The Optimal Pension Fund Size
When it comes to fund management, bigger is generally considered to be better. There is a common assumption that once the fund grows in size, it experiences several benefits which come with increasing economies of scale. The same assumption was also believed to be true of pension funds.
However, empirical studies conducted in the recent past have proved that this is not necessarily the case. Studies show that pension funds become more efficient and productive when they grow up to a certain size. However, once they grow beyond that size, they start experiencing diseconomies of scale. In this article, we will have a closer look at how size affects the performance of pension funds.
Economies of Scale
First, it is important to understand how increasing scale increases the efficiency of pension funds. Some important points which explain this phenomenon have been mentioned below:
- A higher proportion of Fixed costs: It is important to realize that the cost structure of pension funds is largely made up of administrative costs. These administrative costs tend to be fixed in nature. This means that the cost remains the same even when the fund scales up its operations to a certain extent. Consider the important costs which a pension fund has to bear. They are information technology costs, regulatory costs, accounting costs, etc. All of these will not vary as the scale of the fund increases up to a certain amount.
Hence, the percentage of administrative costs to the overall costs of the firm keeps reducing with the increase in scale. This makes the firm more efficient. Hence, employees who invest in such pension funds get a higher rate of return.
- Technological Advantages: Information and communication costs can be very important for any pension fund. The ability to better deploy technology can differentiate one pension fund from another. Hence, once a pension fund has a higher scale, it can allocate more funds toward technology. This allows them to deploy better technology which in turn allows them to select better investments and also manage them better. Hence, an increase in the scale works in the favour of the pension fund and allows it to earn a higher rate of return.
Diseconomies of Scale
The concept of economies of scale is well known in investor circles. However, the fact that economies of scale decline beyond a certain point and turn into diseconomies of scale is not very well known. Some of the points which illustrate this fact have been mentioned below:
- Fewer Counterparties: Hedging is a very important part of the investment strategy of pension funds. It is common for pension funds to hedge interest rate exposures, currency exposures, and other exposures in the open market. However, there are only a handful of counterparties that have the financial strength to take on the opposite side of the trade that pension funds want to make.
Hence, once the scale of a pension fund rises beyond a certain point, finding these counterparties can become both difficult as well as expensive. The pension fund thus either has to continue with unhedged exposure or has to pay a higher cost for hedging. This can eat into the profitability of the pension fund.
- Higher Research Costs: Every dollar that flows into a pension fund has to be carefully invested by the fund. Initially, when the number of dollars flowing into the fund increases, the pension fund is able to better deploy this money and hence can generate better returns. However, as more and more money flows in, pension funds tend to run out of investment opportunities.
Pension funds then have to deploy specialized research teams that try to find offbeat investment opportunities for the funds. Finding such investments can be expensive and leads to increased research costs. Hence, research costs at pension funds increase with the increase in fund flow. This leads to decreased efficiency in the long run.
- Poor Investments: Also, as the amount of money flowing into the pension funds increase, investment managers are under increasing pressure to deploy them. Many times, fund managers are not able to find suitable avenues to deploy the funds. However, since they are under pressure to invest them, they tend to pick suboptimal and risky investments. This is particularly true since the interest rates are quite low. Hence, any investment which yields a significant return is quite risky. These poor investments can significantly damage the financial viability of a pension fund in the long run.
- Slower Response Time: Bigger pension funds have a lot of procedures and protocols in place. This is done to ensure that the funds are being invested responsibly. However, these protocols can work against the fund during tough times.
If the market faces a downward trend, then the smaller pension funds are able to act quickly and rebalance their portfolios to avoid financial losses. Bigger funds have to spend a lot of time on procedures and protocols. Hence, they are not able to make decisions quickly. The end result is that they end up bearing more losses.
The conclusion is that pension funds do have an optimal size. When these funds are too small, they face lower productivity and earnings. Also, when they become too large, they face the same fate. It is important for fund managers to keep an eye on the funds productivity and expenses and deploy to ensure that the fund operates at maximum efficiency.
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