In the early days of the Local Government Pension Scheme (LGPS) pooling project, the debate focused on the relative attractions of a regulated or unregulated structure.
But the die was cast last March when local government minister Marcus Jones hinted heavily that the government endorsed the use of vehicles regulated by the Financial Conduct Authority (FCA) for the 89 schemes to co-invest their assets in the eight pre-agreed pools.
Their structure, standards and systems provide “substantial assurance,” the minister said. “As a minimum, I would expect to see a single entity at the heart of any proposal, with responsibility for selecting and contracting with managers, as well as the employment of staff.”
The collective investment vehicle (CIV), set up voluntarily by London’s local authorities in December 2015, London CIV, has become something of a prototype and is based on a regulated Authorised Contractual Scheme (ACS) structure.
Contrary to the common misconception, the ACS structure is not incompatible with certain asset classes such as illiquid assets and the passive life funds run by the giant asset managers. An ACS can be used for all types of asset class if structured appropriately. State Street, for instance, operates two ACS vehicles that directly hold property.
Most pools are setting up their own ACS; two are hiring an operator, the Wales pool and Access. The eight pension funds in Wales, with combined assets of £15bn, have so far been working under a memorandum of understanding, but to engage an operator they need to enter a legally binding Inter Authority Agreement (IAA), defining the powers and obligations of the participating authorities and the joint governance committee. The appointment of an operator should be announced shortly.
The eight pension funds in Wales, with combined assets of £15bn, have so far been working under a memorandum of understanding, but to engage an operator they need to enter a legally binding Inter Authority Agreement (IAA), defining the powers and obligations of the participating authorities and the joint governance committee. The appointment of an operator should be announced shortly.
Access, which covers the English counties of Northamptonshire, Cambridgeshire, East Sussex, Essex, Norfolk, Isle of Wight, Hampshire, Kent, Hertfordshire, West Sussex and Suffolk, also plans the so-called rental option but has not yet gone out for procurement.
Other pools have modified their stance. For example, the £23.2bn Brunel pool, which covers the Environmental Agency Pension Fund (EAPF) and nine local authority funds in the south west as well as Oxfordshire and Buckinghamshire, is using an ACS in phase 2 but a non-regulated common investment in phase 1.
“We decided not to go for an ACS structure for the time being, but instead to rely primarily on manager-operated funds as it is cheaper and easier for now,” says Naomi Monplaisir, project officer, Brunel Pension Partnership. “We are therefore expecting to be regulated under Mifid II but not AIFMD.”
From a practical standpoint, one advantage of the regulated ACS structure is that control of decision-making is well-defined.
It provides clarity when many stakeholders may want some sort of involvement and have a duty of oversight – but not to encroach on the actual decision-making. However, contravening FCA rules – and the penalties and reputational damage that implies – is also an issue in an unregulated structure.
“Each of the pools is taking the most appropriate approach for its underlying funds,” says Nick Buckland, senior investment consultant at JLT Employee Benefits.
“For example, pools that already have a significant amount of internal management will have a different structure from ones that have little or none. While there is still a great deal of work for each pool to get through ahead of the April 1 2018 deadline, most of the big issues have been resolved. It is now a case of working through the necessary activity to ensure pools become operative and are FCA compliant.
“It is definitely not a one-size-fits-all approach. Without the work that has been undertaken within the pools to assess the best structure it would have been very easy to assume there was a single best solution for all.” There are still issues to be resolved. “One of the things most pools have to establish is how the pension funds can actually hold the pools to account in practice,” explains Bridget Uku, group manager treasury & investments at Ealing County Council.
“The pools are effectively captive, while
It is not clear whether in the event of a manager underperforming the pool will be able to terminate the manager without recourse to the underlying pension funds, or whether the funds must be informed as is currently the case.
“At the moment, my understanding is that the pool will phone and communicate that an asset manager has, say, suffered a massive walkout of key personnel and the fund will decide whether or not to terminate the agreement. In future the funds won’t be acting on their own and will have to be considerate of others in the pool,” Uku adds. Funds will surely be more comfortable acting in unison as the pools progress.
The UK regulator’s decision on how to deal with European rules on investor classification has not yet been made. The Markets in Financial Instruments Directive (Mifid II) classifies local authorities as retail investors, to protect small treasury managers from being mis-sold complex investment products, but some argue this could deny pools access to alternative and illiquid asset classes and even to prompt a fire-sale of complex assets they already hold.
“This could and should have been resolved by now,” says Chris Bilsland, non-executive director at London CIV. “This potentially reclassified LGPS schemes as retail investors. Of course, the FCA is out to consultation on this, but unless there is a sensible solution, say to exempt asset pools, then this is a very unwelcome and unnecessary risk to pooling plans.”
Brunel’s Monplaisir believes an announcement will be made shortly: “Our understanding about client classification and Mifid II is that a practical way forward, where LGPS funds will have a relatively straightforward route to elective professional status, is expected to be formally agreed by the FCA later this month, but we await formal confirmation.”
Andy Todd, head of UK pensions and banks, sector solutions, EMEA at State Street, points out that the criteria for stepping up to professional investor status is not too onerous. The first criteria is the value of investible assets and each would qualify on that basis, and the other two questions relate to the experience and qualifications of personnel.
Most practitioners believe the government’s high-level guidance makes sense as the pools are very different; for example the London CIV has 32 stakeholders to service, while other pools have only three.
But they still face very demanding deadlines for implementing such a large-scale project, exacerbated by government delays on letting the pools know whether their proposals were acceptable, especially as submissions were made prior to Brexit, as the government was caught up in other projects.
“Each of the underlying administering authorities in each pool will have its own governance structures
and processes to go through,” says Buckland. “Ensuring that each of these is joined up, and that each committee has been given the appropriate opportunity to ensure that the pool meets their own requirements has been an organisational challenge by itself.”
The pooling initiative has already produced significant fee reductions, and should hit the top end of Project Pool’s estimates of £145m to £300m in cost savings over ten years.
Uku says that at the beginning of the pooling discussions some participants believed there was no real need for the CIV, that perhaps instead all that was needed was to carry out joint procurements, but LGPS asset managers have come forward with fee reductions and she has spoken to many working for these firms who said that
their senior managers would not have been convinced of the need to offer such generous discounts without the pressure brought on by the pooling agenda.
COSTS & BENEFITS OF SCALE
The longer term benefits have also been underplayed. “The ability to access and analyse data on the assets and their asset allocation will become far more tangible within an asset-pool construct,” explains Todd.
“At the moment analysis is typically at the month-end, so a daily level of market intelligence around assets is a big change and must improve performance outcomes in future.
“Secondly, there will be significant new investment opportunities, well beyond the current remit, such as the ability to co-invest in private equity and global infrastructure, and this will also bring greater diversification.”
Other cost savings will arise from administrators and custodians that have been putting in for this business, sharpening their pencils to improve their bids.
The second stage in the pooling process will be to launch additional sub-funds, perhaps white-labelled and targeted on a certain risk/return or theme. “Most, if not all, of the pools look to be setting up ACS
and will have to follow quite a complicated process to meet regulatory requirements to set up sub-funds,” says Bilsland. “People who are expert in this area are in limited supply and it is quite likely that access
to expert advisers will be a limiting factor to quick progress, at least into the medium term. The only way to manage this will be to limit the opening of sub-funds but the problem should only be a two-to-three year phenomenon.”
Capacity constraints are also feared as fewer investment managers will deal with larger mandates.
“Some niche managers that offer very compelling strategies may not be able to scale up to the required level,” says Buckland. “The pools are conscious of this, and will be putting in place procedures to ensure that they manage issues as they arise. While a big part of the pooling process is for the underlying funds to demonstrate operational savings, this must never be at the cost of investment performance.
The majority of LGPS funds are less than 100% funded, and therefore will need consistent long-term performance to reduce the funding gap.”
A number of pools have appointed chairs, directors and non-executives.
Hiring experienced staff to fill regulated roles is difficult but the pools are having some success in attracting people who previously worked in the City and are looking for a second career, with all but one of the pools offering the opportunity to relocate outside the capital.