Pension Fund Performance and Risk-Taking under Decentralized Investment Management

Abstract

This paper uses a proprietary dataset to study two key shifts in the structure of the UK pension fund industry from 1984 to 2004. Specifically, most pension fund sponsors shifted from balanced managers (those managing across all asset classes) to specialist managers (those specializing within a single asset class), and from a single manager (either balanced or specialist) to competing multiple managers (balanced, specialist, or both) within each asset class. This secular shift from single balanced managers to multiple specialist and/or balanced managers carries significant costs: as modeled by van Binsbergen et al (2008), decentralization involves suboptimal risk-taking at the portfolio level, due to the problem of coordinating different managers through incentive contracts. We study whether this shift has been rational, i.e., whether fund sponsors have experienced increased performance to compensate for the suboptimal diversification. We show that specialist managers exhibit greater pre-fee selectivity skills than balanced managers, which is consistent with the higher fees charged by specialists. Further, pension fund sponsors using multiple managers allocate lower risk budgets to each, which helps to compensate for the suboptimal diversification that arises from the absence of coordination between the different managers. Finally, pension funds allocate more money to managers with good performance, and are more likely to switch to a multiple manager structure (within an asset class) when single managers underperform their peers. Overall, our results provide strong support for the rational choice of delegation structure by pension fund sponsors.