Written By: Susana Dias
Susana Dias of BNP Paribas looks into the challenges and opportunities faced by local authorities as the new pooling regime is formulated
Last year was probably one of the busiest in the history of local authorities. On top of the year end in March came the triennial valuation, and then came the non-trivial matter of forming a pooling arrangement and the substantive submission in July. It is astonishing what schemes have achieved in this time. The pooling train has left the station and now the focus shifts to April 2018, the key date to be operational. What “operational” means is subject to debate, although the government has confirmed that the pool’s authorisation by the Financial Conduct Authority (FCA) is a requirement.
One size does not fit all
Decisions made in the next couple of years will shape the long-term set up of the pools and influence the performance of the pension funds. One of the first key decisions was about the structure of the pooling arrangement. The most common choice was for an Authorised Contractual Scheme (ACS) although some chose an alternative model. Several considerations would have influenced this choice. The need for a management company to administer the ACS and the cost, time and resources involved could have steered some pools down a different track of implementing an ACS solution for the London CIV was around £2-2.5 million.¹ For those that have gone the ACS route, the next decision was about renting or building themselves. There are a limited number of management companies with the appropriate scale for a £30 billion fund, and one of those has recently put its asset servicing business up for sale. Building your own management company may have commercial attractions, and would allow the pools to leverage their in-house expertise to staff the FCA-regulated entity.
Tax transparent funds – nothing new
In 2013 the UK government gave the green light to the ACS, a tax transparent fund which allows withholding tax to be applied at investor level instead of fund level while retaining tax efficiencies. Some countries in Europe established these structures a long time ago. The Irish Common Contractual Fund (CCF) has been around since 2003 and can avail itself of tax transparency in over 20 markets of investment.
Pools will require a new spectrum of services e.g. daily fund valuations, investor recordkeeping and depositary. Global custodians have a long experience of delivering these services to asset managers and are in a good position to assist pools in navigating new requirements. However, operating and service models, and systems and data delivery capabilities are different across providers.
With greater scale to invest in alternatives such as infrastructure and direct property, selecting a partner who supports the full breadth of alternative investments and fund structures becomes key. Taking depositary services as an example, ensuring efficient legal processes to register assets will impact effort and the underlying security of assets. So understanding these nuances becomes important for pools.
With FCA registration comes a new swathe of regulation to understand. No other sector, not even pensions, has enjoyed as much regulatory attention as fund companies. Partnering with a provider that has the knowledge of new regulations and can help ensure the new operating model is future proofed against these changes will be important. For example, new European Securities and Markets Authority regulations are concerned with depositary oversight and how assets are segregated.
New stakeholders – new requirements
Whichever model the pools decide on, the stakeholder landscape will be reconfigured. It is likely to be more complex with layers of governance and decision-making. The stakeholders, including the local authorities, oversight boards and management company have new functions and responsibilities and different needs to be met.
Risk and investment performance will need to be considered by multiple stakeholders; this would include integrating assets held outside of pooling collaborations, and possibly more complex asset classes. This all puts a spotlight on reporting to a greater level than was previously required from the LGPS. Access to the right data at the right time becomes paramount. How are the different strategies performing? How are individual managers performing? What are the key risks across the portfolio? What is the exposure to particular events or counterparties? Having an holistic view of the portfolio will help identify non-performing investments, optimise strategies across asset classes or segments, and identify risks. As local authorities will continue to receive freedom of information requests, being able to respond to requests when the portfolio data is all in one place will make the process quicker and less cumbersome.
Oversight boards will need to engage with the management company that will be accountable for investment performance. With oversight boards representing multiple LGPS, they will need to “slice and dice” data, looking at investments top down and bottom up as needed. Although the current reporting cycle is monthly, the new world could offer the opportunity to assess this daily.
The management company will require its own risk and compliance functions, and therefore have its own data requirements to support manager review and selection. As an FCA regulated entity, additional compliance, risk and reporting requirements to the regulator, including Annex IV reporting, will be expected on a regular basis.
DIY or outsourcing
Managing assets in-house is not new for the LGPS, and there are several examples of strong investment performance and cost effectiveness within the sector. Internally-managed LGPS funds have on average outperformed externally-managed LGPS funds by over 0.5% per annum (after fees) over the last 28 years.1 Pooling offers the opportunity to retain and strengthen this expertise in-house and maintain that performance track record, but will need to incorporate that performance into the newly formed entities.
Over the last decade, operating models have evolved considerably. New front- and middle-office platforms have emerged as outsourcing strategies have become more sophisticated, which can be influenced by cost considerations as well as what is considered a core competence. Best practices have emerged, and case studies exist showing what has worked well – and where the wreckages lie. Selecting an efficient IT platform, which underpins the aforementioned data delivery, is the lifeblood for a fund manager. Managing money in-house requires access to timely investment data to support the investment process. Some schemes may have been able to support this historically with basic data management tools. However, in a new regulated environment, a more robust tech platform will be required. Understanding differences between investment book of records (ibor) to support trading, and accounting book of records (abor) for reporting, become important considerations.
New challenges – new opportunities
The past year has been an enormous strain on an already-lean LGPS sector, and to say this has stretched them would be an understatement. So the challenges are manifold. From the outset, achieving cost savings was a key driver for the pooling initiative. Increased scale will enable, and anecdotally already has enabled, cost savings when considering investment management fees, but potential benefits extend beyond cost.
Increased total AUM creates opportunities to invest in specific asset classes not previously feasible for most schemes. Infrastructure – being the obvious example – is widely argued to have the right income and inflation-linked profile, and be an appropriate asset class for long-term investors such as the LGPS. LGPS funds currently invest around 1% in infrastructure compared to larger funds who invest approximately 5%.1 That said, examples of partnerships to invest in infrastructure already exist (e.g. The London Pensions Fund Authority and Greater Manchester Pension Fund) and they would argue it did not require pooling to achieve that. Indeed, the idea of an infrastructure investment platform for the LGPS sector has been suggested for some time.
There is an opportunity to create a future-proofed investment platform, with an upgrade in technology and reporting to further enhance risk and performance measurement. There are new drivers for embracing environmental, social and governance into portfolios, and the timing is perfect for schemes to use these approaches in their own setup. The balance is getting an already complex “day 1” set up, and ensuring the platform is scaleable and able to incorporate new investment ideas in order to deliver future benefits. With investment regulations now covering the use of derivatives, these new investment opportunities exist. But again, accessing these opportunities requires more complex understanding, processing and risk oversight.
Most people would agree that the pooling train has left the station and everyone is on board. The crew is being assembled and now the process to select partners starts. The good news is the market is not short of knowledgeable people willing to stay on the train for the whole journey.
1. Does not provide investment advice or recommendations