overseeing for numerous clients. They will have a great deal of resources manager research, risk management, portfolio construction, and analytical and qualitative resources. So clients get access to some of the best practices of peers. We know the discussions we re having with other clients and can share trends and other perspectives. It can be difficult to get access to the right managers or to obtain proper diversification in the portfolio. Even with a $1 billion plan, a plan sponsor may only be able to put 3% or 4% in a specific asset class, says SEI s Klauder. $30 million or $40 million of capital may not get you access to the best managers in the marketplace. OCIO decisions are cyclical This issue can be acute in asset classes such as alternatives. Certain asset classes alternatives would fall into this category require a heightened level of monitoring and can only be accessed through existing relationships of scale, buying power or reputation, says Northern Trust s McCareins. An investment outsourcing provider can provide access, expertise and monitoring capabilities in this area. Of course, the decision to outsource probably has to be seen in context. Historically, OCIO decisions have been cyclical, says Strategic Investment Group s Murdock. When capital markets are strong, investment management seems relatively easy and everyone thinks it s okay to self-direct. When markets mean revert, then a delegated solution looks more attractive. Often, delegation decisions are circumstantial, such as loss of key investment staff, poor investment results or an M&A event. Of course, asset owners are rarely faced with a blank sheet of paper, where there is neither internal nor external investment expertise. Often if there is internal resource, that will be maintained. But outsourcing providers think that boards should think about how delegated management could benefit them specifically. One of the main advantages of outsourcing is that the portfolio is overseen continuously and actively, says Marty Margolis, a Managing Director and Chief Investment Officer at PFM Asset Management LLC. By using an outsourced CIO with discretionary fiduciary responsibility, you see a strong connection between active oversight and professional investment management. This allows the board and the sponsor to reduce their day-to-day responsibilities. And in cases where staff is doing double duty in other parts of the finance function that can be very useful. Unique circumstances There s a hidden issue for boards when it comes to outsourcing: the perception of control. The primary disadvantage for the foundations and endowments from outsourcing is the risk of a disconnect from the unique considerations of the asset owner, says Northern Trust s Keshner. If you look at the top 10 university endowments in the U.S., you can expect to see some similar themes heavy alternatives exposure, for instance. But at a more granular level, the emphasis might be on real assets, or absolute return, or private equity, or emerging markets. These can be quite different in different organizations. So with outsourcing, you risk having a bit less of a close connection to your unique circumstances than it would be if you had the resources to create it in-house. But others think that boards should consider this issue more holistically. Control is a bit of a two-sided issue for boards, says PFM s Margolis. Some boards or some people on boards enjoy being in the investment process and talking about the markets. If the fiduciary responsibility for investment decisions is passed to the outsourced CIO, then some of the activity the board enjoys passes to the outsourced CIO. One of the misconceptions about outsourcing is actually one of its strengths, says Northern Trust s Duvall. There s always concern that board or committee members will lose touch with their plan. I see outsourcing as the place to achieve the freedom to focus on the strategy. We work hand-in-glove with our clients on strategy, rather than focusing on the minutia of rebalancing or which small cap manager to choose. We allow the committee to lift their heads and focus on the narrative of the pension plan. What is the longer-term goal and how do we go about achieving it? Full panoply of resources Transitioning to the outsourcing model will require some alterations to practice, so it makes sense to understand the changed roles and responsibilities of the board and its outsourcing provider. In hiring a discretionary partner, you are strengthening and broadening the governance of your investment program, says Deborah Boedicker, Managing Director at Strategic Investment Group. You have an increased potential for higher returns 4

5 net of fees. You are bringing the full panoply of resources spanning from the front to the back office. You may also get economies of scale, as the discretionary partner may be able to negotiate lower management fees that drop directly to the bottom line. A good governance structure is the logical assignment of roles and responsibilities, says Boedicker. You need clear objectives for measuring those roles and responsibilities so that you can measure the success of the program. You need regular and open communication that fosters transparency at the staff and board levels. Finally, education is key. Needs and objectives are never static; it s helpful to have mechanisms that bring together asset owners and outsource providers on a periodic basis. It also pays to remember that this isn t a bilateral arrangement between board and OCIO provider. First, there needs to be a clear separation of duties and a clarity about who is doing what, says Patrick A. Groenendijk, Senior Client Investment Officer, Multi-Manager Solutions at Northern Trust Asset Management. That s because it s usually not just the asset owner and the OCIO provider, but also the custodian, the actuarial advisor, the auditor, the accountants and the regulator that play a role in the investment process. Second, there need to be proper checks and balances, such as independent valuations. At the outset, boards will have to revisit their investment policy statements. Hiring an outsourcer does usually involve making some changes in the investment policy statement, says SEI s Klauder. For example, if the IPS currently says that the committee needs to pick and review each of the investment managers, that language would need to be modified. It s also an opportunity to reconsider board practices. We also often help clients with governance by creating an oversight committee with charter and by-laws, says PFM s Link. There are several issues they need to address. How often are they going to meet, what are they going to do, what they are going to cover? This is not just for the asset owner and the outsourcer, but it means that within the organization as a whole, there are clear expectations about what the oversight committee, board or group is going to do. It helps synchronize the expectations of the asset owner and the outsourcer so everyone s expectations are clear from the outset. New job descriptions It s also an opportunity to restate job descriptions. The investment committee has two main jobs, says Paul Harris, Director at Strategic Investment Group. First, it sets the investment policy and ensures that it supports the goal of the institution. Second, it oversees the OCIO provider, and doing that requires clear and transparent information. A reboot of investment management arrangements can have long-term benefits. We find that investment committees and boards are re-energized when working with an OCIO partner because they learn that they can spend time on the areas they enjoy and where their time is used more efficiently, says Ronald Klotter, Managing Director at Strategic Investment Group. The bottom line is that outsourcing is a leap of faith. So boards need to be sure that they can work with those they choose. It s important to identify an outsourcing partner that has a cultural alignment to your organization, says Northern Trust s Keshner. Just as there isn t a one-size-fits-all approach by outsourcing providers to their market, clients don t always use fiduciary management services in the same way. At one extreme, you could outsource your entire investment portfolio, says Northern Trust s Groenendijk. But at an endowment with knowledgeable internal staff and an investment process that runs well, when they consider an asset class where they don t have a lot of experience, they might want to outsource the management of just that asset class. Outsourcing providers are happy to work on a variety of bases. About 65% of our clients work together with us to set the strategy and the asset allocation, and then delegate the manager selection, oversight and replacement to SEI, says SEI s Klauder. But there is a trend emerging to delegate both asset allocation and manager selection decisions. This is the preferred solution for many outsourcing providers. At PFM Asset Management, we believe that the best way to use the outsourced CIO model is for clients to be able to assign responsibility for the entire portfolio, says Biagio Manieri, Director of Research at PFM Asset Management. That s most effective, of course, where the plan sponsor does not have a large, sophisticated investment staff in-house that is able to manage the portfolio correctly. If the plan sponsor does have some investment staff, then they might consider outsourcing a portion of the portfolio as an alternative. This can present problems, though, as then there will be two groups managing the portfolio that require close coordination so that the portfolio is able to meet plan sponsor needs for return, risk management and liquidity. Some of the different ways that asset owners can partner with OCIOs is in the degree of discretion, says Strategic Investment Group s Boedicker. Some asset owners want to outsource everything and are looking for a turnkey solution where they have to make a minimal amount of decisions. On the continued on page 6 EXHIBIT 1: Distinguishing features of fiduciary management relative to traditional investment consulting Investment Consulting Fiduciary Management Oversight and advice Client heavily involved in tactical issues Focused on risk / return of investments Process for manager changes is slow / reactive Manager minimums can limit investible universe Over reliance on past performance Fiduciary for oversight only Higher overall fees Track record not easily measurable Alternatives tied to investment portfolio only Oversight and advice Client focused on strategic issues Investments tied to organizational risk profile Process for manager changes is faster / proactive Economies of scale allow for broad manager access Research approach allows earlier manager adoption Fully accountable fiduciary partner Cost savings on total plan management Established track record with visible results Alternatives viewed in organizational context (i.e. liquidity profile) Source: SEI 5

6 continued from page 5 other end of the spectrum, some want a more collaborative relationship that includes them in some decisions along the way, such as policy development and long-term strategic asset allocation. There is also the blank sheet of paper issue with the portfolio. It may not be in anyone s best interests to deconstruct a portfolio in order to transition cash to the outsourcing provider. Flexibility is critical for larger asset owners as they may want to retain some existing best practices managers, says SEI s Klauder. So if someone had 15 managers previously, four or five of those managers may stay. We then take fiduciary responsibility for those existing managers, but also build the portfolio as it makes sense in relation to the asset allocation. Investigating delegation One of the big new trends observable in the outsourcing marketplace is the size of the asset pools seeking this solution. It was an unmistakable solution for small to midsized portfolios. We have been seeing larger portfolios greater than $500 million looking at outsourcing over the past five years, says SEI s Klauder. The greatest acceptance has always been in the $25 million to $500 million market. But this is changing in many different areas. Many big DB plans are closing and freezing. The staff members at these organizations may not want to stay. Endowments and foundations are dealing with more sophisticated investment offerings such as alternative investments. To go direct, they will need to boost staff and technology. So you are beginning to see these asset owners investigating delegation. For larger investment pools, particularly those associated with a separate business, such as a pension fund, the issue of outsourcing arises out of an analysis of resource management. The advantages of outsourcing for the smaller asset owner are obvious, says PFM s Spagnola. The OCIO solution is well-suited for those clients who may be overwhelmed by investments in a fiduciary role at the committee or individual level. However, we are also seeing this with larger funds that don t want to be in the asset management business or in it only to a certain extent. We see this with our healthcare clients, in education, in endowments and foundations. Our clients are grappling with many issues and feel more comfortable passing along the investment responsibilities to a dedicated organization like ours. For larger investment pools, the demands of money management have become increasingly onerous. OCIO has always had a strong value proposition for smaller funds who benefit from ongoing professional portfolio management in a cost effective way, says Strategic Investment Group s Harris. Increasingly, institutions with larger portfolios are finding outsourcing a compelling alternative to traditional approaches. As fiduciary standards become more demanding and the investing environment becomes more complex, a Chief Investment Office requires more specialized resources and sophisticated systems. The benefit of engaging a fully staffed OCIO provider offering a total end-to-end solution becomes clear. We re finding that increasingly many very large institutions with multiple billion-dollar asset pools want to focus on their core business. The change in the market is obvious to those on the front line. Three years ago, I had one $1 billion plan prospect every couple of years, says Northern Trust s Duvall. Now we have six opportunities that have come to market in the last nine months. Sunset DB plans The bulk of our new client wins or assets have been in the large plan segment as opposed to the smaller, middle-market segment, says Northern Trust s McCareins. As people are beginning to sunset DB plans in certain industries and growing their DC plans, there s an acknowledgement that they need to do this as efficiently as possible. Often times there is no desire to invest time, people and resources in DB plans. It isn t just defined benefit plan sponsors coming to this decision. We see a number of new markets for delegation, says SEI s Klauder. Large asset owners with over $500 million in assets are looking for organizations that bring a high degree of customization and a commitment to human capital, research and technology. Multi-employer plans, governments and healthcare organizations are becoming established markets. But all these asset owners want to work with a firm that has other large clients and a long-term track record in delegation. Choosing an outsourcing partner is a complex task, much more so than the choice of an investment consultant. OCIOs come in all shapes and sizes, says PFM s Spagnola. That means that asset owners have to be careful in how they construct their RFPs and how they ask questions during the selection process. We believe that if they are thoughtful, they can cut through a lot of the noise out there and find the right kind of partner. It s also a decision that has long-term consequences. An OCIO search is more complex than a manager search, says Strategic Investment Group s Klotter. If you hire a large cap growth manager and it doesn t work out, changing large cap growth managers isn t that hard. If you hire an OCIO provider and they put you in an illiquid investment you don t like, the ramifications are pretty serious. Choosing an outsourcing provider is so challenging because the asset owner is inviting a partner into the heart of the portfolio management business, not just looking for a service. With the OCIO search, you are trying to solve for many equations at once, says Strategic Investment Group s Klotter. You are looking at performance total performance as well as asset class performance. You are looking for policy development expertise. You are looking for governance expertise. You are looking for deep operational infrastructure. We think it also makes sense to look at the ownership structure of the provider and whether it has a history of attracting and keeping key personnel. Ideally, an OCIO relationship is a long-term partnership. You are looking for a firm that you expect to be in business with in five or 10 years time. Crushed in a down market Performance is likely at the heart of the matter, but again, it s not always a straightforward process. In evaluating an outsource CIO provider, you have to be careful in looking at performance, says PFM s Manieri. Are you looking at representative performance that is a GIPS-compliant composite, or are you looking at a cherry-picked account report that looks good today? You also need to be aware of what is driving performance. It s possible to deliver very good performance by taking lots of risk, for instance, by using leveraged strategies. If the market has been going up, then those strategies will look good. But in a down market, that portfolio will be crushed. Another area we think is important is track record, continues Manieri. PFM Asset Management has an eight-year track record that is GIPS-compliant. We don t often see that from other OCIOs. Another area where we stand apart, on the client s behalf, is fees. Typically you ll see a bundled fee arrangement. We think it s more transparent to break out the advisory fee from the underlying asset management fee. Clients appreciate that. These due diligence aspects are especially important in this process. Asset owners want an OCIO provider who is independent and conflict-free, says PFM s Link. They want to be certain that the provider is focused on them and provides transparent information, whether it s about fees or performance. And they should be clear that the provider has a verifiable track record. Most people wouldn t consider hiring a manager without a threeyear track record, so why would you hire an OCIO provider without expecting to perform the same due diligence? Operations are an important issue, as the outsourcing partner will have responsibility for the risk management and operational oversight of the portfolio. When choosing an outsourcer, you need to make sure that the firm has the technology and processes in place to ensure that their solutions are stateof-the-art with regard to manager decisions, asset allocation decisions, reporting and rebalancing, says SEI s Klauder. Asset owners continued on page 8 6

7 Independence Initiative Integrity Outsource Investments with Confidence At PFM Asset Management LLC (PFMAM), we believe that institutional investors who outsource their chief investment officer (CIO) functions deserve a partner who focuses on the fundamentals, not on sophisticated gimmicks, to help clients achieve their goals. A few key principles guide our views for delivering outsourced CIO service: n Client-centric Focus n Fiduciary, Best-in-Class Advice n Asset Allocation n Cost Conscious Solutions n Transparent Structure Full-service, independent, and timely investment execution from a team of experienced professionals. John Spagnola, Managing Director spagnolaj@pfm.com Jim Link, Managing Director linkj@pfm.com PFM Asset Management LLC Two Logan Square, Suite th & Arch Streets Philadelphia, PA PFM Asset Management LLC is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940 and had $50.8 billion in discretionary assets under management as of June 30, A copy of our Form ADV, Parts 2A & B is available upon request. 4417

8 continued from page 6 need to make sure of an outsourcing firm s operational competency. Many are doing this through an internal and external audit review, with typically a Big Four firm doing the external audit and providing an unqualified opinion with regard to those procedures and processes. One operational issue that can concern asset owners is transition. This should be scrutinized as part of the RFP process. From an operational perspective, the transition to an OCIO provider is a key point and requires a smooth and efficient process to avoid performance drag, says Strategic Investment Group s Harris. It is vital to know whether the OCIO provider can accommodate illiquid assets. Can they adopt the assets as part of a comprehensive, tailor-made solution, or will they demand that you liquidate those assets and start afresh? It s also important to understand your own needs. There are two key considerations when understanding the relationship between asset owner and OCIO provider, says Strategic Investment Group s Boedicker. One is the type and needs of the asset owner. The other is the different types of OCIO providers out there. The art is in choosing the right partner that can strengthen the investment program. Know thyself, continues Boedicker. Understanding your unique and distinct needs will help you find the right OCIO partner that can help you maximize your objectives. For instance, a pension plan on a liability-driven investing path may be aiming to extinguish their liabilities by selling them to an insurance entity. So they have a particular investment horizon that may be shorter than a non-profit that has a theoretically infinite horizon. Objective assistance Boards often have biases that should be explored as part of the OCIO choice process. What is your personal preference? says Strategic Investment Group s Boedicker. Some institutions are looking for a low-cost provider, a non-alpha-oriented implementation that is more passive. Others value a partner that will strive to maximize wealth net of fees and expenses over and above a passive solution. Asset owners may feel a bit overwhelmed by the intricacies as well as the responsibilities associated with choosing an outsourcing partner. But help is at hand. When hiring an OCIO provider, it helps to have objective people assisting you in the process, says Northern Trust s Groenendijk. But you should be careful to use a consultant that is actually independent and not offering these types of services themselves. Asset owners also need to deal with the question of how much an OCIO provider uses their own internal products. It would be a bit concerning to you hire a provider in order to get best-in-class management and then to hear the provider say We re the best in the world in everything you want to do. If an outsourcing provider is in turn hiring external managers, then the asset owner needs to be sure that the decision-making process is robust. It s important that the same level scrutiny is involved in manager selection, says SEI s Klauder. When we interview money managers, we send in a separate operational team to give us an opinion of their operations. If they aren t comfortable with, for instance, the segregation of trading from custody, we may not hire them, even if we are impressed with their investment management. The need to delineate roles and responsibilities extends to the reporting and information flow, and is best established at the beginning of an outsourcing relationship. From the outset, there needs to be very clear communication between the asset owner and the outsource partner, says PFM s Link. That communication needs to be regular, open and transparent. Asset owners need to describe in very clear terms what their goals and objectives are, and help the outsourcer understand any restrictions. The outsourcer can t divine these and the asset owner does need to guide the asset allocation decision. It works best as a cooperative process. The investment policy needs to be really clear, continues Link. It s a key factor in organizing the relationship. The flow of information in terms of reporting and holdings information needs to be clearly outlined at the beginning. These relationships can fall apart when there is a misinterpretation of the goals and duties of each party, so you need to be clear, concise and documented to avoid any miscommunication. Having a review process to ensure that reporting is meeting the asset owner s needs is an important element of review. Circumstances may change at the asset owner, or indeed, market movements may necessitate some rethinking of the reporting process. In terms of reporting, we expect clients to review this audit paperwork at least once a year, says SEI s Klauder. Reporting can vary. Some clients are happy with timely monthly reporting, but some want daily internet access to their accounts. There s no question that knowledge about the value of fiduciary management is growing. We believe the OCIO sector is maturing, says Strategic Investment Group s Boedicker. Best practices are being established particularly around assessing the success of OCIO providers. Today there are many disparate providers in the space. Our supposition is that within the next few years, there will be a winnowing down of providers. Those that are successful providers will be great partners with their clients, providing good governance, good investment returns and great client service. I see a trend emerging in which pension plans are looking at OCIO providers, not just for where they are today, but also for where they hope to be tomorrow, says Northern Trust s Duvall. ~ 8

9 OUTSOURCING is Making Inroads into Defined Contribution Plans DC plan sponsors are joining their DB colleagues in opting for delegated management For many reasons, defined benefit plan sponsors have long considered outsourcing as a solution to some of their investment management challenges. Not so in the defined contribution world. Partly because the heritage is more human resources than Treasury, and partly because the defined contribution plan sponsor is constructing the plan on behalf of participants, Defined contribution plan sponsors have shied away from the outsourcing concept. Today though, as more assets flow into defined contribution plans and the management is beginning to mirror a defined benefit plan, the advantages of outsourcing may be even more attractive to this group of plan sponsors. Huge DC plans are using outsourcing for custom defined contribution plans, says Margret Duvall, Senior Solutions Specialist, Outsourced CIO Solutions at Northern Trust Asset Management. Often they are trying quite explicitly to replicate a DB experience. Below the $1 billion mark, many DC plans are stuck in an advisory mode, possibly because of the options on the recordkeeping platform. The fact is that even that landscape is changing. DC plan sponsors need help thinking about plan design, participant outcomes, investments and governance, so there is a place for full discretionary outsourcing here, says John McCareins, Practice Lead and Senior Client Investment Officer at Northern Trust Asset Management. Especially if the plan sponsor is short on staff, resources, and/or it s not a core competency. The DC investment outsourcing space is in earlier innings relative to the DB space from an outsourcing perspective. The rationale for choosing to make a defined contribution plan more like a defined benefit one is clear. Many independent studies show that there is a material difference in the average performance for a DB plan vs. the average performance for a DC plan participant upwards of 600 to 700 basis points over a 20-year period, says Paul Klauder, Vice President and Managing Director, Institutional Group at SEI. Now plan sponsors are asking, Why can t we approach DC the way we ve always done DB, by using best-of-breed managers and offering less choice to participants? By outsourcing that s possible. So DC plans seeking to simplify the investment menu are starting to think about delegation. Sometimes they may take bite sizes. They may just do the target-date fund or several component funds. Phasing into delegation is more pronounced in the DC environment than it is in the DB environment. 60% 50% 40% 30% 20% 10% 0% 40% Not as far along as DB outsourcing Partly this is a question of cost. It s very challenging to get plan sponsors to pay an additional provider for a value-added service on the DC side that they used to get for free, says Northern Trust s Duvall. On the DC side, governance concerns will be equally important to those faced by a pension or endowment, says Ronald Klotter, Managing Director at Strategic Investment Group. Cost concerns may be equally or more important. The argument for additional alpha and access to limited capacity managers may be less important. But today, the trend toward full outsourcing in DC plans is not as far along as it is on the DB side. For some defined contribution plans, this can be a matter of baby steps, though that too may be changing. There is a nice trend of delegation in the DC world, says SEI s Klauder. We ve seen a number of clients that have just delegated the target-date fund, but kept the core lineup the same. In some cases, DC plans seek to outsource their target-date fund, but in most of the RFPs we ve seen, the plan sponsor wants to outsource the entire menu design process, says Jim Link, Chief Marketing Officer at PFM Asset Management LLC. Defined contribution plan sponsors need to take account of the participant in making their choices. As a DC plan sponsor, the incentive is to offer a diversified menu that is justifiable in terms of expense and the range of choices offered, says Strategic Investment Group s Klotter. It s a different set of priorities than those faced by a DB plan sponsor. Unbiased information However, fiduciary concerns still loom large and may not always be met by choosing the recordkeeper solution. DC plan sponsors may wish to consider outsourcing in order to provide reasonable options in order that participants can invest in a way that meets their risk and return goals, says PFM s Link. Plan sponsors have a fiduciary duty that can t be met by allowing everything to appear on the investment menu. And that duty also can t be carried out by allowing a vendor to dictate the investment choices. So if plan sponsors don t have the expertise to design the menu themselves, they need an expert acting in their best interests, who can demonstrate how and why the investment menu has been created. Outsourcing will help DC plan sponsors to receive truly unbiased information, says Northern Trust s Duvall. The DB landscape has evolved so that there is a very high value placed on transparency and having no conflicts of interest. This is why governance and provider relationships have evolved the way they have in the OCIO space. I don t see that paralleled often on the DC side. Many companies have a bundled solution provided by their recordkeeper. DC plan sponsors resist outsourcing because they say they will have to pay an additional fee. I wonder, as DC plans grow, when that lens will shift to saying, These people who are giving me advice for free are full of conflicts. ~ EXHIBIT 1: Of those who said they would consider delegating investment manager selection and oversight to a discretionary 3(38) investment fiduciary, how would they utilize? Entire Investment Menu 28% Broad multi-manger options within simplified investment lineup (branded or white label) Source: SEI 9

10 The Complexities of Fiduciary Responsibility Outsourcing can change the relationships between the asset owner and its providers When considering the question of fiduciary responsibility as it relates to an outsourcing relationship, the ERISA code that governs pension plans offers surprisingly straightforward advice. A traditional consultant relationship falls under ERISA section 3(21) and in that, the plan sponsor retains responsibility for the decisions made. Under ERISA section 3(38), the fiduciary is defined as an investment manager and shoulders more of the responsibility for the decisions made. This distinction can be a useful way for all asset owners to consider the move from investment consulting to outsourcing, and the steps taken in between. Outsourcing providers agree. In 65% of our client relationships, we operate as an ERISA 3(21) fiduciary for asset allocation and an ERISA 3(38) fiduciary for manager selection, says Paul Klauder, Vice President and Managing Director, Institutional Group at SEI. In 35% of our client relationships, both of these decisions are delegated to us, so we are fiduciaries under ERISA 3(38) for both aspects. Even though ERISA refers specifically to retirement assets, this framework is used across many client groups. It s crucial to remember that no external arrangement alleviates the asset owner from all fiduciary responsibility. No matter what kind of assets are involved, the asset owner still retains the fiduciary responsibility to measure the outsourcer, says SEI s Klauder. Outsourcing providers spend a lot of time ensuring that their clients understand what this really means. We work with a lot of public sector entities and not-for-profits where there is often a view that the DC sponsor doesn t have a fiduciary duty or the situation is different because it doesn t fall under ERISA, says Jim Link, a Managing Director and Chief Marketing Officer at PFM Asset Management. But every state has some sort of fiduciary law. So one way that boards can handle their fiduciary duty is by hiring an outsourcing partner. Not legally mandated The outsourcing conversation can be challenging in the foundation and endowment space simply because the language isn t as concrete, says Margret Duvall, Senior Solutions Specialist, Outsourced CIO Solutions at Northern Trust Asset Management. In the pension space, you act as a 3(21) fiduciary in this instance and a 3(38) fiduciary in that one. It s very defined and clear, whereas in the F&E space, it can be difficult to get people to understand those rules when it s not legally mandated. It s really common sense, but an important piece of information to understand thoroughly. Asset owners always maintain the ultimate responsibility for the decisions they make, says PFM's Link. If they hire a non-discretionary consultant, the asset owner retains all the fiduciary, decision-making responsibility. The consultant takes on only the fiduciary duty pursuant to the recommendations that they make. In a discretionary arrangement like outsourced CIO, asset owners retain the fiduciary responsibility for overseeing the OCIO provider, but delegate the responsibility for manager selection and asset allocation. Articulated clearly Of course, asset owners can choose what fiduciary responsibility they keep and what they delegate, within the designated boundaries. We see fiduciary responsibility as being a continuum, says Marty Margolis, Managing Director and Chief Investment Officer at PFM Asset Management LLC. At one end you have the overall strategic decisions, the big picture decisions about asset allocation that remain with the sponsor or the board under all circumstances. On the other end is the OCIO model, where tactical decisions are implemented in 30 to 45 days, vs. the upwards of 180 days that a client would experience under a consultant engagement. We think that the fiduciary responsibility is best managed when it is articulated clearly as to who is in the lead, and who s got the primary responsibility. Although it s important to come to a joint understanding of who does what, outsourcing providers stress the strategic oversight is not a simple process. Having an OCIO fiduciary provider as your co-fiduciary is not about divided responsibility, says Paul Harris, Director at Strategic Investment Group. Rather, it s about a joint and several responsibility. To be clear, investment committees can never fully abdicate their fiduciary role they engage an OCIO to extend and strengthen their governance structure. Governing bodies that are closer to the institution s strategy need to ensure that the investment policies support that strategy. Meanwhile, OCIO providers who are immersed in the investing environment should be responsible for using that information to make the right implementation decisions. ~ 10

11 Not all investment outsourcing providers are trying to fill your shoes. As one of the world s first and largest investment outsourcing providers, SEI offers a flexible solution to complement your current strategy. Try us on for size today: seic.com/outsourcing2014 or 866-SEI-2441 Information and services provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company. Pensions & Investments, July SEI ranked as the fourth largest outsourcer based on worldwide institutional outsourced assets under management SEI (09/14)

12 THE COST In order to properly understand the cost of an outsourcing program, asset owners need to weigh both performance and fees W hen asset owners first think about outsourcing, one issue jumps to the front of the line: cost. There s a perception that the outsourcing solution will be more expensive than the traditional model of internal staff supported by investment consultants. As with many issues in the investment world, it all depends on your point of view, specifically what fees and expenses are included in the cost equation. Outsourcing providers think that asset owners considering a total fiduciary management solution need to add up all the explicit costs, as well as the implicit savings. In looking at the question of cost, one needs to be careful how costs are defined, says Biagio Manieri, Director of Research at PFM Asset Management. If cost is narrowly defined, as in how much the client is paying a consultant for their consulting advice vs. what they are paying for an outsourced CIO provider, then the latter will be more expensive. The correct way to think about cost is to include all costs. If you have a consultant engagement, you need internal staff to evaluate the recommendations and monitor the portfolio. So you need to include those costs in your calculation. It also makes sense to think about the overriding objective of outsourcing. The focus should be on improving outcomes, net of all fees, says Brian Murdock, Chief Executive Officer at Strategic Investment Group. In this sense, a firm like Strategic that actively manages portfolios striving for superior net results can make outsourcing frankly selffunding and additionally can materially affect the long-term level of assets. Professionally managed portfolios Patrick A. Groenendijk, Senior Client Investment Officer, Multi-Manager Solutions at Northern Trust Asset Management, was a Dutch plan sponsor until recently, and so brings a client perspective to the question of cost. A focus exclusively on cost is not the right way to approach OCIO, because what counts is net return investment returns after costs, he says. So as I always told my board in the Netherlands, I am happy to spend a million if we might make 10 million extra. If you only focus on cost, that one million would seem expensive. OCIO providers, of course, charge a fee and if you look at that in the narrowest sense, that adds to the cost. Other factors decrease the cost to the asset owner. Lower fees are negotiated because of the leverage of the OCIO provider with external managers and frankly, a more professionally managed portfolio that has a greater chance of achieving a higher investment return. Practically speaking, asset owners should look to deconstruct the outsourcing fee, as it is likely that any provider will be hiring external managers. Asset owners should think about the cost of delegation in a number of ways, says Paul Klauder, Vice President and Managing Director, Institutional Group at SEI. One way would be to look at the outsource provider s proposal for their fees and those of the managers they would use and compare this to their current run rate for the portfolio. That s a Level 1 analysis. A Level 2 analysis would compare and evaluate multiple outsourcers. Some organizations, particularly larger ones, have dedicated internal resources, so they may have cost savings around savings internally for the resources and technology they might have used to support the resources. When a staff member who was spending 85% of their time overseeing these portfolios is now spending just 10% of their time, this could be a cost saving that is worked into the cost equation. Another consideration is the construction of the portfolio. Certain asset class allocations can considerably affect the overall cost of outsourcing. The cost of an investment program is driven by three aspects, says John O. Keshner, Managing Director, Multi- Manager Solutions at Northern Trust Asset Management. First is the asset allocation. How much will be allocated toward alternative investments that are cost-intensive, and how much to other asset classes? This will be the biggest driver of cost in any investment program. Second, are you going to be actively oriented within traditional asset classes, or more passively oriented? And finally, the third component is the structure of the investment advisory component which can be executed by in-house staff or by an outsource partner or by a hybrid. While these points are all useful in considering how outsourcing mandates may be costed, what evidence is there that costs often decline when a portfolio is fully out- 12

13 EQUATION sourced? We typically see our clients experiencing 10% to 20% savings in aggregate costs, and that tends to be explicit dollars that an investment outsourcing provider is able to generate on behalf of the plan, says John McCareins, Practice Lead and Senior Client Investment Officer at Northern Trust Asset Management. We can negotiate more aggressive fee schedules with our individual investment managers than any one client can do alone. Because of the assets behind us, we can hit break points faster than any one client can do alone. And in addition, there is an implicit cost savings to the end client in being able to reallocate internal resources towards other higher ROI projects within their broad core competencies. Implicit costs Providers suggest that while topline savings are quite common, explicit costs should not be the focus of the exercise. In terms of actual pricing, the range can be anywhere from 150 basis points down to 10 basis points, says Strategic Investment Group s Murdock. But our track record since inception has been to outperform combined client policy benchmarks by well over 100 basis points net of all fees. Not just our fees, but the fees of all the sub-managers as well. So we don t think cost is really essential to the conversation at all. No one suggests that costs are unimportant, though. It s just that they must be considered within the range of advantages that a delegated management solution can bring. Hiring an OCIO provider means that you can be sure your assets are professionally managed and monitored, and that you get access to best-in-class external managers, says Northern Trust s Groenendijk. It s also the case that there is an Beyond Investment Consulting ultimate cost advantage because those providers do a lot of business with asset managers and can negotiate better fees. As part of an OCIO program, you as the client have the ability, through the aggregation of assets, to get access to funds you might not otherwise be able to access, says John Spagnola, a Managing Director and Head of Multi-Asset Class Management at PFM Asset Management. You may also benefit from better terms in those funds because of the asset level the OCIO has in these funds. It s another way of looking at the cost issue that tilts in favor of the OCIO model. Cost is almost always a high priority for clients. Outsourcing providers contend that lower costs are one of the prime advantages of the solution. There s an opportunity to lower costs with outsourcing, says SEI s Klauder. About 80% of our clients see lower costs vs. what they were paying before. ~ Many asset owners use investment consultants for a variety of purposes. These can include manager selection, advice on strategic asset allocation and for monitoring purposes. This relationship is generally an advisory relationship, with a limited fiduciary responsibility (see story page 10). But hiring an outsourcing partner changes the landscape dramatically. OCIO providers argue, as expected, that an asset owner doesn t need an investment consultant in an outsourcing relationship. That s because most of the functions asset allocation and manager selection will simply be duplicated. OCIO providers can and typically do take the place of the more traditional non-discretionary investment consultant, says Deborah Boedicker, Managing Director at Strategic Investment Group. An experienced and well-staffed outsource CIO should bring the full panoply of services from front to back office. They do what a traditional consultant would do and more. This and more really focuses on execution. The big difference between the traditional consultant relationship and an outsourcing relationship is more in the operating model than on the fiduciary side, says John Mc- Careins, Practice Lead and Senior Client Investment Officer at Northern Trust Asset Management. The consultant makes recommendations, but the client retains the decision and responsibility to execute. Outsourcing involves bringing the ideas, but also taking responsibility for executing them. New universe of consultants The consulting community is fully aware of the distinction. Many are retooling their business models to provide a wider range of services. In the majority of our relationships, an asset owner is moving away from a consultant, says Paul Klauder, Vice President and Managing Director, Institutional Group at SEI. The reality is that many of those consultants are also bidding on the business as an outsourcing provider. It s a big change in the market. I would say that 85% to 90% of our relationships do not retain an investment consultant. Those that do may do so for historical reasons. A board or investment committee may trust the advice provided by a consultant and wish to retain this resource. Consultants are also seeing opportunities in the rather complex process of hiring an outsourcing provider. Consultants are expanding their businesses to move into the discretionary investment outsourcing space, says Strategic Investment Group s Boedicker. We ve also seen a new universe of consultants emerging in the last few years to run OCIO searches. This business is very project-oriented. They bring knowledge of the OCIO community, the different governance structures and the different types of OCIO providers. This can be helpful because these are very different searches from what those clients are used to seeing when hiring a new manager. We are also finding consultants doing governance consulting to help boards understand how roles and responsibilities change when you hire a discretionary partner. If boards understand their role thoroughly, they may still feel they wish some support in executing their oversight responsibilities. Some clients retain an investment consultant to review the outsourcing provider from a performance measurement perspective, says SEI s Klauder. Others agree. In selected instances, fiduciaries feel they need to retain a consultant, not in the traditional sense, but to support the committee in monitoring the OCIO provider, says Strategic Investment Group s Boedicker. Asset owners like Taft Hartley plans, where they tend to have very large committees with a wide array of skill sets and expertise, gain comfort from having a consultant to monitor their fiduciary partner. What is clear is that investment consulting faces a challenge from the rise of the OCIO business. I think the role of the consultant will change, says Patrick A. Groenendijk, Senior Client Investment Officer, Multi-Manager Solutions at Northern Trust Asset Management. They are well aware of this, as they are offering OCIO services. But they could play the role of an oversight manager. 13

14 Measuring OCIO Success Judging the performance of an outsourcing provider requires a new set of metrics When an asset owner outsources, they retain one thing always: the ultimate responsibility for the performance of the portfolio. If the outsourcing partner has responsibility for making and implementing investment decisions, then the asset owner must monitor and assess the success of those decisions. Not surprisingly, making these judgments requires a different set of criteria than those that might apply to an investment consultant or an investment manager. Devising a framework for assessing an outsourcing partner starts with the objective. Because this is a partnership, the portfolio s objectives and constraints should be devised together, so both asset owner and outsourcer know what success looks like and not just in quantitative terms, but also in qualitative measures that can be harder to assess. Using an outsourcing partner for even just part of a portfolio will require some sort of assessment framework, but when the entire portfolio is outsourced, the method will need to be that much more far-reaching. The investment policy statement is the obvious place to start, but asset owner and outsourcing partner will need to work together to put procedural meat on the policy bones. Often this process underscores the fundamental nature of the change that outsourcing will bring to the work of the asset owner board or investment committee. Asset owners should be aware that if they outsource portfolios, they should monitor these very closely because, ultimately, they are their responsibility, says Patrick A. Groenendijk, Senior Client Investment Officer, Multi-Manager Solutions at Northern Trust Asset Management. It does mean that the asset owner is a bit more detached from the portfolio because it is being managed at a distance. This perceived disadvantage can be managed through good reporting and education by the OCIO provider. Component benchmarks Since portfolio performance is a reflection of the quality of the investment management, quantitative criteria usually involve the development of appropriate benchmarks. The investment policy statement will outline how we will be measured, says Paul Klauder, Vice President and Managing Director, Institutional Group at SEI. There are clear metrics on how the client will evaluate us. A plan with 10 different asset classes, each of these will have an independent benchmark. Then the total portfolio is rolled up and viewed against a weighted average of those component benchmarks, so that our performance can be viewed on a net of fees basis. Other measurement devices would involve progress against corporate goals, contribution policies, FAS 87, pension expense volatility those elements that are important to the corporate entity, continues Klauder. Qualitative measures would include the client s comfort level with the team and the overall client satisfaction with SEI. On the qualitative side, outsourcing firms see their role as encompassing a range of roles from governance advice to operations, ensuring that a board or investment committee can keep abreast of their responsibilities and risks in a fast-moving financial and regulatory environment are an important part of the job. Judging performance over time involves several metrics, both quantitative and qualitative, says Ronald Klotter, Managing Director at Strategic Investment Group. Setting the right benchmarks upfront is the most important to the quantitative side. We spend a lot of time on agreeing to a mutually acceptable investable benchmark in the policy development stage. Benchmark returns and our returns are evaluated on a net basis, net of fees and expenses, so clients know exactly what they are earning. Qualitatively, we see our role as ensuring that the committee has adequate governance, that operational controls are in place and followed, and that ongoing committee education is provided. We do annual performance reviews because it is part of our fiduciary duty to keep the committee informed and we recognize that part of their duty is to monitor us. Advice and service Each outsourcing firm articulates this process slightly differently, but most hit on many of the same points. Judging the performance of an OCIO provider falls into three buckets, says John McCareins, Practice Lead and Senior Client Investment Officer at Northern Trust Asset Management. One is the quality, timeliness and appropriateness of our advice. Second involves assessing the investment decisions that we are making on behalf of the plan. This is done by articulating specifically what outcome we expect, based on client specific goals and objectives, and then checking whether we reached this outcome. It should also involve assessing whether we were able to add incremental returns above and beyond the desired outcome. Finally, plan sponsors need to assess our service, separate from our advice. Are governance procedures and reporting consistent with the committee s expectations? However the success criteria are devised, asset owners need to remain vigilant, because changing an outsourcing provider is a more complex and painful process than just firing an investment manager. ~ EXHIBIT 1: Partner with Outsourced CIO with Depth and Experience Supplement internal investment and back office resources Ensure that outsourcer s interests are aligned with yours PARTNER WITH OUTSOURCED CIO WITH DEPTH AND EXPERIENCE Take a comprehensive approach to risk management Enhance analytical and operational capabilities STRENGTHEN GOVERNANCE Set clear guidelines, lines of responsibility and benchmarks ENHANCE RISK-ADJUSTED RETURN POTENTIAL Manage total portfolio, not silos of assets; seek multiple sources of alpha Benefit from strategic and tactical insights to add value and manage risk Delegate portfolio management and policy implementation Rebalance actively to maintain targeted tactical risk exposures Source: Strategic Investment Group 14

15 Does your Outsourced CIO meet all of your needs? Stands as a fiduciary partner with you Designs a customized investment program Organized as a team, mitigating key man risk Staffed as a comprehensive investment office from front to back Employs a robust investment process and sophisticated risk analytics Implements in a cost-effective way Delivers excess net of fee returns A PIONEER IN OCIO SOLUTIONS SINCE strategicgroup.com For more information, contact Deb Boedicker at or dboedicker@strategicgroup.com Copyright Strategic Investment Management, LLC. All rights reserved. Strategic Investment Group is a registed service mark of Strategic Investment Management, LLC.

16 - Advertisement - Good Governance in OCIO Mandates Creating a governance structure that mitigates conflicts of interest addresses a main concern for pension fund trustees considering the use of an outsourced CIO (OCIO) provider. Patrick Groenendijk, Ph.D., a Senior Client Investment Officer in the Multi-Manager Solutions group at Northern Trust, and, previously, Chief Investment Officer at Pensioenfonds Vervoer in The Netherlands, offers insights into governance issues. Q: What do you consider to be characteristics of good governance? First, it is worth pointing out that good governance is not the same as a lot of governance. There are diminishing returns to adding extra governance measures, as at some point the resulting structure may become too complicated and costly to be effective. More governance is not necessarily good; smarter and better designed governance is. Good governance is basically about two things: Clear separation of duties, and proper checks and balances. Let s take a pension fund as an example. Parties involved in the OCIO mandate might be the pension fund, the OCIO provider, external asset managers, the actuary, the custodian, and possibly others. Think just about the investment activities: establishing and adjusting the strategic asset allocation, making tactical asset allocations, manager selection and monitoring, proxy voting, compliance management, and finally, reporting. In such a complex setting, separation of duties is essential. The Investment Management Agreement between the pension fund and the OCIO provider should clearly specify who is responsible for, and accountable for, which activities. Q: What issues do plan trustees need to address to mitigate potential conflicts of interest? Based on my own previous experience as the Chief Investment Officer of a multibillion dollar Dutch defined benefit plan, here are several relevant issues: The role of the OCIO search consultant: If a search consultant is used, it is very important to make sure that the consultant is completely objective. Loss of objectivity can occur when a consultant gets paid a fee by a provider, or as is more common also offers services that directly compete with other OCIO providers. Guidelines on the use of actively managed internal products: The main task of an OCIO provider is to select, monitor and replace external asset managers. There are instances however, when the OCIO provider also runs actively managed strategies. To keep the governance as clean as possible, OCIO providers generally do not use their own active internal products. The use of passive internal products, is less of an issue, since these are typically replicable strategies designed to more closely track a benchmark. Organize independent risk management and oversight: A pension plan is exposed to both asset-liability and implementation risk. The asset-liability risk is about getting the beta right, whereas implementation risk focuses on the alpha part of the portfolio. Since both these components are implemented by the OCIO provider, it is critical that the pension fund makes sure that a second pair of eyes oversees these activities. Thus, the pension fund needs to establish a risk management function. Q: What are some of the hurdles that might impede the adoption of good governance? An obvious one is inertia. Board members feel comfortable with that status quo and are not inclined to make big changes. Another is the costs that come with better governance. Implementing a good governance structure costs money upfront, while the benefits become visible quite a ways down the road. Finally, strong historical personal relationships between various service providers and a pension fund often have high priority, making it difficult to implement governance changes that could negatively impact that relationship. Q: Can the governance structure impact performance? Research has shown that funds with a robust governance structure on average outperform poorly governed funds by 1-2% on an annual basis. The outperformance is achieved both by better financial performance and improved cost efficiency. In addition, better governed institutions earn more trust from their stakeholders. For Institutional Investor Use Only. The views in this document are for informational purposes only and should not be construed as investment advice. Past performance is no guarantee of future results. There are risks involved in investing including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. For more information contact Margret Duvall at Margret_Duvall@ntrs.com