As the LGPS funds embark on the challenging process of pooling, there is much to be learned from the experience of their peers across the globe, writes Stephanie Baxter.
At a glance
- Swedish and Canadian public pension funds are good models to look at
- The most effective governance structures are those that best reflect the needs of the underlying funds
- Funds can attract talent if they're professionally run and keep politics at bay
As the local government pension funds (LGPS) embark on pooling investments, they should be looking closely at the experience of other public schemes globally.
The hard work of setting up the structures by April 2018 begins with some questions still unanswered. Aside from the actual process of pooling, some of the big challenges include creating an effective governance structure and hiring good talent.
They will need to decide whether pooling makes sense for all investments. While it makes sense for passive investments, equity and fixed income, other assets may make less sense to pool.
There is possibly an optimum size or sweet spot for pools. As public funds get bigger, they have to have more complex investments so end up moving into more alternative classes to generate the same returns.
This can be the case with the largest public funds, whereas the LGPS will eventually look more similar to Sweden's pension fund model, which has five AP buffer funds, with AP 1,2,3,4 around €30bn-€40bn (£26bn-£34bn) of assets each. Meanwhile, each of the LGPS pools will range from £13bn to £36bn in size.
Bfinance senior director Richard Tyszkiewicz says: "Because the AP funds are operating on a much smaller level than Norway's €800bn Government Pension Fund Global, for example, they have the scale to do what they want in terms of customisation, managed accounts, co-investment and direct investment, but they're not so big that they would swamp some of the asset classes."
"The sensible approach is not to just blindly aim for economies of scale; it depends on the asset class. Can you make savings and does it make sense to pool? Allow people to continue investing for the benefits of their own members, pool where it makes sense and then do something alongside that. It's also important to look at how efficiently you can invest below a certain size. There's a sweet spot for each asset class, and what you're trying to do with pooling."
It is hoped that having eight LGPS pools will foster competition and greater performance. It is useful to look at the Australian superfund market, which has undergone huge consolidation over the past decade.
State Street asset owner solutions head of UK pensions and banks Andy Todd says his firm recently connected two of the LGPS pools with a superfund.
"That formed part of their due diligence, as much as to identify the differences as well as the common points."
The obvious difference is most assets that have gone through consolidation are defined contribution rather than defined benefit, and there is full merger of both assets and liabilities.
Superfunds need to continually compete for business of their underlying corporate sponsors, and employers can transfer their members' rights from one superfund to another if they do not like the direction of travel.
This is unlikely to be the case for the LGPS funds now they have aligned themselves around specific pools, although it is unclear how easy it would be to leave one for another.
The Swedish AP funds also compete with each other effectively, says Tyszkiewicz: "The AP funds operate fairly independently, have their own board, and can decide to co-operate on certain things but they're seeking to outperform each other so have separate governance structures."
They set their own overarching investment goals to benchmark their own performance.
BNP Paribas Securities Services UK head of sales for pensions Sid Newby believes the same kind of competitive tension will develop among the LGPS pools. "In today's world each individual LGPS fund will still benchmark their own performance against their universe - which is other LGPS schemes. In the future will the LGPS still compare scheme to universe of schemes or compare pool to pool?"
Getting the governance structure right will be paramount to each pool's success.
Todd says from his experience of Australian superfunds, it is important that the activity of member funds and associated pools is in the best interests of the underlying members.
He says: "There's no such thing as the best governance structure, but the most effective ones are those that best reflect the needs of the underlying funds. With pools that consist of member funds with a high degree of already internally managed assets, you can see where they have tended towards building their own operator function because their mind-set is perhaps more aligned with that of an asset manager."
Whereas, it makes sense for pools with no internally managed funds and mostly passive investment to look to rent the operator function, he adds.
Part of good governance is about hiring good talent to drive forward the professionalism of the LGPS pools.
Tyszkiewicz says although it will be a fairly complex process, he imagines the LGPS pools will be able to attract good people given these are very high profile public positions.
He points to the example of the AP funds: "There have been periods where some of the AP funds have had turnover of staff but they've been able to attract really good people because they're so high profile."
Investment professionals at public sector funds are well paid but not eye-popping sums that would typically be seen in the hedge fund world. In the face of pay restraints as a public sector entity, they have to find other ways to attract talent. At the AP funds, there lot of focus on the organisations' culture, brand, value of working for them, and career opportunities, according to Newby.
The pools should look at the kind of people other public pension funds have managed to attract, such as the Canadian funds.
London School of Economics research fellow Simon Wong, who has also independently advised public pension funds globally, says:
"Among public pension funds there have been progressive practices, exemplified by the Ontario Teachers' Pension Plan, where people have realised that investment of such large sums requires a high degree of technical and commercial experience.
"People who represent both employers and employees are now increasingly very highly skilled in business and investment matters. Teachers, no matter how well they do in a classroom, are generally not well-equipped to govern and direct a pension fund."
Meanwhile, the country's largest pension fund, the Canadian Pension Plan Investment Board (CPPIB), has a standalone separate legal entity with an independent board. Wong says it is run "professionally by an impressive group of people", adding:
"You want senior people from the business world that understand the challenges, in addition to those from the investment community."
Keep politics at bay
There are no politicians on CPPIB's board and it is required to operate at arm's length from the Canadian government. Wong believes autonomy for public pension funds starts with a strong governance framework.
"I worry about politicians sitting on trustee bodies as it sets them up to be in a position where they could be pressured," he says. "If I were a councillor sitting on a trustee board, I would be putting myself in a difficult position. There would be pressure anyway on these funds to put money in projects perceived to be supportive of local economies."
He points out that pension funds can become more attractive to people from the business and investment world if they're professionally run and not subject to political dictates.
"This is another reason for keeping politics out or to a minimum."
As the LGPS pools will be expected to raise infrastructure investment, they can take heed from their peers globally, some of whom invest up to 15% in the asset class. However, there have been concerns over government pressurising the schemes to invest in UK projects.
The Swedish funds are very internationally-minded when investing, which takes away some of the political pressure, and seek investments that meet their objectives rather than political requirements, says Tyszkiewicz.
Australian and Canadian pension funds arrived at the view of putting a meaningful percentage of assets in infrastructure as they thought it was a good asset class, but were not driven by the government.
"For them, it was more an evolution in investment approach and wanting to take advantage of investing in more illiquid assets but not necessarily to help support the economy," says Wong.
Whereas, if the latter is the starting point, it leaves a fund vulnerable to making an investment that may not necessarily be beneficial to the fund. He believes this could be dangerous, and adds:
"If Brexit makes us look less attractive as an investment destination, will these [LGPS] funds be expected to fill the gap?"
Looking further into the future, examples abroad suggest the eight LGPS pools may not be static and could go through more consolidation.
For example, take the long-running debate over whether the AP funds should be further consolidated to save on costs and further capitalise on economies of scale. Although last year the Swedish government abandoned plans to reform the system after backlash from funds and employer groups, it could come back on the cards in future.
Newby says: "There will be a discussion over whether LGPS pooling is just a stepping stone to even more consolidation, and whether the LGPS will be merged into one. But the APs have been talking about that for over 10 years and it hasn't happened yet."
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