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We need flexible investment regulations

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Pensions are a big deal. They are a big deal for members and they are a big deal for employers.

The aim is to deliver a good scheme to members at an affordable and stable cost to the members and their employers. We are in the middle of a period of change. The new benefit package is now operational from April 2014 with the switch to a career average scheme from final salary, increases in employee contributions for the higher paid and retirement tied in to state pension age.

Following last year’s call for evidence process, the government has recently launched a consultation on the case for passive investment and the greater use of collective investment vehicles. The aim is to increase net investment returns and thus start to reduce deficits in LGPS funds. There are many examples of LGPS funds achieving excellent investment performance over the long term by the use of active management and surely no one would want to see the baby thrown out with the bathwater. However at the aggregate LGPS level, the evidence is that active management has not added to net returns.

Later this year, we will also see the government’s proposals for changing the way schemes are governed. Much of this activity is driven by affordability. From the mid-1970s to 2000, investment returns were exceptionally high and solved virtually whatever problem was thrown at pension schemes. The cost of schemes generally remained affordable and with some funds moved to contribution holidays, particularly in 1989 when the government said LGPS funds only needed to be 75% funded. Strains began to show in the mid-1990s, but from 2000 onwards, investment returns have overall been very disappointing from equities and the deficit problem has been compounded by very low long term interest rates that have driven up the value of liabilities assessed by actuaries. Higher deficits have fed through into higher employer contribution rates.

‘There are many examples of LGPS funds achieving excellent investment performannce… However, at the aggregate LGPS level, the evidence is not active management has not added to net returns’

There are no easy solutions to the deficit problem, but clearly the preferred solution or a contributor thereto is to have mechanisms in place that give the best chance of optimising net investment returns. An indicator of the importance of investment returns is that for my fund, a 1% additional investment return is worth more than 8% of current employees’ pay. The call for evidence and governance changes will be aim to be helpful in improving investment returns.

Another area that merits consideration are the regulations and rules that govern LGPS investments. The current LGPS investment regulations came into force in 1998. There have been several times when a fundamental review of the regulations was expected and LGPS funds continue to anticipate the publication of new regulations by the Department for Communities and Local Government. Some changes have been made such as headroom limits on investments that were introduced in November 2003 and further relatively minor changes that came into force with effect from January 2010 – namely:

  • The requirement for funds to have a bank account separate to that of the  administering authority;
  • The granting of explicit power to borrow; 
  • The requirement for the fund’s stocklending policy to be set out clearly in its published statement of investment principles.

These current limits have been retained by DCLG as a risk control tool. Other risk controls that have been introduced include the need a publish a SIP and a funding strategy statement, and a requirement to either comply with the revised Myners principles for investment decision making or explain non-compliance.

Pensions

Source: Alamy

The latest change in April 2013 was aimed at facilitating more LGPS investment in infrastructure. After a short consultation, DCLG amended the regulations to increase the headroom limit on investment in limited partnerships from 15% to 30%. We at LAPFF responded to that consultation and along with many other responders argued for a more fundamental review of the regulations.

The effective management and investment of pension funds is driven by a variety of factors. A balance needs to be struck between principles and detailed rules together with putting in place a framework that will help deliver good decision making. In the context of an investment industry that is innovative and changes rapidly, we believe that a single set of prescriptive regulations, with minor changes over time, is not appropriate or adequate.

The current LGPS investment regulations can be too prescriptive on certain issues such as the investment limits and the ban on derivatives. They are also silent on other issues, and open to interpretation, which can lead to ambiguity. The LGPS is the largest funded pension scheme in the UK and such ambiguity should be avoided to ensure that the scheme’s governance is both transparent and understandable to contributors, beneficiaries and not least the taxpayers who ultimately carry the financial responsibility for its solvency.  

By comparison, private sector scheme investment regulations are set up on the basis of a prudential framework and we believe a similar approach would be an appropriate basis on which to design new LGPS investment regulations.

Private sector regulations could be adapted as appropriate to reflect specific LGPS governance arrangements and to remove reference to those aspects of the European Commission’s Institutions for Occupational Retirement Provision Directive which cut across other aspects of LGPS specific regulation. We believe an appropriate set of high level investment regulations, accompanied by DCLG or other guidance, would be more flexible and beneficial than the current arrangements. The guidance however needs to be light touch or there will be limited benefit from moving on from the status quo. It will also be helpful for investment regulations to use current, Financial Conduct Authority-style language which should be consistent with the private sector pension scheme investment regulations. The fund management community would not then have to interpret two sets of investment regulations

‘The current LGPS invesment regulations can be too prescriptive on certain issues such as the investment limits and the ban on derivatives’

The requirements for diversification, suitable investments and proper advice continue to provide a solid platform for decision-making. The importance of investment returns to deficit management at both fund and individual employer level further reinforces the on-going need for such advice on investment strategy and its implementation. Such advice is available from many quarters, including fund managers, investment consultants, actuaries and, of course, the officers of the administering authority. The growing diversity of employers, reflected in their funding levels and liability profiles, is also resulting in some employers looking to participate in investment strategy issues. Thus proper advice remains crucial to ensure that the essential transparency and clarity referred to above is evident in the making of investment decisions.

In conclusion, plenty has changed within the LGPS recently and there is the potential for lots more change. The need to achieve beneficial investment performance has always been paramount for the LGPS and the current low-yield environment only adds to the challenge, making investment decisions even more difficult for all funds. We at the LAPFF appreciate the work that colleagues at DCLG, the Chartered Institute for Public Finance Accounting and the National Association of Pension Funds have already undertaken on potential new investment regulations and we are keen to see the momentum for appropriate change maintained, irrespective of the recent DCLG consultation.

Who knows what the outcome of the DCLG consultation will be? Will it mean that we need to change the investment regulations to permit 100% passive investment? If that is made compulsory, I doubt that there would be many throwing their hats in the air in celebration!

Kieran Quinn is chair of the Local Authority Pension Fund Forum

 

 

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