Written By: David Crum
David Crum of 330 Consulting offers some perspective on recent discussions over the future of the LGPS.
A very delicate subject for an article, don’t you think? And potentially quite a wide ranging topic too. I’m the first to admit that I’m not a pensions “expert”, and so I’m staying away from commenting on changes to benefits, accrual rates and the likes. But I have some experience of the governance and investment arrangements of LGPS funds, which forms the basis of what this article is about.
In the face of continuing speculation on the nature and cost of the investment arrangements of the 101 individual LGPS funds, is the LGPS sustainable in its current form? The answer, I believe, is no, it isn’t – but that doesn’t mean throwing in the towel and going down the superfund(s) route. I’m not so easily persuaded to give up on something that has been working pretty well for many, many years. It’s showing some signs of wear and tear at the moment, but that doesn’t mean it should be consigned to the scrap heap.
So, what’s wrong with the LGPS right now?
The two main accusations coming from the pro-merger camp appear to be as follows:
1) That there are too many small funds, with insufficient purchasing power and insufficient/insufficiently qualified internal resources to do a proper job of managing the investments. As a result, funds are paying too much for investment management services (where performance and remuneration are not appropriately linked), and are not making the most of all of the possible investment opportunities out there; and
2) That the governance arrangements of the individual funds contribute to the problem, with a lack of public scrutiny being part of the problem, and the charge of “a lack of accountability and clear authority” being made by the Centre for Policy Studies.
At the recent LAPF Strategic Investment Forum, the final panel session was entitled “How large a public sector can we afford?”, during which the promerger argument was again put forward. What I’ve heard so far from the promerger proponents is, perhaps unsurprisingly, not the whole story, and some key aspects of any potential merger scenario have not been raised. Let me come to that in a moment.
Before that, here are my comments on the different parts of the “inefficiency” argument being put forward:
Small fund size
There can be no argument that, relatively speaking, there are some “small” funds in the LGPS, although even the smallest LGPS fund (ignoring the Transport funds) weighing in at approximately £170 million is still quite large when compared against the universe of private sector pension schemes. Small, however, needn’t be the disadvantage that it’s made out to be, as I believe the nature of a fund’s governance arrangements is the critical factor in determining success.
Poor purchasing power
Like me, you might be initially attracted to the argument that small funds have relatively little purchasing power when it comes to investment management fees. That has almost certainly been true for some funds, but for others they make the most of the hand that they have been dealt, and use the public procurement process to create competition amongst investment managers via framework agreements. This can act as a reminder to managers that they’re relatively easily replaced, and need to remain competitive in all aspects of the service they provide.
The problem when considering purchasing power is that accurate, detailed data is not available on what each fund spends on all of its investment relationships. I believe that steps are being taken via a number of routes to try to remedy this, including through local pension fund group meetings. Let’s hope such steps succeed in getting the appropriate data, using it to help funds work out where they truly sit in the cost spectrum, and help identify which of the existing investment mandates needs to have its fees renegotiated or market tested.
I also hope for the success of national framework agreements, which I believe have the potential to do a lot of the heavy lifting when it comes to reducing costs. Why go through the turmoil of a superfund merger, when most of the cost savings can be achieved through the use of collective procurement agreements open to all LGPS funds?
Do larger teams generate better returns? I don’t know to be honest. Many funds combine the roles of pensions and treasury manager, and in the current climate of austerity, it might seem wrong to argue against this. However, pension funds (and I daresay treasury functions!) most certainly deserve dedicated resources, to ensure that both the investments and the elected members receive a decent level of attention. We don’t need to hire exbankers on million pound salaries to create “excellence”, but some more thought on resources wouldn’t go amiss.
Poor governance arrangements
I’ve often spoken of my fundamental belief in the “lay member” model of governance that exists in pensions committees, and indeed I’d rather have 101 lay committees than one board of “experts” any day – and I really mean that. However, I am concerned about the time spent by pensions committees in general on pension fund matters (four three-hour meetings a year on average), and more specifically the time spent on reviewing investment managers. I fundamentally believe that the task of manager monitoring should fall to a sub-committee, which can scrutinise the managers in more detail and with more time per manager. Such an approach would leave the pensions committee free to consider strategic matters – not operational investment matters – as the main business of each meeting. A pet peeve of mine, and I know I sound like a broken record on this point, but I believe addressing this issue is also fundamental to keeping the broad structure of the LGPS management arrangements as they are today.
Lack of public scrutiny
Over the last five years, I have regularly tried to find information on what individual funds do at their respective pensions committee meetings, and have regularly been thwarted by information being withheld from the public under the Local Government Act 1972, or something similar. Whilst I’m willing to accept that some information discussed at pensions committee meetings is sensitive and should be withheld from the public domain, other information – such as investment manager performance information, and overall fund investment performance – should not be withheld.
So, I don’t believe the investment arrangements of the LGPS are sustainable as they currently stand. I do, however, believe that the issues I’ve identified above from the specific “inefficiency” argument could be rectified quite easily, without the need for a merger of all 101 funds.
I mentioned earlier that in my view the pro-merger argument put forward so far is not the whole story – here’s what I believe has not been covered to date:
1. Transition costs.
Changing the shape of the assets from the 101 individual funds with several hundred existing investment manager relationships into a superfund(s) that resembled the investment preferences of the new body/bodies would not be an insignificant project, and indeed could be extremely costly. Given the uncertainty about what a future merged investment strategy might look like, it is understandably hard for people to estimate such a cost. However, in the interests of a balanced argument, it seems only fair that this is raised, since it will be a cost, and possibly a very large one. If UNISON are able to commission research into the potential savings that might come from a merged LGPS, then surely someone should equally be able to come up with a transition cost estimate using one of the large European or US public sector funds as a “target portfolio”?
2. Local disenfranchisement
Are we really willing to ride roughshod over the local democratic process, sacrifice the investment choices of locally-elected representatives, and make these preferences disappear into a large, London-based (if the jostling is to be believed) entity? Pensions committees up and down the land take investment decisions based on their own fund specific circumstances, and I fundamentally believe that that is the correct thing to do.
3. Lack of diversification
I’ve deliberately used this phrase as one of the main pillars of pension fund investing is diversification. Simply put, not having all your eggs in one basket. If this phrase has been around for hundreds, if not thousands of years in one form or another, and is still used today, then it must be a pretty fundamental concept. Why have one superfund? Or three or four megafunds? Why concentrate the risk in a very small number of entities and individuals? Currently, should one LGPS fund do something rash with its investment strategy, it will not bring down the other 100 funds. However, if we have a superfund created to form a “centre of excellence” run by “experts”, what happens if they do something stupid? Very clever people can occasionally do the wrong things – the banks are a recent example, but let’s not overlook the almost $1 billion losses incurred by the $200 billion California Public Employee Retirement System in 2009 as part of its internally managed securities lending programme.
4. Centralised control
Another aspect of concentration risk. With one board controlling the superfund, they will have immense power, but also will undoubtedly have immense political pressure placed upon them. If there had been an LGPS superfund in existence for the last five years, what are the odds that it would now be financing a significant amount of infrastructure and other similar projects in the UK right now – almost regardless of their potential return or risk? Where’s the check and balance to stop government taking the reins? Local decision making reduces this risk of this happening – centralising arrangements increases the risk, and makes me very uncomfortable.
It’s right that the sustainability of the LGPS is reviewed and questioned on a regular basis. But it should be done by hearing both sides of the argument, and with consideration of all potential costs, as well as benefits. Clearly, I’m very firmly of the view that the current arrangements, with a bit of work, will be good for the next decade or so. If markets recover and bond yields rise, the aggregate funding level will rise, and things won’t look quite so bad. They say it’s always darkest before the dawn.
I hope that those who will make the final decisions pause to reflect on the successes of the LGPS, and not just perceived areas of current weakness after a period of significant market stresses. There’s no reason why the current management setup can’t be brought bang up-to-date, with relatively little effort, for it to continue to serve both the scheme members and the taxpayers.