Written By: Steve Webster
Steve Webster of MJ Hudson Allenbridge looks at the various factors which Local Government Pension Schemes have to consider as they go through the complex process of asset pooling
Three years in the planning, give or take, and for most LGPS the prospect of pooling assets begins to become a reality in 2018. For some, the exercise of reformation started a few years ago with mixed results. However, this experience, if nothing else, should provide valuable lessons for those starting their journey this year.
The pooling of assets is designed to provide long-term savings to the pension schemes, in terms of both administrative and investment costs, and it is clear that a simple deduplication of effort and increased economies of scale must reap rewards. Beyond this, however, is the question of value add and what, if any, enhancement pooling will provide to overall risk-adjusted returns and access to previously unobtainable asset exposures.
However, before designing the future, there is the tricky business of getting there. The process of merging LGPS assets into their respective Pools should in theory be pretty straightforward, but only when you dig a little deeper do you start to reveal some of the challenges which Pools face in making these transitions. The decisions made now will impact cost, future performance, resource requirements, and relationships with member schemes. Prompt and effective planning by Pools and LGPS alike will be critical for future success.
So first, the costs. The initial estimates of transition costs from the combined submissions made to the government in 2016 range from £200 million to £320 million¹ which is large compared to the total proposed savings or planned operating costs for running the Pools, but pretty small when compared to total AUM (13bps). So do these costs matter? If counted as investment risk then 13bps is pretty much background noise to overall investment performance, but as a hard dollar (sterling) expense, it’s a different story. The truth is that transition is an exercise in effecting change and not in generating returns, so any costs in making these changes are a bottom line expense which reduces the potential future value of assets. These expenses are separated into fixed costs (dealing commissions, taxes, fees) and implicit costs (market impact and spreads) and, as we can see above, these can vary significantly depending on transition strategy, constraints, and the risk exposure of assets during transition. What is clear is that the cost of change is a measurable and accountable expense regardless of its origin and thus requires appropriate management and oversight.
Managing a typical transition process requires skill and experience and, in the case of pooling, a bit of diplomacy. One constraint unique to pooling is the balance between the fairness of allocating transition expense and the overall cost. You might expect that when you combine multiple clients into a transition, each participant fund will naturally be subject to the same proportional expenses, but that’s far from the truth. In reality there will be losers, where the incumbent investments have little commonality with the Pool offering, and winners, where there is no change. The approach most likely to be adopted by Pools is to ensure that all member funds share costs proportionally regardless of their legacy investments, which, while ensuring there is no cry of “foul play”, does place constraints on the process which may actually increase overall costs. In truth without knowing what is possible, it’s tough to measure the costs of what is probable. Knowledge of the lowest possible cost and risk transition or “best case scenario” reveals the excess costs and risks arising from these “operational” constraints and helps justify the chosen approach.
Resource and responsibility will also be key constraints on the transition exercise, not least because the likely approach to transitioning assets will be very different to that previously experienced by local authority pension funds. Whilst the local authority remains the client in the process, the appointment of transition managers and responsibility for oversight will likely pass to the Pool manager. This makes sense when you consider the nature of the exercise, but does create pressures on the Pool operator and pension fund alike. The Pool manager will be a new entity, with new staff, controls, and operating procedures, managing an investment exercise which is likely to be a new experience for all involved. The pension fund which retains fiduciary responsibility for the exercise is likely to be less well-resourced as a function of duties migrating to the Pool managers, but nevertheless will need to retain their ability to approve and understand the costs they have incurred. This question of responsibility and accountability may have even greater importance now all local authority pension funds have become private clients under MiFID II. Although nearly all will have independently agreed to be “opted back up” to professional client, this arrangement is a test of “relevant experience”, which if it subsequently fails, will raise serious questions about the responsibility and accountability of unintended or misunderstood costs. Appropriate and independent advice to all concerned will, if nothing else, show an acknowledgment of the challenges faced and the need to apply a level of experience in solving these challenges and interpreting the results.
Executing the migration of assets to the Pool will most likely be managed by a transition manager. Most LGPS funds have first-hand experience of these service providers and most will also attest to the difficulty in deciding on which to use and, subsequently, deciphering their transition reporting. That said, the services provided by transition managers tend to be good value for money, given that the complexity of the offering is often remunerated with no more than a typical broker commission. However the description I tend to hear most from LGPS funds when describing transition managers and their practices is “dark arts”, which I’m sure is intended as a compliment to their ingenuity, but may equally refer to a perceived opaque complexity in the work of transition managers. Whilst this level of complexity might be of concern, looking beyond the headline measures of performance is key to understanding how successful a transition has been.
The typical measure of performance is “implementation shortfall” which, in short, deducts the change in value of all purchases from all sales. If, as estimated, the total realised shortfall for the entire pooling exercise was £250 million, then the next question will be “is this good or bad?” A comparison of this number to what was estimated is one simple way to determine this. However, whilst the transition manager controls the speed of execution, they have limited control over risk exposure and, in particular, how markets may move during these changes. If during the transition the market moved in favour of the Pool’s changes, then £250 million could be a terrible result, whereas if the market moved against the Pool’s changes, the opposite might be said. Or to use an analogy: if I tell you that the cost of repairing your roof is going to be £2,000, and during the repair the cost of roof tiles falls by 50% and I still charge you £2,000, then that is expensive, if not slightly opportunistic. A transition manager’s ability to control costs while balancing risk is a core skill, so understanding the attribution of expenses relative to how these skills were applied not only reveals true performance but separates luck from judgement.
The selection of a transition manager by each of the respective Pools is clearly a difficult process. The number of transition managers available is limited to seven providers in the UK and, whilst there are obvious considerations about skill and capability, there are other more practical constraints related to capacity. This becomes even more important when a transition manager is selected independently by more than one Pool at one time. Whilst the appointment of a single transition manager to implement a Pool’s entire transition program may seem to simplify the process and workload for the respective Pools, it is worth considering that the skills and capabilities across all transition managers differ significantly based on asset class, region and available solutions². Access to and selection from a broader panel of transition providers should, in theory at least, deliver the best solution at the best price for each specific challenge. Indeed, it could be said that a greater co-ordination between respective Pools and the broader transition management providers may in fact provide much greater cost savings across the entire pooling exercise, which after all is the ultimate aim. Such co-ordination might involve certain similar transition events occurring within different Pools being co-ordinated as a single transition event. This would enhance available liquidity, reducing costs and potentially delivering longer-term savings to the wider investment Pools.
In summary, the costs of making the required changes to pooling are inevitable and can create a distraction from the real business of building a more effective investment management structure which delivers a better value choice of investment product and solutions. However, the decisions made now will live on in the future accrued performance of the assets transitioned and, possibly more importantly, the transparency provided will build the trust necessary for future success.
1. Extrapolated from those transition costs estimates published
2. As per the findings published in MJ Hudson Allenbridge’s UK Transition Manager Review, August 2017