A report from the Centre for Policy Studies has renewed interest in the fees LGPS funds pay to investment managers.
The LGPS: A Lost Decade is the latest in a long line on public sector pension costs from research fellow and former investment banker Michael Johnson.
Mr Johnson, who worked with the Treasury on pensions policy under David Cameron’s government, claims LGPS funds’ use of active asset managers over the past 10 years has been an “expensive folly” that produced lower returns at a higher cost than cheaper passive and/or in-house investing would have done.
However, LGPS experts claim Mr Johnson’s report is inaccurate.
The paper said that, allowing for differences in how individual LGPS funds report their returns, the LGPS as a whole had a nominal return of 67% over the past 10 years (5.3% per year), or a real (inflation adjusted) return of 31% over the decade or 2.7% per year.
The report claimed this was unimpressive when compared with various indices. Nominal returns over the same decade for the FTSE All-World Index of equities were 121%, while the World Government Bond Index returned 106% over the decade, it said. “It is evident that, in all cases, the indices performed better than the LGPS’ fund managers,” Mr Johnson wrote.
“This is a strong endorsement of passive fund management, and it would have led to smaller funding deficits than today’s reality. In addition, it would have been a lot cheaper, and considerably simpler, to implement.”
However, Chris Bilsland, non-executive director of the London Collective Investment Vehicle, says Mr Johnson’s calculations do not compare like with like.
“Trying to assess the added value of active managers by comparing the quantum value of investments over a fixed period is simply too simplistic and likely to be flawed,” says Mr Bilsland.
He said investment returns were dictated more by asset allocation decisions made by pension fund committees, which may be taken for strategic or ethical reasons, than by investment managers selecting stock on behalf of the funds.
He added: “The active managers cannot be blamed for that.”
“Also demographic changes are bound to have had an impact. For example, because of shrinkage in the workforce, funds have begun to move into negative cash flow. This results in dividends being retained or even assets having to be sold to meet the liabilities. So it’s not a like for like comparison if this has not been allowed for.”
Mr Johnson called in his report for the LGPS to replace all of its actively managed listed assets with passively managed funds, on the grounds that it would achieve the same if not better returns.
However, John Raisin, an independent adviser who works with Haringey, Waltham Forest and Barking & Dagenham’s fund committees, says this would not be the case.
“The question of whether listed assets across the LGPS should be passively managed was considered by the government in 2014-15 and rejected,” says Mr Raisin, referring to DCLG’s consultation on collaboration and cost reduction, which resulted in the pooling initiative.
“Furthermore the replacement of all actively managed bond portfolios, which would be a consequence of Mr Johnson’s proposal, would be a completely inappropriate approach as it has a number of fundamental weaknesses.
“For example, the largest weighting in a market capitalisation-weighted bond index is given to those who are the most indebted. This leads to the concentration of risk. The duration of a market capitalisation-weighted bond index will vary over time in a manner which is not necessarily advantageous to holders. For bonds or fixed income, active investment strategies such as multi-sector credit/absolute return strategies are far more appropriate.”
The report claimed fund management costs were “utterly shocking”, did not represent value for money and were likely grossly underreported in any case.
Using the Department for Communities & Local Government’s 2015-16 data on LGPS costs, Mr Johnson asserted that funds paid £802m in fund management costs in that year, an increase of 277% from the 2006 cost.
LGPS costs data
Mr Johnson added that it was “reasonable” to assume that many costs were not properly accounted for and that these would amount to £1.45bn over the decade.
He also said that the LGPS “has never collected, let alone reported, performance fees its funds have paid to ‘alternative assets’ fund managers”, through which the scheme (including the Scottish and Northern Irish funds) invest £10.5bn in private equity, £5.4bn in hedge funds and £3.4bn in other alternatives.
Were the LGPS to run its private equity investments itself, it could avoid paying £200m per year in performance-related fees (as opposed to fees relating to the size of mandates), Mr Johnson said. Running its own hedge funds portfolios could save the scheme £100m per year, and the cost of outsourcing alternative investments has racked up a bill of a maximum of £2.5bn, Mr Johnson said.
But Mr Bilsland rejects these claims. “In principle, [Mr Johnson] is correct that manager fees have probably not been consistently and fully disclosed and accounted for in the past by all funds; hence the intervention of the LGPS Advisory Board and the Chartered Institute of Public Finance & Accountancy in issuing new guidance,” he says.
Cipfa stated in 2015 that seemingly extreme increases in costs for some LGPS funds could be explained by new reporting guidance which required them to count and record costs differently.
Mr Bilsland adds: “It’s hard to calculate what the quantum [of unreported fees] is but I would be very surprised if it was anything like as much as claimed by the CPS as the main omission has been some performance fees, which are only a minor proportion of overall fees.”
Mr Johnson said in his report that the current group of eight LGPS pools should, by 2023, be “whittled down” to three based on which perform best. He also urged the government to scrap local governance of the funds, currently delivered through administering authorities’ committees, local pension boards and section 151 officers, and replace it with one independent governance committee for each pool.
But Mr Raisin says Mr Johnson’s claim that current governance arrangements were “labyrinthine” was wrong, and that it was essential that governance remained at a local level.
“The governance arrangements of the LGPS were thoroughly reviewed as part of the Hutton Review of 2010-2011 and parliament subsequently passed the Public Service Pensions Act 2013 which enhanced governance arrangements in the LGPS,” Mr Raisin says.
“The establishment of the LGPS Scheme Advisory Board and local pension boards both provide mechanisms for clearly enhancing the governance and administration of the LGPS at a national and local level.”
He adds: “The government has given much attention to the investment arrangements in the LGPS since 2013 and as a result of this has determined that individual administering authorities should remain responsible for investment strategy but that the implementation of that strategy should be carried out by a number of pools.”
Mr Johnson has been known to be influential with central government on broader areas of pension policy, such as changes to the tax treatment of individual pension pots.
However, following the overhaul of the LGPS’ benefits structure in 2014, and then the government’s long and bitter battle over consolidation of investments, it is understood that DCLG has little appetite for further drastic changes, at least until this phase of the pooling project is complete.