The government’s July Budget document on pooling requirements for local government pension scheme funds has raised a range of practical issues.
Number of pools and choice in their use
State Street Global Advisors’ recording of LGPS funds categorises assets into approximately 26 separate areas, but active and passive management are included in the same category.
Therefore, without considering the various passive approaches and range of active management arrangements, there are significantly more than 50 types of assets and types of manager being used. Government proposals indicate they expect a very significant reduction in this number. Quoted equity and bond assets will be the most affected by asset distribution with 80% of LGPS assets held in these two asset classes.
If funds are to continue to be given freedom to determine asset allocation locally, there is a conflict with only having a small number of asset pools (as indicated by government) to use, relative to the range of investment management briefs used currently.
The changes will have a significant impact on LGPS funds, their advisors and fund managers. There will be much reduced fee income for the latter two and restrictions on a fund implementing its asset allocation strategies compared with the current position.
Vehicles for asset pools
Various vehicles and arrangements could be used for creating the LGPS asset pools, for example:
- special purpose vehicles
- framework arrangements
- nominated suppliers
- in-house management
All have their advantages and disadvantages when issues such as costs, ease of use, accountability, management requirements and operating arrangements are considered. There will be many views on what is most suitable for funds.
A related issue will be the nature of the pool. Again a range of options are available including:
- a bespoke LGPS fund in which funds purchase units
- a fund manager running a segregated fund for the LGPS
Performance management of the asset pool and its manager needs to be considered particularly the level at which it operates. Does each LGPS fund in the pool carry out its own management as at present, or is it done for them by a third party, or a selected group of funds on behalf of all funds? The arrangements must ensure funds can discharge their statutory responsibilities adequately in terms of managing their investments.
Defining and maintaining a pool
There is the potential for much debate over the definition of a pool and its boundaries. These will include assets allowed in the pool, the vehicles permitted and the investment management approach to investing the pool assets. A number of questions are raised, such as can a pool have a number of different sub-pools, for example can quoted equities have a different sub-pool (and possibly manager) on a regional or country basis? Can funds select their own make-up of sub-funds?
Associated asset management functions to be carried out
The following associated asset management functions need to be considered and discharged in any pooling arrangement:
- custody of assets
- stock lending
- corporate governance of underlying asset
- liquidity and dealing restrictions
- legal documentation and responsibilities between the council responsible for the fund and the pool (pool manager or pool vehicle)
Individual funds are to retain responsibility for asset allocation and presumable short-term tactical asset allocation. Their options will, however, need to be limited if the number of pools are to be contained to a relative small number.
For example, they may currently determine a percentage allocation to equities and a split by region/country divided between passive and active. Under the proposed changes they will, however, probably have only one or two active options and one or two approaches based on passive indexing. They will not be able to select indices for passive and differing levels of active management. If sub-pools were permitted it may be feasible to allow greater choice with funds selecting differing proportions of sub pools. Asset allocations will nevertheless become more uniform.
Liquidity in a pool will be important as well as cash flow management. Will cash have a separate asset pool?
Are all assets suitable for pooling?
Liquid quoted assets are relatively easy to pool eg equities and bonds. This represents around 80% of assets. For some assets it is possible to establish pools for new investments such as property, hedge funds, private equity, but such assets currently held are not easily pooled, not least because of valuation issues and committed future payments. Management costs for these assets are likely to be high.
A practical option would be to exclude certain assets and control the position with a discretionary percentage for funds, say 10 or 15% of assets, to be excluded from compulsory pooling. Another option is to have new money only in these investments being pooled.
Some funds undertake currency hedging. Is this a management option outside pooling?
Funds are increasingly seeking suitable local investments. Should they be allowed a percentage of their assets outside the pooling arrangements to undertake such activity, say 5 or 10%?
Are there any general exemptions to investment pooling requirements?
If a fund meets a level of performance that could be adversely affected by pooling, a case could be made that they should be given more freedom not to use the pools. At the other end of the performance range, poorly performing funds should be restricted on any freedom from pooling. Performance would need to be driven by medium- to long-term returns together with management and operating costs.
How will pool requirements work as funds mature at differing rates and need more specialised investments to lower risk?
Objectives of pooling
It is easy to lose sight of what the government is trying to achieve due to the range and complexity of the issues. When the issues are being considered it will be important to have an agreed set of objectives, which could include:
- ensuring investment management is cost effective for all funds
- assets are effectively managed and statuary responsibilities met
- no detriment to high performing funds
- poor performing funds to be helped
- LGPS can continue its work in leading on issues such as corporate governance, establishing new asset classes, using local knowledge to select investments that otherwise may be missed
- LGPS can make a meaningful contribution to national challenges where appropriate and practical eg. infrastructure, housing, local economic regeneration
- any changes support and meet the Kay review recommendations.
Brian Bailey, non-executive chairman, Pensions & Investment Research Consultants. Mr Bailey was director of the West Midlands Pension Fund for 25 years