Written By: Craig Blackbourn
Craig Blackbourn of Northern Trust Capital Markets emphasises the importance of choosing the right transition manager to guide funds through the long and complex process of pooling
Asset pooling under local government pension reform, itself the biggest structural reform in the pensions sector for decades, has gathered pace since April 2018. With Local Government Pension Scheme (LGPS) funds now compelled to pool £260 billion of assets under management split across 91 funds into eight distinct asset pools – the need for effective transition management is paramount.1
The practice has already delivered significant benefits to multinational companies – attracted by greater economies of scale, reduced costs and enhanced negotiating power. At a time when pension funds continue to face multiple headwinds, the opportunity cost of failing to ensure effective transition management is just too great.
What’s next for asset pooling?
The UK Government, the driver behind these significant structural changes, has been vocal on the benefits of pooling and predicts a £660 million of cost savings per year, as well as highlighting the benefits of bolstered negotiating power when combining funds. While much progress has been made since 2015 when the government announced its intentions to pool LGPS assets, there remains a plethora of challenges and considerations for LGPS funds to properly analyse. Some of the key elements include:
- Sharing responsibilities
With most pools expected to share several responsibilities jointly with their underlying funds, division of clear accountability will need to be formalised. This could cover monitoring of service providers, measuring of investment performance and tendering for further service.
- Data and transparency
It is particularly important that LGPS funds retain proper oversight of relevant data including performance and compliance reporting. The transition from segregated accounts to a pooled environment risks reducing the quality of transaction level data that is critical in building up a comprehensive picture of best execution. Those investors that require more detailed data on underlying holdings will need to be catered for. Data aggregation solutions are likely to play an increasingly important role.
- Proper governance and oversight
While maintaining good governance and control over the assets being invested in is key, LGPS funds will also need to consider partnering with the right transition manager who is able to guide them through the pooling process without introducing unintended risks and additional operational costs.
Navigating the major hurdles
Hidden risks, costs and surprises can arise from even the most straightforward transitions. Completing these structural changes is not without risk – even within scenarios where assets may be retained from the legacy portfolios before being moved across to the pools, there are several potential flashpoints that LGPS funds and their chosen transition manager should mitigate. Execution slippage, defined as when the same execution price for buys and sells is not achieved, is a major risk that could compromise the value of portfolios. However, the right transition manager will have a local presence in markets around the globe and be able to utilise tools such as exchange crossing mechanisms to minimise slippage.
FX opportunity costs are also a real risk for LGPS funds. This occurs when local cash cannot be moved between accounts, requiring sub-custodians to execute FX trades at different times for buy and sell orders. Transition managers are able to work with counterparties to align FX execution points as closely as possible to limit slippage.
Settlement errors and charges also account for a portion of asset pooling risk. The varying settlement cycles in different markets and countries create possible headaches and demand an increased focus on cash management.
Derivatives, swaps, currency forwards, some bonds or mortgage securities require special planning and consideration. Questions such as: will the outgoing manager close the legacy portfolio’s positions in these instruments, or will the new target manager assume them? These factors will affect the transition’s timing, but could also impact portfolio values and lead to depletion if not properly managed.
Country specific rules around Change of Beneficial Owner (CBO), the formal process required to move assets from funds to asset pools, add additional layers of risk and trading costs. Across developed markets CBO transfers, market fees or charges generally do not exist. However, notable exceptions exist that must be factored into transition management planning.
In France, under the EU Financial Transaction Tax Regime, a LGPS fund would incur a 20bps charge, while Ireland and Poland would require a 100bps levy.2 A transition manager can estimate the costs in advance of any activity and assist with solutions in an attempt to mitigate them.
Moreover, as we look to less developed economies and emerging markets where CBO charges are more common, LGPS funds will need to plan effectively to minimise portfolio depletion, while also guarding against FX volatility.
One size will not fill all
An appreciation of the detail of the various operational needs is crucial. The planning phase of the implementation will be the foundation for a successful transition. Engaging with the key stakeholders – the legacy authorities, the pool operator and the asset servicing agent – to understand their expectations, constraints and timelines will be an important consideration. The transition manager needs to consider and understand the downstream effects of each element of their action plan, as there will be specific nuances and requirements attached to each of the stakeholders.
Project management and action planning is a central focus of a transition manager along with a recognition that transitions are fluid, customisation is required and change is a constant variable. When issues arise they need to be assessed and managed instantaneously to ensure that the respective parties are receiving the appropriate information in a timely manner.
Choosing the right partner
There is little doubt pooling will bring cost savings and efficiencies and, in time, give pension funds a more powerful voice on key issues that affect its members. To realise these benefits, LGPS funds must partner with the right transition manager and independent consultants able to guide them through this long and complex journey.
To put the building blocks in place, effective planning is central. This includes expert project management and the creation of a customised pooling strategy designed to meet specific objectives. This can help avoid any unwelcome surprises across different markets and nuances around asset pooling in certain asset classes.
Establishing a clear relationship with a transition manager, maintaining a transition account ready for trading on a global basis, scenario planning to identify potential issues before they occur and ensuring that all necessary legal documents are in place are all factors that will help to minimise risk throughout the process. Moreover, liquidity planning is also important – identifying cash needs to support funding requirements on certain transactions will help LGPS funds and transition managers to better plan cash holdings.
A high-quality transition manager will then work closely with the LGPS fund to implement a plan of action, using the skills of strategists and traders to conduct pre-trade analyses, minimise risks such as execution slippage and settlement errors. Support from a transition management partner to achieve clear and transparent reporting will also be essential.3
However, with the process well underway particularly in more liquid instruments, we are only at the start of a years-long journey that has the potential to make far-reaching differences, set new standards for the pensions industry and leverage what is a once in a lifetime opportunity.
1. Beyond Asset Pooling, Chris Dulieu, Northern Trust
2. Transition Management: The Path to Pooling, Craig Blackbourn and David McPhillips, Northern Trust
3. Moving Mountains, How to effectively manage risk when transitioning assets, Northern Trust