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Study: Should Plan Sponsors Wait Before Deciding to Terminate Investment Management Firms?

Jan. 25, 2013
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Plan sponsors for corporate and public retirement plans, unions, and endowments, employ investment management firms that have typically delivered market beating performance in the past. Post-hiring, however, the investment managers do not always generate similarly high results. Though it seems at first that these investment managers are consistently underperforming, Professor Amit Goyal and Professor Sunil Wahal uncover in a recent study that these results may have more to do with plan sponsors’ characteristics than direct underperformance from the investment managers.

They conclude that if plan sponsors had stayed with the fired investment managers, their excess returns would have been similar to those delivered by newly hired investment managers.

The study also found that it isn’t uncommon for excess returns to generally be non-distinguishable from zero in the first two years of an investment manager’s engagement. It is by third year that returns start showing signs of improvement and become positive. In addition, plan sponsors that hire consultants engage in excessive performance tracking which may result in premature termination – we spoke with the study’s co-authors to learn more about their key takeaways, outlined below.

The Role of Plan Sponsors and Consultants

Plan sponsors generally have assigned or self-imposed goals and they assign particular amounts for the investment managers to invest in certain asset classes using a specific investment style.

Some sponsors who are headline risk sensitive – meaning wary of public scrutiny to headline stories that can adversely affect a company’s stock – may even choose to hire consultants to receive assistance with investment management portfolio recommendations. For example, retirement plan sponsors hire pension consultants for recommendations during the hiring period.

We interviewed Professor Goyal from the University of Lausanne to understand the benefit of hiring consultants during the hiring process. The main upside to hiring a consultant is in case of negative outcomes resulting from a hiring decision. The presence of consultants provides added certification and protection from public scrutiny.

Interestingly, however, the retention of consultants by plan sponsors, though useful for these recommendations during the hiring period, actually proved to be harmful in advising large plan sponsors post-hiring. After analyzing 412 round trip decisions between 1996 and 2003, results showed that large plan sponsors that retain consultants post-hiring, engage in excessive performance tracking which results in increased possibility of early termination at the sign of negative performance.

The Termination of Investment Managers

By the conclusion of the study it appears that plan sponsors terminate investment managers for an array of reasons. Causes for termination generally fell into either of the following two main categories:

  • Non-performance based terminations – include those where plan sponsors simply merged two plans, investment styles, or in the event of personnel turnover and investment management firm mergers.
  • Performance-based terminations – terminations based on negative returns on investments.

However, their data suggests that generally in the first two years, excess returns for the entire study sample are non-distinguishable from zero and it is generally by the third year that returns are positive.

What Should Plan Sponsors Do?

When we asked Professor Goyal whether it would be beneficial for plan sponsors to consider a three-year benchmark when assessing excess returns before formulating firing decisions, he couldn’t comment on providing a specific time frame because situations can differ case-to-case.

Professor Goyal did suggest, however, that frequent overturn may not be beneficial and that when making hiring decisions, plan sponsors shouldn’t focus excessively on past management performance.  

To read the full study, entitled “The Selection and Termination of Investment Management Firms by Plan Sponsors” visit SSRN.