The previous and present governments’ focus on cutting costs, cutting deficits and improving the governance standards of LGPS funds has put additional pressure on funds to perform.
The government has tasked the LGPS Advisory Board with creating a set of key performance indicators (KPIs) covering all aspects of LGPS funds’ work, in order to promote uniform standards across the scheme. From April 2013 the LGPS’ governance and administration came under the remit of The Pensions Regulator (TPR), adding to the pressure on standards.
However, early indications show that LGPS funds are well placed to respond.
Although officers have long maintained that the LGPS is one of the best-run public sector schemes, they recognise that there is room for improvement. There have been concerns that standards are not uniformly high, and that there is no coherent structure in place to improve funds when they fall behind.
In 2014, Surrey and Lambeth’s funds volunteered to take part in reviews organised by the Local Government Association (LGA) and carried out by independent pension scheme advisory firm Avida International.
Jeff Houston, head of pensions at the LGA and secretary of the LGPS Advisory Board, says: “The concept was to explore methods for measuring the effectiveness of governance in LGPS funds.
“Previous attempts have focused on objective measures (how many meetings, how big is the committee, etc) whereas this process added ‘on the ground’ views including the priorities of the committee, the division of time, the quality of supporting papers and the knowledge of committee members.
“We hope to encourage other LGPS funds to take similar steps to assess the quality of their own governance.”
The £2.8bn Surrey fund (all data based at 31 March 2014) had a funding ratio of 79% with a net cash flow of £50m and 84,767 members, of which 32,530 were active and 21,598 were pensioners.
The fund’s one-year investment return to 31 March 2014 was 8.5% against a benchmark of 7.1%. Its three-year investment return was an annualised 8.3% against a 7.3% benchmark, with the five-year annualised figures at 14.0% return against a 13.2% benchmark. Investment results were consistently above benchmark, Avida reported, and this was judged to be a benefit of good governance.
The fund invested 63% of its investments in equities, 13% in fixed income, 10% in diversified growth, 5% in property, 5% in private equity, 3% in absolute return and 1% in cash.
Avida’s analysis found that in most asset classes, the fund was paying within standard cost brackets; this included passive and active equities, private equity, and absolute return. Surrey appeared to be paying slightly above the average range for fixed income.
Surrey’s internal costs were also scrutinised. Its number of full-time employees (2.5) was “average to low” for a fund of Surrey’s size, while its administration costs of £27 per active or pensioner member was comparatively low.
Its annual spending on support services and office costs was average at £220,000, although its 2013-14 actuarial cost was high, Avida said.
In total, taking into account investment management and advisory fees and support costs, Surrey spent £16m per year, which Avida said left it with “scope for negotiation” with suppliers.
Phil Triggs, strategic finance manager for pension fund and treasury at Surrey CC, says that, as a result of the Avida study, a group of officers and board members undertook a review of the internal and external costs of the fund, including those investments where fund-of-funds structures and private equity did not fully disclose all fee types.
The group met with all the fund’s investment managers and suppliers over summer 2015 and will report back to the board in September with the results of revised fee negotiations.
On governance, Avida found Surrey’s performance to be good overall but with some areas of risk, which it recommended the fund officers addressed.
Avida said Surrey’s pension board had a “high level of dependence on a relatively small number of key people”, although it added that this “key man risk” was somewhat mitigated by delegation of some investment decisions via its use of diversified growth funds (DGFs).
Avida found that Surrey lacked sufficient insight into the costs of its private equity portfolio, although this was partially countered by the small size of Surrey’s exposure to the asset class and because it invested via an internally run fund-of-funds structure.
It added that Surrey received clear reporting from its officers, but that more could be done to take into account Surrey’s particular portfolio risks.
Surrey’s investment management charges were not excessive, Avida said. It added that its access to “scarce investment opportunities”, i.e. those in high demand and that could command extra returns, was evident in its private equity holdings but not elsewhere in the portfolio.
Surrey’s relationship with its employers was good, Avida said; 100% of employers asked by Avida said the fund kept them well-informed. On average, employers’ understanding of Surrey’s liabilities scored six out of ten, although Avida said this was dragged down by a few inexperienced officers at those organisations. Surrey’s formal reporting to its employers scored on average eight out of ten, while its informal communications scored seven out of ten.
Board members spent on average 17 hours per month on the fund. There was a broad range of hours spent by different members, from eight to 35 per month, although this reflected varying levels of expertise.
Avida found that, on the whole, Surrey’s pension fund was working well, appearing to be “very well organised” with board meetings well prepared and decision making properly supported. It said Surrey had “almost complete transparency” with scheme members, employers and taxpayers, and that its board received “comprehensive reporting” from investment managers. The board also underwent regular self-evaluation, and as a result of all this, investment results were “consistently above benchmark”.
Avida made a number of recommendations. It said the funding ratio “could be monitored in more detail” and “should be more explicitly used as a driver for decision making”.
An attribution analysis of changes to the funding ratio could help board members’ understanding of the fund’s sensitivity to external risk factors, and the board and officers’ expertise could be enhanced to meet the complexity of private equity and liability driven investment (LDI).
Mr Triggs says LDI had been implemented into the fund following extensive training of board members by officers and consultants.
The fund needed better analysis of transaction costs on bonds, equities, foreign exchange and transitions, and an ex-post analysis of investment decisions “would be beneficial”, Avida said.
Avida said that Surrey’s board spent 60% of its time on strategic issues in 2014, which was an improvement on 2013’s 50% but should be increased to 70%.
Mr Triggs says that the Avida study has been a very illuminating and worthwhile process.
He says he was pleased that the overall opinion on the governance and workings of the fund was positive, and was very keen to work with the consultant in implementing the improvements that were recommended, especially with regard to the transparency aspect of all fund costs.
“Such a comprehensive review of a LGPS fund by an expert consultant is quite rare, and it was a pleasure to work through the process and take advantage of the advice,” he added.
In the last 18 months the Lambeth fund underwent a total makeover in its personnel, strategic direction and structure, and so officers were particularly keen to see whether the changes had had the desired effect, Mr Houston said.
At the time of the review the fund had 19,000 members of which 5,000 were active and 6,500 were pensioners.
In terms of the fund size and investment returns, 2014-15 had been positive. At the end of March 2015 the fund’s assets stood at £1.1bn. The average local authority fund returned 7.9% over the three-year period to March 2015, whereas the Lambeth fund returned 10.7%, ahead of its benchmark of 4.5%. Further, the fund returned 10.5% in 2014-15. This equated to an additional £16.2m over the year compared to the return achieved by the average LGPS fund, and £109m above Lambeth’s specific benchmark set at the 2013 valuation.
The funding ratio at the 2013 valuation was 73% and although by the end of 2013 the funding ratio was 80%, this dropped back to 73% a few months later. As happens to all LGPS funds at some point, Lambeth not had “a very smooth ride”, Avida said. However, to address this risk the fund had since 2103 put in place premium stabilisation and derisking plans to help prevent this fluctuation.
Lambeth held 40% of its portfolio in active equities, 31% in fixed income credit, 10% in property, 7% each in hedge funds and absolute return or DGFs, 3% in private equity and 2% in cash.
Avida’s analysis of Lambeth’s investment management fees found that in most asset classes, the fund was paying within standard cost brackets. This included active equities, fixed income and absolute return.
Lambeth appeared to be paying slightly above the average for some active private equity and property. Following the Avida study the fund has looked at its property holding and its committee will consider new options in September. The fund has also negotiated a fee reduction on its private equity holding since the review.
Lambeth’s administration cost per head was average for a fund of its size, at £32 per active or deferred member.
Its spending on support services was average at £376,000 per year, while its actuarial, investment consultancy and custodian costs were low in comparison to the LGPS average.
Its investment team of 1.5 full-time employees was small for a fund of its size, having reduced from 3.5 eighteen months ago, Avida said.
Overall, Avida estimated Lambeth was paying £6m per year for investment management fees including portfolio and custody services.
Its total spending was £6.5m or 59bps per year, which left it with “scope for further negotiation”, Avida said.
Lambeth LBC treasury and pensions manager Andrien Meyers says: “The fund has almost 30% of its portfolio in alternatives and is using its bond allocation more effectively than before by implementing LDI.
“LAPF Investments magazine rated the fund sixth in the scheme for investment returns and performance at the time of the review, up from 97th the year before.
“Taking into account a well-diversified portfolio and consistently better than average returns, all for a cost of 59bps when most funds with similar allocations pay around 100bps, the fund is cost effective.”
Mr Meyers says in the past, Lambeth’s governance solely focused on investments with minimal scrutiny on other aspects, but that the Pensions Act 2013 was an opportunity for change.
The fund has created a new pensions committee and board with full decision making powers. The committee has responsibility for all matters including governance, investments, funding, accounting, employer and scheme member engagement, communications and administration.
Avida said the fund had adopted the right approach to governance.
However, Avida found Lambeth too suffered from a high level of dependence on one investment professional in its committee, a pensions officer and an independent adviser. It said Lambeth had “significant key man risk at officer level” but “limited investment expertise at wider committee level given [the] complexity of [the] portfolio”. However, Avida said this risk was mitigated to an extent by committee members receiving regular, independent and targeted training.
Board members on average spent six hours per month working on the fund, Avida found, which was “low compared to most funds”. Members’ knowledge of the funding ratio was good, but their understanding of sensitivity to risk factors was low. To address this issue, committee members are now presented with navigator and risk reports.
The report found that 40% of board members could estimate to within £3m Lambeth’s investment costs, which Avida said left “room for improvement”.
Lambeth’s fund, despite its relatively small size, scored highly on its access to scarce investment opportunities, thanks to its private equity, hedge funds and high-conviction equity managers.
Lambeth’s investment management charges were not excessive, Avida said. Its access to economies of scale was judged as “medium” with scope for further investment management savings, although Lambeth was praised its membership of the London Collective Investment Vehicle (CIV).
Avida said the committee must, when making decisions, have more focus on risk management, and that although this is understood at officer level, committee members would benefit from portfolio risk reports.
Avida said Lambeth should reduce the key man risk by hiring additional staff. It added the committee should focus less on operational issues such as presentations from fund managers and spend more time on strategic matters such as portfolio structure and risk management. The fund has since stopped regular fund manager presentations in favour of a “risk-based approach” for these meetings.
The fund should update its statement of investment principles to offer more decision-making guidance to the committee, Avida said.
All in all, Avida said that the Lambeth fund was “reasonably well-organised”. It praised the fund’s well-prepared committee meetings and documents, that the committee focused on costs, and its decision support structure comprising its investment statement of investment principles, knowledge and skills policy and responsible investment policy.
Its delegation of manager research to an investment adviser and of operational tasks away from the committee to the pension team was wise, Avida said, as was its delegation of tactical investment decisions to managers via its DGF and LDI strategies. As a result, its investment returns were consistently above benchmark.
Mr Meyers says: “The fund has been on quite a journey of change over the past 18 months, focusing on governance, risk management and engagement within the sector.
“The results of these changes are encouraging, with a new committee bringing better strategic focus, and changes to its investment and contribution strategy leading to better performance, reduced costs and being recognised for several awards over the last year.
“The ultimate validation of these changes was this review, the outcome of which has prompted Cipfa and DCLG to publically acknowledging the fund’s good work. The LGA intends to publish a ‘best in class’ guide for other funds to follow.”
Mr Houston says: “Both funds had lots of good things to report; in particular, effective meetings and decision-making was common to both while high levels of transparency and clear delegation were also commended.
“The requirement for improved competencies of committee members, especially in the more technical areas of investment, was highlighted. The tendency to focus on tactical rather than strategic investment issues was also noted for improvement.
“Both were encouraged to improve costs and fee structures through co-operation with other funds.”
However, Mr Houston adds: “I would imagine that most, if not all, of these would be replaced to some degree across the majority of LGPS funds.”
Mr Houston says the Advisory Board’s plans to improve standards across the scheme were unlikely to be as detailed as the reviews undertaken by Surrey and Lambeth, but that there was a great deal of value to be had from such an exercise.
“The board is working on its own set of KPIs covering all areas of a fund’s responsibilities and functions, which is currently being trailed with a view to a launch later this year.
“However, the methods used in these pilots are an effective way of determining either how much a fund might need to improve or how far they have come. Without seeking to promote the particular organisation we used, I would encourage all funds to seriously consider such an initiative.”