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What ups and downs face LGPS pooling in the future?

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With pools increasingly in operation, Peter Worth discusses the pros and cons of funds clubbing together on assets

Public sector pensions, including the Local Government Pension Scheme (LGPS), have been criticised in the past few years, with reports such as “local UK pensions schemes waste millions on high fees” and “costs are out of control in the death spiral LGPS”.

Like all generalisations, these claims are not entirely true. A total of 1.7 million people in the UK receive a local government pension and the LGPS plays a vital role in maintaining dignity and financial independence for retirees.

Investment management costs are small in percentage terms, at just under 0.5% of the fund value overall. This compares favourably with typical fees of 1%-1.5% for a personal pension plan or 0.75% for a workplace pension – the Department for Work & Pensions benchmark, though actual scheme fees may be more or less than this amount.

But the inconvenient truth is that the LGPS consists of 101 separate pension funds (12 in Scotland and 89 in England and Wales, ranging in size from £100m to £23bn). Investment costs vary greatly between them, in a way that cannot be explained by fund size alone. In 2016-17 investment costs ranged from less than 0.1% to more than 1% of fund values.

It was this disparity, and the sense that significant savings might be made, that prompted the then Department for Communities and Local Government in October 2013 to announce proposals to establish ‘national asset pools’ in England and Wales.

Depending on the existing mandates, fee savings of more than 10% per year can be obtained

Indeed, the government’s stated aim was that pooling should deliver “significantly reduced costs while maintaining overall investment performance”. This process led to the launch of the eight pools.

The boundaries for eight asset pools across England and Wales were finally agreed in July 2016, with the expectation that at least 70% of existing portfolios would be ‘transitioned’ to the new organisations within three years.

The Scottish government is still considering whether to follow a similar path, but with no new legislation spelling out the British government’s intentions, it was left to pension funds to come up with their own proposals for legal structures, operating models and governance.

Options were put forward and considered but it eventually became clear that government’s preferred choice was to have arrangements in place whereby investments were combined at operational fund management level, rather than joint arrangements for procurement, custodianship and contract monitoring.

As Phil Triggs, tri-borough director of treasury and pensions at Westminster City Council, has highlighted in a previous supplement, this lack of clarity meant a variety of different pooling models emerged.

Convincing the funds

A key challenge for asset pools is being able to provide adequate assurance back to the constituent pension committees. Transferring mandates to pooled funds can realise substantial fee savings for individual pension funds.

Depending on the existing mandates, fee savings of more than 10% per year can be obtained. However, notwithstanding the potential savings, some funds remain reluctant to transition assets, citing concerns regarding governance – a core issue for asset pools.

To encourage more pension funds to transition, asset pools must do more than simply copy what is available. Many funds are looking to invest in housing, transport and environmental projects that bring tangible benefits to local people as well as competitive returns. They would undoubtedly welcome new product offers from asset pools if they meet these criteria.

Any potential for savings needs to be considered against investment returns and benefits provided to members, as Charlotte Moore explores here.

There is a risk of over-emphasis on cost reduction. Cost, performance and risk are intertwined factors which need to be considered together. This has been reflected in the recently published Cipfa paper Proposals for LGPS Fund Reporting in a ‘Pooled World’.

The LGPS has a reputation for both investment performance and benefits paid, with fund values increasing by 26% during the past three years and pension increases linked to the consumer price index. Risk management is key to maintaining this track record, as funds need to balance short-term liquidity and long-term growth, ensuring they can afford liabilities crystallising 30-40 years in the future as well as next month’s pensioners’ bill.

For most funds, this can only be achieved by securing expert, but usually expensive, advice. Out of the top 10 LGPS performers in terms of asset growth in 2016/17, only three achieved this level of growth with lower than average investment costs.

We should not lose sight of the fact many funds are doing a good job for their members

In other words, you tend to get what you pay for, and many external fund managers are adding value in terms of investment return and consistency far more than the extra fees charged.

In addition to investment management fees and expenses, administration and governance arrangements cost the LGPS almost £200m nationally. Most funds in England and Wales are comparatively small, with 45% holding investments worth less than £2bn. Given the large fixed costs of running a pension scheme, costs per member are inevitably higher at smaller funds.

Administration costs per member at London boroughs average £39 per member (2016/17 DCLG SF3 returns), more than twice that of county funds (£18 per member) and metropolitan funds (£16 per member). This is simply because provincial funds are five to seven times larger and can achieve economies of scale without cutting service quality.

Keeping it local

Expanding the role of asset pools by adding on administration and governance tasks to investment management would therefore seem attractive. But this would require significant legislative change, for which there is currently little appetite.

Retaining the current legal structure but improving joint working could achieve the same end without the need for further structural change. It could also benefit employing bodies by allowing funding strategies, asset allocation policies and contribution rates to reflect the significant local variations in member and pensioner profiles – in other words, keeping the ‘local’ in LGPS.

Many funds already have some outsourcing, agency or shared service working in place but it is fragmented. Extending combined administration and governance arrangements to smaller pension funds on a similar scale to pooling of investment management could not only generate financial savings through economies of scale but also open significant non-financial benefits.

These could include:

  • Capacity to develop specialist expertise at both officer and member level
  • More resilient services that do not hinge on one or two key members of staff who may suddenly leave or become incapacitated
  • The chance to improve the quality of pensions administration, and the accuracy of membership records, both of which are patchy
  • More clarity about the service levels members and pensioners should expect
  • Separation of funds from their parent local authorities, improving segregation of duties and internal control

Joint working at this level would also enable the LGPS to consider more in-house investment management. Currently only 15 schemes employ this option, which is not feasible for smaller funds but is a good way of developing market knowledge and expertise.

It can also potentially reduce fees. Funds managing investments in-house on average spend one third less than those relying entirely on commissioned services.

Weighing it up

So where does this leave us in terms of the government’s pooling initiative? Ultimately, is it to be welcomed or not? I would argue there are three key points.

First, the asset pools will save money for the funds choosing to invest in them but current transition targets are unrealistic and a lack of clarity at the outset has frustrated practitioners and got the whole process off to a shaky start.

Going forward, pools will be much more successful if they focus on bringing a new and distinctive offer to the market, which meets the needs of published investment strategies rather than replicating what is available.

Second, the current one-size-fits-all approach focuses too much on investment costs, ignoring both the returns these fees generate and the granularity of current performance across the sector.

Those funds with higher than average costs need to demonstrate that their fund managers are generating higher or more consistent returns.

Some pension funds are performing better than others and a concerted effort to bring everyone up to the standards of the best is long overdue. At the same time, we should not lose sight of the fact many funds are doing a good job for their members, actively seeking attractive investment opportunities and outperforming the market at a modest cost.

Third, there is scope to build upon existing outsourced, agency and shared service arrangements to combine administration and oversight functions at smaller pension funds in England and Wales. This would provide opportunities not just for financial savings but also for higher quality and more resilient services.

Peter Worth, independent consultant, Cipfa associate, and managing director, Worth Technical Accounting Solutions

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