Michael O’Higgins describes the chairmanship of the Local Pensions Partnership as a “tailor-made” role for him given his background and beliefs.
As a former chair of both the Audit Commission and The Pensions Regulator, Mr O’Higgins’ professional experience is relevant to running the £13bn pool but he adds: “I’ve believed for a long time that [pooling] is the right thing to do”.
“Before I chaired the Audit Commission, [it] released a report in 2006 that said London councils could save back-office costs of about £20m per year if they co-operated,” he says. “When I was at TPR, we had data that made it quite clear that pools or larger funds tended to have lower costs and better performance. It’s not a universal rule but on average bigger funds were better governed and had lower costs and better returns.”
The LPP has a distinctly different governance system to other pools. Its model provides the participating funds’ pension committees with less direct control over fund manager choice than any other collaborative vehicle although they will retain control over strategic asset allocation.
The London Pension Fund Authority does not run a pension fund for employees of a particular council but for people who worked for organisations such as the Greater London Council, the Inner London Education Authority, and a variety of third sector organisations.
As such, it does not have a committee of elected members, unlike its pool partners, Lancashire and Berkshire, the latter of which formally agreed to join the vehicle in November.
Lancashire and the LPFA are shareholders in the LPP holding company. This in turn owns two companies: LPP Investments, a fund management company regulated by the Financial Conduct Authority, and LPP Administration. Each of the three companies has its own board, and there is an executive committee that oversees the entire operation.
Mr O’Higgins says the shareholders – the pension funds – set their broad investment strategies but are “insulated” from the detailed decisions over which asset managers to employ.
He said the pooling of the two founder funds’ £5bn in global equity holdings in November 2016 provided an example of how the process works. “Before we pooled, we had seven external managers, plus we did some internal management,” he says. “We chose three managers and increased our own internally managed stake to 40%, so we manage a bit over £2bn internally and three external managers manage £1bn each. We saved £7.5m per year on investment manager fees just by that act itself.
“There was no involvement by the councillors in that decision-making, there was no involvement by the board of LPP. What we have done is create, underneath the main board structure, the LPP investment board, which has no shareholders on it, and underneath that an investment committee which is executive-led. The investment committee made a decision and made recommendations to the LPP Investment company board.
“It was insulated from shareholders but there was a process that shareholders understood and knew was going to take place and be observed by the FCA-regulated LPP Investment board.”
Mr O’Higgins says elected members on Lancashire’s pension committee are “strong believers” in this model.
“They don’t see their role as making investment manager decisions,” he says. “There is no sense that we’re giving them any choice or that we present them with a list of options or tell them when we’re deselecting a fund manager; we don’t operate like that.
“Their role is to hold us to account for delivering on performance, ensuring members’ benefits are paid and councils’ contributions don’t have to rise too rapidly. The strategic asset allocation decisions rest with our shareholders, although we do advise on that. So, if they said, ‘we want 99% in emerging markets’, we might say, ‘can we have a discussion about that?’”
This model, Mr O’Higgins says, “has enabled us to move very rapidly in pooling”.
“We now have four [sub-funds], apart from the global equity portfolio: global infrastructure, private equity and credit. We have pooled £9.6bn of assets so far,” he says.
Mr O’Higgins says the LPP’s investment philosophy, particularly on alternative fixed income, matches well with his own. When chair of the regulator, Mr O’Higgins coined the phrase “reckless prudence” in relation to pension schemes’ traditional view of gilts as low-risk investments because they offer a guaranteed return. It was and remains his belief that although gilts and other traditional forms of fixed income provide a guaranteed pay-back, this is now so low – or in some cases, negative – that funds investing in these assets open themselves up to the risk of missing out on higher returns or better income available elsewhere.
“You need to invest in alternatives of a sort, alternative fixed income: infrastructure, property. I called it ‘recklessly prudent’ – just investing in fixed income when there was no return,” he says.
“If you look at our funds, we have less than 1% in traditional fixed income, which is very unusual in the local government space because advisors keep telling you stay safe. That’s what investing in infrastructure projects or the right property projects can get you; you’re matching your liabilities but you’re getting a return,” he explains.
Prior to the creation of the LPP, the LPFA and the Greater Manchester Pension Fund (part of the Northern Pool) set up a shared vehicle for infrastructure investing. GLIL, as this vehicle is known, now includes the other two members of the Northern Pool, Merseyside and West Yorkshire and Lancashire. Berkshire, though scheduled to join LPP, may not necessarily join GLIL.
GLIL is primarily focused on UK infrastructure, while a separate infrastructure vehicle within LPP is reserved for global infrastructure opportunities.
“In LPP, of our total portfolio, about 10% is in infrastructure, which is quite high compared to others and probably closer to what the government thinks it should be – but we’re not doing it because the government thinks that,” Mr O’Higgins explains.
He adds GLIL will announce “further developments” in 2018: “We would hope to make it available to other LGPS funds and pools.
“There’s widespread agreement that each pool should not try and be an expert in everything,” Mr O’Higgins says.
“Therefore, if people want to invest in infrastructure through GLIL or through the other platform, that makes more sense to me than everybody trying to develop expertise in each area because there aren’t enough experts in the LGPS to go around to cover private equity eight times, to cover infrastructure.”
Current thinking within the LGPS is that a central platform for infrastructure, via which all funds or pools will invest, will be developed eventually. Mr O’Higgins said this could be GLIL “or a different mechanism; time will tell”.
“There are governance issues to be sorted out,” he says. “At the moment, the other pools are busy dealing with the nuts and bolts of pooling. When they come through that, we’ll begin to look at how we deal with governance issues around an infrastructure pool; is it run by one pool on behalf of the others? Where does accountability lie, and how do you get the accountability lines right?”
That said, Mr O’Higgins is very clear that setting up separate governance structures for each collaborative investment between funds or pools would be a mistake.
“If you imagine Brunel and LPP co-operating on an investment, we each have our own governance structures, so if you then create another governance structure for some shared investment, that works fine if it’s one, but if you replicate that across every co-operation between different pools, you’ll be spending an awful lot of time in meetings,” he says.
Real assets present a great opportunity for pension funds, Mr O’Higgins says, but funds should think carefully about the nature of the investments on offer.
“Pension funds need to be careful about greenfield innovation because that’s where you can lose money quite fast,” he says.
“The things that work better for pension funds are where the income stream is relatively well established. Where we have bought into things it’s usually where somebody else has had the investment for a while, it has matured to a certain level, it’s going to give a return of 6% for the next 25 years, and they want to take their capital and do something more exciting with it. We think that’s a good place to park our capital.
“I’m not sure LGPS funds are going to be a source for investing innovation, but where I think they might be [a source of funding] is around the housing space. [There is] housing, transport, energy, all the utilities, where you can see the possibility of income streams that meet the liabilities we have.”
Mr O’Higgins says early conversations about this type of investment are already under way.
“I’ve had discussions with the mayor of London’s advisor on housing and whether there’s a role [for pension funds]; it’s potentially doing something in London with the London CIV,” he says.
“There are significant parts of regeneration around the country. If HS2 goes ahead, there will be massive regeneration around the centre of Leeds, for example. We don’t want London only investing in London or Manchester only investing in Manchester because that runs the risk of politicised investments, but if we co-invest, and make sure there are several pairs of eyes looking at if this is a sensible investment, you can do socially useful things at the same time as making a return for members.”