Rich Nuzum is President of Mercer’s Investments & Retirement business and a member of Mercer’s Executive Leadership Team. Rich is also the Executive Sponsor for Mercer’s Pride Business Resource Network.
Rich’s prior roles include President and Global Business Leader for Mercer’s Investment Management business and global Chief Investment Officer for Mercer’s Investment Management business.
Rich holds an MBA (with high honors) in analytic finance and accounting from the University of Chicago and a bachelor’s degree (with honors) in mathematical sciences and mathematical economic analysis from Rice University in Houston, Texas. He is a CFA® charterholder and a member of the CFA Institute.
Rich has repeatedly been named to CIO magazine’s annual list of the world’s most influential investment consultants and received CIO’s 2017 Industry Innovation Award as Consultant of the Year.
Mercer is the largest investment consultant ranked by worldwide institutional assets under advisement, reporting $15.96 trillion in institutional AUA as of June 30, 2020 and further has Delegated Assets under Management of $304.5 billion USD as of 30 November 2019.
We speak about investment consulting, what needs differently sized asset owners need from an investment consultant. We also talk about finding innovative investment managers, the strategies small, medium, and large asset owners use to outperform relative to their capabilities. We also get into the concept of Outsourced CIOs, the trends in the retirement fund world and of course, we get some career advice.
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TRANSCRIPT EPISODE 60
[00:00:04] ANNOUNCER: Welcome to The Wall Street Lab Podcast, where we interviewed top financial professionals and deconstruct their practices to give you an insider look into the world of finance.
[00:00:23] AVH: Hello and welcome to another episode of The Wall Street Lab Podcast. My guest today is Rich Nuzum. Rich is the President for Wealth at Mercer and worth $304 delegated assets on the management, over 1,300 staff members and over $15 trillion assets under advisement. They are the number one investment consultancy globally by assets under advise. Rich has held many leadership roles within Mercer from President and global business leader, to Chief Investment Officer for Mercer’s investment management business. He has held roles across the world from Tokyo, to Singapore to New York.
He holds an MBA with high honors in analytical finance and accounting from the University of Chicago, and a bachelor’s degree with honors mathematical science and mathematical economic analysis from Rice University in Houston. He also did some graduate work at the University of Tokyo, and is a CFA charterholder.
We talked about – what does an investment consultant do. We talked about how Mercer finds innovative investment managers get a competitive advantage as an asset owner, then we talk about the work and use of investment consultants and outsource CIO, and how institutional objective setting and risk profiling is done at Mercer.
Of course, with the president of a company with 15 trillion as on the advice, I asked for some career advice. I hope you enjoy the episode as much as I did interviewing Rich. And if you like it, please give us a thumbs up, five-star review on Apple Podcast or wherever you get your podcast from.
And now, without further ado, our interview with Rich Nuzum.
[00:02:36] AVH: Hi, Rich. It’s a pleasure to have you on the show. How are you?
[00:02:40] RN: Hi, Andreas. I’m great. Thanks. Thanks for having me.
[00:02:44] AVH: Can you tell us a bit more about yourself? Who are you and how did you get to where you are today?
[00:02:53] RN: Okay. I lead Mercer’s investments and retirement business globally. That includes our institutional investment consulting, our provision of managed research to asset honors in a digital way, and our outsource Chief Investment Officer business. It also includes our retirement actuarial services and our bundled defined benefit and defined contribution capabilities. It stands clients in 85 countries around the world. I joined Mercer 29 years ago in Tokyo, Japan. I was studying at graduate school at University of Tokyo, under a professor who at the time was the Paul Krugman of Japan, but he went on [inaudible 00:03:33] to be Deputy Governor Bank of Japan and an advocate for creative monetary police, and probably did a lot to help rescue the Japanese economy from the global crisis. What I knew him, he was just an economics professor.
I came out of Todai – Tokyo University and joined Mercer in Tokyo, and then worked Chicago, Tokyo again, Singapore and now New York. Lots of roles along the way, always doing institutional investment consulting for large pension funds and sovereign wealth funds, insurers, endowments,foundations, family offices, other institutional asset owners.
[00:04:09] AVH: There’s a lot of my favorite countries on that list that you’ve worked. How did you end up in Tokyo in the first place?
[00:04:16] RN: Well, I’m pretty old now. When I came out of school in the late 1980s, came out of Rice University down in Houston, there were lots of people in Texas who are bilingual, Spanish-English. I had some Spanish but that didn’t differentiate me as a student. Japan was on top globally, Japan as a nation had taken semiconductor manufacturing away from the US, had looked like it was going to auto manufacturing away from the US. The Japanese stock market represented 46% of the world’s stock market. It was trading at a higher valuation than the US.
The City of Tokyo, the value Tokyo real estate for the city was larger than the value of real estate in the State of California. Japan was on top, and I got off the plane and there are books like The Japan That Can Say No and the Japanese Economic Miracle and so on and so forth. If I’ve been smart with perfect foresight, I would have learned Mandarin instead of Japanese, and I would have got off the plane in Shanghai or Beijing. But I got off the plane in Tokyo and plan to start a career international business, get fluent in Japanese, go from there. That actually worked out, but in the 29 years since then, 30 years now since then, Japan has continued to do well. It’s still a wealthy economy, it’s still a major economy but China has come up, and up, and up. China past Japan for number of headquarters in the Fortune 100 a couple of years ago. China is now past US for number of corporate headquarters I think in the Fortune 100. If the world was bipolar back then, it’s now multipolar, with China having risen and all the EU.
[00:05:58] AVH: Interesting. I think I want to get into the question about global trends a bit later. But for everybody that may be asked not heard of Mercer yet, can you quickly explain what your company’s doing.
[00:06:13] RN: Okay. Mercer helps employers with the health, wealth and career needs of their employees. We have three main lines of business, health, wealth and career. Under wealth, we have investments and retirement. On the retirement side, we’re trying to design long-term saving arrangements, whether that’s a Social Security fund for government or a corporate defined-benefit plan or a corporate defined contribution plan. Then figure out what you need to contribute to that plan over time to provide for retirement security for individuals. It could be citizens of the nation, state or a municipality. It could be employees of corporation or government.
On the investment side, we’re then trying to figure out what’s the best way to invest assets. A lot of those assets are for retirement plans. There’s some synergy and interaction between our work on the design and funding and accounting side as retirement consultants and our work on the investment side as investment consultants. But there are lots of asset owners that are not retirement plans. So insurance, some wealth plans, central banks, central banks, family offices and then the whole retail sector. We don’t typically work with retail investors directly, but we work with the banks and insurers and dot-coms in financial planning networks that serve individuals. So we work with financial intermediaries on a B2B2C basis, recognizing that their own customers are retail customer.
We help organizations make investment decisions, but importantly, we then help them implement the investment decisions. The game is about being early and being right to capture innovation. On one side, we’ve got 7000 plus investment managers that are waking up every day to new information in the market and trying to figure out how can we invest client assets to outperform this environment. On the other side, we got about 7000 Mercer clients that have existing investment objectives, and investment programs needs. And we’re trying to match up that innovation from the investment community with those needs on an ongoing basis to achieve good results for clients. The client that moves fastest gets the best return when there is a good new idea or innovation. Being early and being right drives our performance. That’s really our mission day in and day out.
[00:08:29] AVH: How do you recognize innovation in that space early? How do you try to accomplish that for your clients? And a follow-up question, how many of your clients for example pension plans are really active in dumping on to innovation, right? I always thought they are more the very traditional investors, only investment managers that have like five-year track record, something like that.
[00:08:29] RN: Okay, great questions. I’m going to divide the answer into three. On innovation, we have two key competitive advantages. One is, because we’re representing $15 trillion in client assets as a consultant. Investment managers have a very strong incentive to bring their best ideas to us first. If they can impress us with their idea, we’ll take it to a lot of clients. They’ll get assets to manage against that idea. They’ll be able to commercially exploit that idea before their competitor’s engage in parallel invention and move the market pricing to get rid of the value of the idea.
One competitive advantage is, we get to talk to all the smartest people in the industry around particular innovation. They don’t share their secret sauce with each other, but they’re sharing it with us. If I had eight investment managers come to me with the same idea, and they’re all claiming it’s innovative. I know but they don’t, they’re all engaging in parallel invention and none of them really have competitive edge. They’re onto the same thing, and market price are just going to just quickly and — the value ed is going to be eliminated very quickly for market efficiency.
If I talk to those eight and one of them clearly has seen around the corner and is on to something, that the other even is smart and well-resourced, the other seven aren’t. They’re not under it yet. Then I know that one has something innovative, and if we bring that to our clients, our client has a chance to buy in early. Then when the rest of the market comes to understand what that first innovator already understands, buys and behind, our clients will get a go. So our first competitive advantage is the numbers of smart people to come to talk to us, and they’re not talking to each other, and not talking to our competitors in the same way because our competitors are smaller, and not as well-resourced to listen.
The other big competitive advantage we have is, because we have a model that delivers our research digitally to the in-house staff of the largest, most sophisticated investors in the planet. If you look at a league table of the world’s largest pension funds or the world’s largest wealth funds, on both cases, Mercer has on ongoing relationships with more than 40 to 50 largest investors. We’re not their only advisor, we’re not their only strategic partner but we tend to be in the rooms when they’re thinking about these days is virtually in room, not physically in the room. But we tend to be in the room without thinking about their toughest challenges in trying to capture innovation. So we get co-create with them.
We’ll be in that room and they’ll have three, four, five other strategic partners in that room, trying to attack the challenge that the industry doesn’t have an answer to yet. Innovation is going to come out of that process, that none of those strategic partners including Mercer could have done on our own. But because we’re in those rooms in the figurative sense on an ongoing basis with so many of the world’s largest sophisticated investors, that’s another comparative advantage that we have in capturing innovation.
Another part of your question is, how can pension funds act on this? The most sophisticated, the largest do move quickly. So some pension funds are set up to have a comparative advantage in governance and can act very quickly on ideas. Others aren’t and they don’t have to be. The great thing about these very sophisticated clients and these investment managers trying to drive innovation is, they’re keeping the markets very efficient on an ongoing basis. Market efficiency in our view, the inability of most investors defines information that lets them beat the market in a systematic way. That doesn’t happen by accident. That happens because as soon as you’re agile in funding innovative ideas that investment managers have, and as those assert managers buy in Social Securities, they’re changing the market prices to get that information into the market price.
Most pension funds could be free riders, and most family offices and retail investors can be free riders. They can pick their asset allocation, put all of their governance effort into strategy, the right strategy to achieve their outcomes. When it comes time to implement, they can invest in passively managed index funds and have a reasonable belief that they’re going to beat the majority of other investors out there at much lower fees. That’s a great thing, to be able to be a free rider and get a good result.
Now, if you could have been one of the organizations with a competitive advantage in governance, if you are willing to spend the money on staff, and consultants and partners to do that, and instead you’re a free rider, you’re probably giving something up. But most institutions aren’t big enough or sophisticated enough, or they have other constraints around what they can pay staff and so on. If you look around the table and you don’t know who the dumb money is in a poker game, then it’s you. And it’s much smarter to say, “I don’t have a comparative advantage in governance, I’m going to be a free rider, I’m going to do that deliberately and I’m going to get a good result. I’m going to get it cheaply; I’m going to get it reliably” as opposed to trying to play the game. But large sophisticated funds do have we think a comparative advantage in governance and to move quickly.
[00:13:43] AVH: I always thought that it’s more the smaller to medium-sized investors that actually would employ investment consultants, because I thought they would have a large in-house team and not outsource that. How is that you work with the largest investors of the world and why do they not have in-house teams?
[00:14:06] RN: The largest in the world definitely have in-house teams. I dial in for a call that started 4:30 in the morning my time yesterday with a Middle Eastern client that employees many hundreds of in-house staff and does direct investing and highly sophisticated. They would say they don’t use consultants in the traditional way. They don’t need a monthly or quarterly monitoring report, they don’t need a formal manager selection report and help with files and reviews. That sort of classic governance model that we’ve seen in mid-market is not what they need.
What they need is a window on the world of what other investors that are hundreds of billions in assets and have hundreds of in-house staff, what are they doing around delegation of authority, investment processes and procedures, engaging with the general partner community, accessing co-investment and secondaries. Whatever the issue is, they want to know what are other super smart sophisticated players like us doing. So having a consultant at the table that works with other large ultra-sophisticated asset owners helps them. What they also need his help with that co-creation, and so they need a partner that is able to sit at the table and participate in a diverse build with other strategic partners, including that may be securities managers or investment banks. Or otherwise, not from the consulting industry.
The reason why we have large share there is our digital management search offering and our digital strategic research offering. We 20 years ago decided that niche of sophisticated clients, they don’t need out traditional services, our performance evaluation reports, our management selection reports. What they need is, when we do we do qualitative forward-looking research, when we think we found something innovative or when we think we found something that the manager thinks it’s innovative, but we actually think it’s parallel invention with 20 other people. They get that on their desktop, and it’s not that they take our manage research note and that tells them exactly what to do.
The feedback we get from in-house is, the meetings I took and the meetings I didn’t take because I read your note pays for the subscription research X times over. It’s just such a productivity enhancement. I wake up in the morning and there’s 215 Mercer management researchers feeding me stuff. I could look at that and then prioritize my own efforts. I’m so much more productive than if I’ve done some of those meetings myself. Because classically, what happens is, somebody gets in to see one of these in-house staff, and they flown half way around the world, and you’re five minutes in the meeting. And the in-house staff realizes this is a complete waste of time. In some cases, they just throw the manager out, but in most cases, they give them 45 minutes to an hour, because you can’t really have somebody fly half way around the world and throw him out after five minutes, even if it’s a waste of everybody’s time.
When you read our notes, that almost never happens. The in-house staff is down the curve, they know the strategy, they know it’s a potential fit. Whether the managers come in to sit down or whether they’re planning a research trip to come and see the manager, it’s not going to be a waste of anybody’s time. Because we’ve got that digital capability, that willingness to share all of our research on an ongoing basis. When that same in-house staff member has a question, that sort of a strategic nature, and is thinking about, “Whom I’m going to call? Whom I’m going to bring into that room with my other strategic partners to brainstorm about, what do we do about negative interest rates, what do we do about the Vix trading at 85 instead of 20, what do we about this historically unprecedented threat or opportunity?” They’re going to call Mercer first because we’ve got the ongoing relationship with them as the provider of their digital research.
[00:17:43] AVH: You mentioned several times, management that are innovative and impress you. So I get that you act as a pre-screener, but what kind of criteria you would have towards the manager to sort of manage -— to jump the hurdle and get a positive review from you? Can you like to elaborate a bit what do you really see as innovative, as a good strategy? What are kind of the attributes that a manager would need to bring to the table?
[00:18:09] RN: There are four factors that we look at that we believe are necessary and sufficient to beat the market. It’s competitive edge in idea generation, portfolio construction, implementation and business management. By far, the most important of those four factors is idea generation. How does the investment manager for particular strategy figure out what’s going to drive securities prices ahead of time, how do they source ideas about what’s going to move markets or the values of individual securities and how competitive edge again in that against other investment managers that may be just as smart and just as well-resourced and have all the past success credentials? Do they have competitive edge? That’s the most important. If you don’t have that, you can’t beat the market. You need competitive edge and idea generation.
Portfolio construction is, how do you create a portfolio security that is exposed to areas where you have an inside edge and not exposed to risk factors where you don’t have a view? How do you void giving back your value-added through bad luck areas where you didn’t intend to take a position? Implementation is how do you trade that portfolio on an ongoing basis cheaply but quickly so that you get the value of the ideas, you can be early and be right, and not move the market as you do it and give up in transaction cost, the valuable ideas.
Those first three factors are necessary and sufficient to beat the market against your peers. Business management comes in on a longer-term time horizon. Are you constantly enhancing your competitive edge on the first three factors or you’re giving that up, because you’ve got personnel turnover, or you’ve got portfolio managers running around doing sales presentations and not managing the money? Or you get complacent and because you’ve had good results for year two, you think, “Okay, we’ve got this. Look, we don’t need to innovate.” And other people past your innovation.
We’re very forward-looking in trying to identify innovation and were very focused on across all measures we talked to in the same asset class, our manage research specialize by asset class. If I’m a researcher on immerging market equities, I’m talking all the time with the best emerging market equities managers in the world who has a competitive edge in a point in time. The psychological dynamic is a team that’s been outperforming will relax a bit. They’ll think, “Okay. We got this. Client loves us. We’re doing well in the market. What we’re doing is working. Don’t mess with success. First, do no harm.”
Another team that’s equally smart but it hasn’t been working for them because they lost their competitive edge is going to be at the grindstone thinking about how do we innovate this process. It hasn’t been working as well. What can we do differently? You’re constantly passing each other. It’s like an ongoing competitive race.
Now, contrast that to what you entered at earlier with your question around pension funds. Most of the industry, most of our competitors looks at things like assets under management, length of track record, stability of teams, stability to process. When I entered the industry 30 years ago, if we met with the management and they said, “We’ve been doing the same thing for 20 years, it’s been working, it’s the same team, it’s the same process. We believe it’s replicable.” That was a good answer. Today, if a management come in and said, “We’ve been doing the same thing for 20 years, and we’ll keep doing it.” With the pace of development, of new information sources and the pace of innovation asset management, you’d be surprised they were still in business. You can’t do the same things you — you can have a discipline. You can be disciplined about how you get innovation.
But to say, “We’re going to do the same thing,” you’re in, you’re out and trust this is going to keep working. I’m sorry, the market is just too efficient. There are too many other smart people trying to do the same thing. Even if your secret sauce doesn’t leak, other people will get at it through parallel invention over time.
One of the paradox is, is the markets are very efficient, it’s very tough to be a securities manager and beat the market. Picking active managers is not very efficient, because most people are picking out the managers, looking at measure of past success. They don’t have the resources to get at competitive edge to look at what we believe are the drivers to future success.
[00:22:12] AVH: How do you discern what is actually innovation? What kind of questions do you ask or how do you tell that the thinking process on how to get recurrence is actually right. Do you just challenge them, look at how their idea is and then think, “Okay. Does this make sense?” Because if there isn’t a new idea, there is no tract record yet, right? So there is no evidence that it’s actually working. Do you back test their strategies or do you just try to ponder them with question until they shrink out at one point of the strategy? How do you know the strategy is the relevant?
[00:22:53] RN: I would say that in my opinion impossible to do on an absolute basis and easy to do on a relative basis and what I mean by that, I’m a generalist investment consultant and I meet with a global water technology manager and think, smartest person I’ve talked to in six months. That was so interesting. It all sounded so innovative. I can see how that would work. I believer there are great returns there. I’m just so impressed.
I walk out and I ask my manager researcher who’s researching water technology managers all time as a full-time job, “What do you think?” “Well, there’s no innovation there?” “What do you mean? They’re brilliant.” What’s happening is the researchers are meeting with people like that all the time. They’re hearing exactly the same thing from this very smart well-resourced person that they’ve heard from 20 other people. And we’ll go to a different meeting and I’ll be equally impressed because I don’t know that much about water technology, I’m a journalist. And my researcher coming out of that meeting saying, “Okay. I’ve heard seven things there that are different that I heard from anybody else.” It’s clear that if they exploit those seven things, they’re going to beat the rest of the pack.
On a relative basis, its easy to evaluate competitive edge. On an absolute basis, you can’t. I’ll give you a different example. My 12-year-old crashes be these days in basketball. He’s just so much better than I am as an adult. But then we’ve got him on an AAU team where he place in New York City, and all of a sudden he’s — I still think he’s above average, but he’s above-average. He’s not going to make it to the MBA. If your — the investment manager is going to survive in the industry are brilliant, they’re great at what they do. Within the population, they’re like to 0.1% or better at what they do, but they’re competing with each other and getting at the best of the best. You have to do it on a relative basis, you can’t do it absolute.
The other part of your question is about completely unproven things. I think the biggest gains are going to a new asset class or sub asset class early when nobody has a track record and make an investment. But then you diversify. So that if you get some of those calls wrong and some of you will get wrong, it won’t pan out the way that you expected or the manager expected. On average, you’re trying to win. You don’t have to be right every time. One test for whether an asset owner should be a free rider as opposed to try to push the envelope and beat the market is, can they stomach getting some things wrong? Do they have single line out of risk tolerance?
If the invest in a 10 really innovative private equity ideas, and one of them goes to zero. Is that going to cause a stakeholder to question the whole process and say, “Why are we doing private equity? We clearly got this wrong? How could you make that mistake?” As opposed to, “Okay. On average, across the 10, we beat the market, we beat the rest of our portfolio. We should do more of that. What’s the governance model? What’s the stakeholder risk tolerance? What’s the sophistication level? Can you make diversified bets, accepting that sometimes the odds may have been on your favor on average, but you’ve got some individual positions where you didn’t get a good decision, bad result?”
[00:25:50] AVH: What other field of work does an investment consultant do? So you mentioned a couple task in passing, that are usually not done for large asset owners, but what are like typical task that you would do for like a small and medium-sized asset owner?
[00:26:09] RN: I think for all of our client segments, the most important thing we do is help with objectives, risk tolerance and long-term strategy. And by far, the toughest of those and most important is, what are the investment objectives and what’s the associated risk tolerance. An investor may say to us, we want and 8% nominal return, or we want a 4% above-inflation real return. Then we’ll go through over what time horizon and why do you want that? And are there any unique things about your organization that would cause that objective to differ over time that would also hit the investment portfolio.
An example is, if we’re working for a sovereign wealth fund from a country that has oil reserves, a copper reserves, if oil prices rise over time, stay healthy, the country is going to be okay anyway and they’re going to be able to fund the sovereign wealth fund. If oil prices crash for whatever reason, economic recession, technological innovation. If oil prices crash, the country is going to be in trouble and need to look to the sovereign wealth fund for better returns.
That sovereign wealth fund may have said to us, we want 8% nominal or 4% real. And if we just took that at face value and didn’t ask other questions, we could have put them into a strategy where they were getting that 8% of 4% by betting on oil prices, staying stable or rising. What we would have done disservice to is, their objectives that actually is, “We want nominal for real, but we’re going to really need that when oil prices get crushed.” Of course, in a portfolio that hedges against oil price risk, and we’ll be a lot happier through time. We’d still like 8% nominal, 4% real. But when it’s most valuable to us is when the value of what’s in the ground and the value of what we’re earning by taking out of the ground is under threat. That’s when it’s more valuable.
You need to ask a lot of questions to get at the real investment objectives, and then risk tolerance that the cardinal sin for an investment consultant is to exceed your client’s risk tolerance. Risk tolerance only comes into play when things go badly. Let’s say we get a client and we convince them that part of the answer to their investment objectives is to diversify in the alternative investments. Let’s say we get them into private equity, real estate, infrastructure private debt, hedge funds. We do that in 2006, 2007 just in time for the global financial crisis, and markets drop by 40%.
The portfolios that they just started creating in private markets are down, and not looking like they’re going to have good ventures, good returns. If we did a great job with that client on objective setting and risk tolerance, that client should be saying to us, “Okay. The markets have really gone against us in the short terms, can we go heavier? Can we go faster?” Now is a great buying opportunity. We want to go heavier into these alternative asset classes. If we’ve exceeded the client’s risk tolerance and not done a good job with the objectives on risk tolerance, the client’s reaction can be, “Oh my gosh, we took all these risk on — and it went against us in the first year after we did it. What a mistake? We need to pull out?”
You want your client to have the governance and have the mindset of buying into market opportunities, buying into weakness as oppose to being a fore seller. The strategy process is not around the numbers, it’s around helping the investment committee or the stakeholders of the board pre-experience both positive and negative outcomes across the range of economic scenarios. So that when something like that actually happens in the future, and we’ll never get it exactly right. We didn’t predict the Coronavirus. We did add pandemics on the list of things that could happen. But we put clients through, “Okay. Open the envelope, here’s what happened in the markets.” We did that based off the global financial crisis. We did it based of the crash of ’87.
There’s plenty of historical scenarios you can use to help your client pre-experience what can go wrong. Then ask the question, in this circumstance, what do you want to be doing. If the answer is. “Well, we would accelerate our commitment to risk the asset classes, we would use our opportunistic risk bucket. We would be taking advantage of the opportunities.” Then you’re in good shape. If the answer is, “Well, we couldn’t stomach that.” That would end the organization, we’d all get voted out of office or fire. Then you know, okay, we can’t actually do that strategy, because we’re too path dependent, we can’t stomach the down side to get the upside over time.”
[00:30:35] AVH: That’s sounds a lot like, “Don’t smoke, it’s bad for you.” How do you make sure that if the event arises, the client is actually follow through? Because it’s one thing, if the envelope, I imagine like extra sheet and there’s like new portfolio is found 15% or 30%. They’re like, “Yeah, okay. That’s — I would just buy it.” But then the situation is there, do they actually stay with their decision? And how do you make sure they stay with their decision?
[00:31:05] RN: We just had a really live test, and we were worried about it. We had 10 years of relatively well-behaved markets and stocks hitting new highs on a routine basis, coming out of the global financial crisis. When we looked at where there were senior stuff at our client’s investment committee members and boards, there were still a small minority of people who’ve been on those types of roles when the GFC hit. But 10 years is a generation in the investment industry, so a lot of the people around the table haven’t been through that before.
We weren’t sure — we put on through these hypothetical scenarios and I’ll come back to how we did that in a second. But we weren’t sure whether they did really have the risk tolerance. Then we had a much sharper, faster correction losing 40% on stock markets in two weeks with the Coronavirus crisis. We weren’t sure whether clients would have the risk tolerance to do rebalancing or deploy their opportunistic risk budgets.
We were pleasantly surprised that they did. The client that had pre-experienced crisis said, “Finally, we’ve got a meaningful market correction stuff to buy.” Like they’ve been waiting for 10 or 11 years to put this plan into practice and they finally got to pull the plan off the shelf and implement it. So that did work.
I think to your point about the metaphor smoking commercials is part of how we get them there. If we’re talking about a defined contributions scheme, we’ll have personas and we’ll actually show a picture of a person in their 30s and then that same person, 40s, 50s, 60s, 70s, 80s. Often, we’re using software to age them digitally as oppose to actually having live pictures. But we’re helping humanize it. Like most people, even good board members, good investment committee members, they got there by being really good business people or good in their day jobs, maybe they’re a doctor, a lawyer or whatever. They didn’t get there by playing poker. They can’t think in numbers or math the way that an investment professional might tend to do or been taught to do. They think in human terms.
For working with the University of Endowment, we’ll say, “In this scenario, the money available from the endowment to help the budget of the University would fall to the point that you can afford these things. You can’t afford to offer these scholarships you’ve offered, or you would spend the endowment down within seven years if you kept at it.” We try to bring it back to human terms. If we’re working with a non-for-profit hospital, here’s what we’ll do with your P&O. You wouldn’t be able to afford to do as much care for people without means. You wouldn’t be able to handle the uninsured people coming in because you wouldn’t have money and trying to bring it back to their mission, and what it’s really going to men in human terms. And not just the audit terms, but human terms in different ways to make it real and help bring the psychological impact of living with that risk.
You think back to March of this year, we had markets go down for weeks solid, and okay, we’ve been through this before, we’re going to rebalance, we’re going to buy in. Then they went on for another week, and all of a sudden that rebalancing decision is looking, “Why do we do that? We bought into early, and now we’ve lost more money and it’s getting really threatening our mission.” This is happening in people’s real lives that they’re worried about their families and their own health. And in their day jobs, if you’re running a university, you’re having to send you students home. If you’re running a hospital and all of a sudden you can’t do any elective care, and you’re in the front line of Coronavirus.
If you’re running a retail or travel company or small business and you’re looking at bankruptcy, your day job is hugely stressful, your maximum risk there. And at the same time, the investment portfolio is tanking and in the short-term, these actions you’d all thought about in the vacuum in these nice conference room five years ago. Open the envelope, you through the case study. Suddenly, it’s real. It’s very hard to rebalance. It’s very hard to want to buy in. It’s very hard to want to provide liquidity to markets that are season out for lack of liquidity.
But by and large, the client base did that, because they’ve been through those exercises, they’ve been trained. The toughest time to do that is going to be the best time to do that and it’s proved out again as it has in the past crisis.
[00:35:11] AVH: I want to jump into one other topic that we quickly mentioned earlier, and that is OCIO, so Outsourced Chief Investment Officers. How does this role differ from an investment consultant?
[00:35:27] RN: It differs less than I think the consensus would have us believe. I think one of the innovations in the last 10 years in the industry or 15 years is towards a modern form of Outsourced Chief Investment Officer, which bundles really investment consulting advice on strategy. Everything we’ve already talked about. The clients are still going to take the decision on their long-term strategic asset allocation. And often the clients taking this decision on which asset classes they’ll use, will they do private equity or not? How much will they put in private equity? What types of private equity? Use active versus passive management. The client is still involved in strategy.
But at some point, in the process, instead of the client making the decisions, and then in-house staff having to implement, they’re turning that over to their consulting partner and saying, “You pick the managers for us. You open the accounts with our custodian.” You oversee the wire transfers, you sign the fun docs with the private equity managers, you handle the capital calls.” This implementation work, you’re going to do for us.” There are different variations on that and degrees, but I think what happens in CIO relationship is that, some tasks that would otherwise be handles by an in-house staff or some decisions that would otherwise be taken by the asset owners, governance process are delegated to the partner to do for them.
Then the client can focus their resources on strategy, and not worry about the implementation, except that they’re monitoring the OCIO and they’re going to hold the OCIO accountable for results against benchmarks. In the classic example, clients turnover management selection to us. And a client may say something like, “We’ve been doing manager research with you in the consulting model for a long time. And actually, we always take your recommendation.” So if we’re users, we’ll say. “Oh, you’ll do it for us. We’ll get the benefit of your aggregate buying power, we’ll pay lower fees, you guys will handle the implementation work instead of our staff, and we’ll have more time to focus on strategy. That’s a fit for us.”
I think the other thing about OCIO is it doesn’t have to be all or nothing. Sometimes, those OCIO buy asset class so they may use a sale for an alternative but not traditional assets. They may use OCIO for new allocations, but not existing allocations. Others do it by program. So a multinational may have a consulting and an in-house staff model in the largest countries. Then in small countries may use OCIO because it just doesn’t make sense for them to focus their time and effort on the 80% of countries that account for 20% of their assets. They’re going to focus on the 20% of countries that account for 80% of their assets.
[00:38:07] AVH: Then the in-house OCIO is more on the strategic level, but outsourced CIO is probably involved in doing really the operational implementation of the strategy that was discussed with the client.
[00:38:22] RN: Yeah. In most of our OCIO relationships, we’re giving the strategy advice, and then we’re implementing for the client. The benefit of that is, we understand the strategy, we understand the risk tolerance. When things happened that you didn’t imagine ahead of time, go back to global financial crisis, there was a point when swaps traded through treasuries. Before that happened, a lot of market observers said, “Well, that can’t happen.” Then in the recent Coronavirus crisis, we had oil crisis go negative on the oil features. If you ask people ahead of time, “Can that happen?” They will say, “I don’t think that can happen. How could that happen? How could an oil have a negative price?”
But when that happens, when that kind of unprecedent things happen, if the OCIO understands the client’s objective and the risk tolerance, they can either do something within their discretion authority that’s going to make sense to the client after the fact. Or of they don’t have the authority to do it, they can go back to the client and say, “Can we please have permissions? Sign here so we can do this for you because you’re going to get a better result given your objective.” Having those two things integrated, the strategy, advice and implementation makes the implementation better.
Whereas, historically, when it was more common that one firm would give investment consulting advice. And if there was an OCIO relationship, it would be with a different firm and a fund to fund [inaudible 00:39:40]. Those off the shelves building blocks, they delivered aggregate buy-in power benefits. They delivered operational benefits, but they weren’t operated with the inside knowledge of the clients objectives, risk tolerance, constraints, why their strategy was the way it was. So in extreme circumstances like the global financial crisis and the Coronavirus market correction, you couldn’t get this very fast opportunistic play on, “Well, here’s a big opportunity, a big threat and here’s exactly what we’re going to do about it because we understand what the client is trying to do.”
[00:40:12] AVH: How do I imagine an outsourced CIO? Is an endowment, hiring one certain person that is responsible as the CIO? Or is this one person responsible for several client? Or is it always a team of people responsible for multiple clients. How does it work in practice?
[00:40:34] RN: In our case, it’s always a team effort. I think industry-wide, it’s generally a team effort. Around half of our assets under management is an OCIO custom implementations and the other half make use of our multiclient pulling vehicles. When a client is making use of a multiclient pulling vehicle, they’ll have a strategist that they work with, so a single team member, backed by a team but kind of a front person for the strategy advice. Then there’s a portfolio manager for each of the strategies, each of the asset classes in the multiclient pulling vehicles. It’s very much team approach there in a custom case. We may have a client portfolio manager that’s a top the entire implementation, but they’re still going to work with the same asset class leads that manage our multiclient pulling vehicles will be giving them very strong advice or taking delegated authority to implement the individual asset class leads for that custom client.
It’s a team effort, but we try hard to make sure that there’s a single person the client can go to who understand their strategy, risk tolerance, constraints, governance, what they’re trying to achieve and how and who’s accountable to them for everything that we’re doing for them. That person is the interface between the rest of our organization and the client. Everything we’ve talked about so far is related to front office decision making, but there’s a lot of operations work that happens in the OCIO model. We’re getting daily feeds from the custodians, we’re loading those securities into our software to check against risk tolerance guidelines and ESG criteria. We’re making sure that the risk and the portfolio are in line on a daily basis in past compliance jobs and make sense to us given the client’s strategy.
That information is all getting loaded, aggregated and then we’re trading across the portfolio to rebalance exposures across some advisors of deploy new contributions to the client, and raise money for benefit payments, raise money to meet capital calls, deploy distributions. There’s a daily trading cycle, and there’s an operation’s team that’s full-time, real time, making that all happen. Which generally does not exist in the standard consulting model, and the consulting model. The client’s in-house staff are doing that, but they’re generally doing it with monthly data from the custodian managers, with the lag. Whereas in the OCIO model, that’s typically on a daily cycle, it happens in real time. So you pick up some implementation, risk control benefits in the OCIO model that aren’t typically available in the consulting model.
[00:42:58] AVH: Now, I have one more question that I was very interested about, knowing this is a huge business for Mercer. You mentioned them a couple of time throughout the conversation, pension funds. You said in the beginning, I think you mentioned defined contribution. I know there’s defined benefit. Can you shed some light onto the differenced between the two sorts of pension funds and how the industry is developing?
[00:43:30] RN: In a defined benefit plan, the plan sponsor, which is often the employer of the participant or the employee, the individual. The plan sponsor is committing to provide a certain financial outcome to the purchased plan. It could be a dollar amount of lump sum, it could be a proportion of final average salary, it could be a proportion of final three years salary. What the outcome is can vary by plan. But the sponsor is saying, if you work this many years for us and you have this salary history, and you retire at this age, it’s usually age, years of service and salary history. There can be other criteria. But if you do X, you’re going to get Y.
A participant who knows with certainty, this is what my career is going to look like, and I’m going to retire at this age. I’m going to have the salary history and years of services on. They’ll be able to figure out exactly what they’re going to get. It may be inflation adjusted, it may not but they’re going to know what they’re going to get. And if what’s contributed along the way is not enough o fund that, the sponsor has to make that up. The participant doesn’t have to worry about the investment earnings because they’re going to get that outcome regardless of the investment returns. The investment risk and the funding risk is with the plan sponsor.
In a defined contribution scheme, what happens is, the sponsor says, “I’m going to contribute X to the plan.” I may do other things for you. I may arrange a record keeper, an investment management arrangement and do my best to make sure those are high quality, but I’m going to contribute X. How you invest that is typically up to you. In some cases, the sponsor decides how to invest it. But whatever happens with the earnings over time, at retirement, you get what you contributed, what was contributed for you, plus anything you contributed, plus the earnings. So, neither one of us has any idea of what that outcome is going to be. We can project it, but it’s uncertain. In the year before your retirement, if the market dropped by 40%, sorry, your account balance just dropped by 40%. It’s your risk, it’s not on the sponsor, it’s your risk.
Defined benefits scheme where the outcome is guaranteed and the investment risk is with the sponsor. There’s defined contribution schemes where the input, the contribution from the sponsors committed, but the outcome is variable and the investment risk is with the participant. Then there’s hybrid schemes, where the sponsor may create a corridor and say your outcome is going to be within this corridor and where in the corridor and where in the corridor is going to expand on. So it’s defined contribution within the corridor, but above and below a certain level, it goes defined benefit or there might just be a floor and no ceiling for an asset plan. There are hybrid arrangements, but basically, most of them are DB or DC.
[00:46:12] AVH: How does your involvement vary? I mean, in a defined benefit contribution plan, I can understand because you have to hit the target number, similar to an endowment. But how does it vary when it comes to a defined contribution plan?
[00:46:27] RN: So defined contribution is tougher because we think of it as B2E2E. So we’re a business advising an employer about something they’re doing for their employees. Both Mercer and our client, the employer has to think about the psychology of individual decision making. With a defined benefit plan, we talked earlier about investment objectives and strategy, and risk tolerance, and governance. We’re taking committees through that scenario around, “Do you have the response the response to something like this?”
With a defined contribution plan, the committee is taking decisions about what to offer the participants. But typically, those participants, and then choosing what to invest in, and we don’t have as much opportunity to educate them. We’re not meeting with them face to face typically. They don’t have a lot of bandwidth to get educator investments. We’re trying to design what we call smart defaults and target date funds are the classic example. Where we try to make it really easy for the participant to get into a high-quality, diversified investment strategy that’s going to match up well against their risk tolerance and needs, and deliver an outcome that they’ll be happy with, originally happy with, without exceeding their risk tolerance and downturn.
What we and the industry in general have come up with so far, this seems to work well is the target date fund design. Where you could say to the participant, “If you think the date you’re going to retire at is X, then this is probably about the right option for you. If you want to do something custom, you can but this is a smart default. This is something that we’re going to — if you don’t make an active choice, you’re going into this as of default and it’s the best we can make it without knowing anything about your specific circumstances outside of work, your other savings, your savings history, your net worth, what you might have inherited, what your partner, spouse is doing. It’s not perfect, but it’s the best we can do without getting a lot more information. If you want to provide that information to manage account or financial planner, then you can do that and do something custom, but here’s our smart default.”
Defined contribution is tougher because we’re dealing with individual investor psychology. We’re dealing with masses of employees, their capacity to engage is limited. They’re not focused on retirement until they get close to it typically. The best we can come up with this industry so far is target date funds.
[00:48:46] AVH: Now I know that defined contribution is actually growing, also in defined benefit. I think it’s more of a switch. Can you shed some light on why this is happening and what’s the industry trend here?
[00:49:00] RN: Yeah. Two levels. In the developed Anglo-Saxon economies. So Australia, New Zealand, US, UK, Canada, Ireland where pre-funded corporate defined benefit was the main form of savings. We could throw Japan in there also, which breaks the Anglo-Saxon model, but they borrowed it from the US.
Pre-funded defined benefits was the norm, and corporations, employers were the sponsor. What’s happening there is, employers have been through series of crisis. The tech bubble, the US housing crisis and global financial crisis, and most recently Coronavirus. It’s not their core business to offer retirement benefit arrangements. When it goes well, they earn more than the actual investment consultant told them to expect. The benefits go to employees typically. When it goes badly and there’s market correction, the employer has to pay more. So they’re looking at it and saying, “This is not a two-sided bet. When it goes well, we don’t get the benefit. When it goes poorly, we have to pay more. Why are we doing this? It’s not our core business? Corporate employers are shifting from offering defined benefit plans to offering defined contribution plans
If you look at new economy firms, dot-coms, new established enterprises, in those countries that historically had DB, they’re almost 100% DC. They’re not offering DB at all. When you look at old economy firms, they had DB, auto manufacturers, auto part manufacturers, banks that have been around a long time. They had DB but they’ve closed the plan of new entrance. In many cases, they frozen the plan for further accruals. So on a go-for basis, they’re only offering DC. That’s what’s happening in those economies.
In the rest of the world, places like China, India, Singapore, Malaysia, pre-funded corporate DB was never dominant. As those governments have looked at, “Okay, we know have an opportunity to worry about, we’re wealthy enough that we can worry about retirement income security. People aren’t starving anymore. We’re at a level where we can worry about long term needs in the Asian population. What are we going to do about that?” Well, they look at the US as one example where Social Security is close to bankrupt, projected to run out of money. They could look at other countries and see the same thing. They said, “Well, that’s not sustainable, we’re not going to do that.” Those countries that were wealthier before us, they’re moving to DC, so we’re just going to skip to the end. It’s sort of like, never having landlines for phones and going straight to mobile networks. Never having bank branch banking and going straight to ATMS. You skip straight to defined contribution.
You don’t do it employer based, you just have a national defined contribution scheme like the Central Provident Fund in Singapore or the Employee’s Provident Fund in Malaysia, or the Mandatory Provident Fund in Hong Kong, which doesn’t look like a national scheme, because employers are picking the default provider. But there’s multiple default providers competing for business, and each employer doesn’t have their own scheme anymore by and large. There’s maybe a dozen left that are employer based. The rest are using these multiple employer plans. Australia, New Zealand and the Nordic countries, there’s a lot of countries including some developed markets that have gone straight to our Social Security scheme is going to be national DC. The Latin American countries that have an AFP or 4A system, we don’t think of those as national DC because there’s multiple competing prior second providers.
The employer’s role is to pick a provider and remit the contribution. In most cases, if the employee wants to pick a different provider, they can do that. The employers is only picking the default. It’s employee choice of providers, employee choice of investment. The employer contributes and that’s it, and the government takes care of regulating those providers. That seems to be a stable equilibrium. So the path from DB to DC seems to be one directional. Companies move from DB to DC, they don’t move back. Governments move their Social Security from DB to DC, they don’t move back. That’s what we’re seeing globally.
[00:52:51] AVH: I can see the appeal that this scheme has for companies and governments, then only the question comes to mind. The people that invest and take the risk now, can they live off the money that they made over time, and this is I think a very big discussion to maybe we have at another point.
[00:53:12] RN: I think that’s a huge question, and it’s interesting because I mentioned earlier, it’s hard to get defined contribution participants engaged with the scheme. But with the decline in interest rates globally, for example in Chile, which historically we’re seeing as a model for Social Security and DC system. Because of the reduction in interest rates, the annuities that individuals can buy when they hit retirement are now paying much lower. It’s lower annuity rates. With the given lump sum, you’re buying less retirement income.
We’ve literally had riots in streets because that interest rate risk wasn’t hedges in the scheme designs, so participants are now surprised that they did everything, they feel like they did everything the government told them to do. Everything they were encouraged to do, defaulted to do and they get to retirement, they don’t have enough to live on. It’s a very real issue. But in the defined benefit countries, that’s going to fall on the government and tax payers to make up. In the defined contribution companies, the individuals will have to adjust their working lives, and their savings to offset the impact of lower investment returns or lower interest rates. It is a key issue and we have a huge gap against retirement income security needs globally.
I think the other reason that DC is prevalent at a government level is labor mobility. It’s not just that the government don’t want to take the investment risk on their on balance sheet and have that fall through a taxpayers. When they look at, “How do we have an economy that’s sufficient as possible, and get our labor to move from old sectors to new sectors so we have faster per capita GDP growth, we have higher productivity, we have better tax receipts, we have better wealth creation.” It’s important to have a flexible labor force and have labor move from employer to employer easily. A defined contribution scheme makes that easy because your savings goes with you. A defined benefit scheme gets in the way of that, because most employers built in incentives to their defined-benefit design investing and so on, to cause employees to stay with them longer. That may make sense for that company. At a society level, it makes the labor force less mobile.
When Japan introduced Japan 401k, a Japanese defined contribution, we consulted to the Ministry of Trade and Industry and the Japanese Chamber of Commerce on that. The key reason they did it was to make the Japanese Labor market more flexible. They felt like having people stay with an employer because of the defined benefit scheme, when actually if they move to different employer, they can make more salary. It just wasn’t bad for the economy. It was hurting GDP growth. So they introduced DC explicitly to try to create labor mobility.
[00:55:40] AVH: That actually makes a lot of sense. I’ve never seen it that way, but then I guess what really is needed is for people to get better and more financial education, to really take full advantage of the opportunities provided, and this is going to be huge in the future. Now, I don’t want to take up too much of your time, but I would love to get some career advice from somebody as experienced as you. Do you have any tips for our audience?
[00:56:14] RN: The consulting industry, if you like working with people, if you like a balanced quantitative and qualitative, if you like being exposed to the most innovative minds in the world, and have investment managers literally trying to break down your door to tell you about their latest innovation, not quite literally but pretty close to it. It’s a great industry. If you want to manage money in the sense of picking individual stocks or bonds, I wouldn’t come to the consulting industry, I’d go straight into investment management. But if you want to do marketing, sales, business management, other things in the investment management industry or be in-house as the Chief Investment Officer of a large asset owner or an investment officer to a large asset owner.
Consulting is a great place to get trained and go in-house. It’s a great place to get trained and go into business management for the OCIO management industry. I’ve enjoyed it, I’m 30 years in and still learning things every day. I wished I’d known about it. My guidance counselors never told me about it. I got into it by accident. I feel very lucky and fortunate that I am in this part of the industry because it’s not well-known but it’s a great end to do with your career.
[00:57:19] AVH: Thank you, Rich. This is some really good advice, and I hope inspires some listeners to check out the investment consultancy industry. This is what we always try to do, right, to provide to people a look into certain parts of the industry they might not have heard from the guidance counselor or from the popular press before. So thank you so much for giving us an insight into your daily work, into this industry that is a huge, that is not much on the radar. Thank you so much for coming on the show, Rich.
[00:57:56] RN: Thanks, Andreas. Thanks for having me.
[END OF EPISODE]
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