The 89 local authority pension funds across England and Wales that are merging to create eight co-investment vehicles, to boost scale and reduce costs, are at very different stages in the process. But their structural plans are nearing completion and they are expected to start moving assets within a year. Only one, Borders to Coast Pension Partnership (BCPP), has announced a delay.
The scale of the project is unprecedented, with a significant proportion of the pools’ £217bn in assets set to be transitioned over the government’s relatively short timetable. The pools must identify the most efficient way to transition assets, taking into account the need for flexibility around market conditions, while minimising restructuring costs, and putting in place a manager line-up that fulfils future investment requirements and delivers the cost savings required.
The transition management industry worked closely with the pools in providing cost analysis for their submissions to the government in July 2016. The next stage will be advising on the restructuring work and providing detailed cost analysis and transition planning once the pools have decided their manager line-ups. Firms have also been sharing their experiences of managing assets within a multi-manager pooled environment, which is new to many of the pools.
A key part of the process will be the completion of a national Framework Agreement for the provision of transition management and implementation services. Following the consultation in May, the focus is now on the contractual language, with completion of the request for proposal (RFP) process in the third quarter. The framework will give the pools more clarity on the different providers and their capabilities across not only transition management, but more broadly across implementation in general, which will be relevant for the future management of the assets.
The structures employed to manage pool assets vary, ranging from complete out-sourcing of the investment management and investment operations to a third party, to the creation of Financial Conduct Authority-authorised entities that will manage the assets using a variety of vehicles, including – but not limited to – authorised contractual schemes (ACS).
Even within the ACS vehicle approaches differ. Some pools will act as gateways to investment structures that the underlying schemes directly invest in, while others will invest in units within funds created by the pools themselves – and others will use a combination of the two. A number of pools already have an internal asset management capability that will remain a part of their solution in addition to external managers.
The London CIV and Local Pensions Partnership (LPP) are ahead of the game. “They have both been very helpful to the others in sharing experiences and lessons learnt from the various stages of the process,” said Nick Buckland, LGPS adviser for JLT Employee Benefits. “The Cross Pool Collaboration Group has been regularly meeting to enable representatives from each of the pools to share thoughts, common issues and to act as a voice for the pools if one is required. Each pool is operating in a slightly different way, due to the requirements of the underlying funds and therefore each has a different perspective.”
“A couple of the pools are in the process of putting key staff in place to start working on the investment plans, and firming up details of the underlying sub-funds or portfolios,” Buckland adds. “Until this process is complete, I imagine the plans for actual investments and the timelines will remain in the planning stage.”
Although London CIV is a large and complex pool, it has not used transition managers so far, according to non-executive director Chris Bilsland. “So far, the London CIV hasn’t used them as until now we have lifted and shifted existing managers and appointed new managers. We have yet to move funds between managers, or to release a manager, and I think it is then when we will look to utilise transition management.”
The pooling project comes with great potential to save costs. In countries where there is scale in the pensions sector such as Australia, pension operating costs are said to be 40% lower than in the UK.
“Professional transition managers will be vital in the process of transitioning the pools in the most cost-efficient way,” said Andy Gilbert, managing director, BlackRock. However, “poorly-executed transitions have the potential to offset a large portion of the cost savings the funds try to achieve, and the overall objective is of course to strengthen performance so preserving it is only the start.”
“Better performance does not have to come at additional cost. The cost and risk savings of a bespoke solution typically offset any additional fees, making a strong case for using professional help. Furthermore, a top transition manager can use the scale of its organisation to reduce transaction costs, which directly improves the generated alpha of the fund.”
The operation itself will be highly complex. “The rationalisation of active equity mandates will require careful management of idiosyncratic risk within the trading, in addition to liquidity and market impact, volatility and information leakage,” said James Sparshott, head of local authorities at LGIM. “The operational risks will require expert project management – coordinating the volume of information and maintaining clear and effective communication will be critical.”
Differences in size, investment complexity and experience in transition management within LGPS schemes suggests great diversity in the challenges faced and the most appropriate solutions for each pool. Critically, there is still much debate about which managers should be retained – which leaves the sequence in which assets from each scheme should be transitioned into the pools still very much at the discussion stage. Only when there is clarity on target managers and investments can the similarities and differences in transition risk and cost, and consequently the optimal investment sequence to share transition costs, be determined. Compromise from both the schemes and pools will be required.
“Under a collective investment, scheme performance as well as costs are shared on a pro-rata basis,” explains James Mitchell, co-head portfolio transitions solutions at Goldman Sachs. “At first glance this seems to be a hindrance to different schemes which may have greatly varying levels of commonality and cost to rebalance their own mandates into the chosen pool structure. In reality, with some forethought on the sequencing of events and a malleable structure for investment one might be able to achieve a fairer split of costs than by simply consolidating all assets in each asset class in one go.”
One consequence of going from a £2bn to a £40bn scheme will be a seismic change in service consumption. “We believe that the change not only in the services provided but also in the way they are delivered may not yet be fully appreciated,” adds Mitchell. “Clearly, the mostly immediate challenge is how one fairly consolidates the asset base and equitably shares costs. After this many opportunities exist for investment services utilised in the prior life to be accessed in a different way as a much larger fund. Obvious examples are whether to hold pooled or segregated investments and what type of agency lending programme one should consider.”
Mifid II investor status
For all the pools, the additional buying power will also open up access to greater investment opportunities, including more specialised and illiquid asset classes such as infrastructure and private assets that require additional skills and knowledge.
Pools that are regulated will also require new skill sets for their various responsibilities. Many funds are seeing the transformation as a timely opportunity to set standards of governance and performance monitoring.
Mifid II rules remain an issue for investing in sophisticated asset management strategies, however. Initially, Mifid II required all local authorities to be treated as retail clients by their asset managers. But in July the regulator dialled back the rules, making it easier for LGPS schemes to be “opted up” to professional investor status, by changing the classification of professional investors, so all administering authorities can now be opted up if they run £10m (€11.4m), which of course is small fry to these funds. Despite these concessions, the funds face a significant administration burden in the months before the regulations are implemented in January.
“The need for these funds to opt up cannot be emphasised enough,” explains Andy Todd, head of UK pensions and banks, asset owner solutions at State Street. “Mounting cost pressures and persisting lower-for-longer yields have led pension fund investment committees to seek higher yielding and often illiquid assets to assist them in meeting their strategic investment targets.
“Despite Mifid II rules around local authority pensions and their exposure to illiquid assets being softened, these funds still need to declare they’re happy to have an exposure to such assets. If this is overlooked they risk significantly increasing existing liabilities, and may end up receiving a termination letter from their asset manager, who will legally no longer be able to provide an alternative exposure.”
At London CIV, “so far the emphasis has been in equities”, but Bilsland said that the pool is now looking at fixed Income. “We are looking to go to market with that in the autumn, and we are also looking at low carbon solutions. In the first instance, we will probably invest in some low carbon index funds as trying to be active in that market is more difficult,” he said.
Investment in infrastructure has evolved considerably since 2011, when then-chancellor George Osborne backed the establishment of a UK-wide national infrastructure platform by the Pensions and Lifetime Savings Association (PLSA), which subsequently disintegrated after some founding schemes pulled out.
There have been a number of collaborations such as the Pensions Infrastructure Platform and GLIL, a joint venture set up by Greater Manchester Pension Fund and the London Pension Fund Authority, but it is expected that the concept of a national infrastructure platform will re-emerge when the pools are up and running.
“A number of initiatives around consolidation that we are seeing the LGPS adopt have, at some level, been adopted by the private sector already, especially in areas such as infrastructure, but it may encourage a greater focus on consolidation in more liquid asset classes too and, more broadly, at the administration and governance level also,” explains Russell Investments’ Adolph.
“The benefits of consolidation, not only from a cost, but governance perspective, have been driving pension fund mergers in the Nordics and the Netherlands for a number of years, so this is not a new phenomenon. But it is one that the private sector in the UK has been slow to adopt, with notable exceptions such as Railpen and the Electricity Supply Pension Scheme to mention but two.”
Others also cite RailPen as an example of how pooling has worked well and welcome the appointment of its chief executive Chris Hitchen as chairman of the Borders to Coast Pension Partnership (BCPP), in the expectation that he will drive similar initiatives in the local government sector.
The benefits of pooling should also extend beyond the immediate impact of economies of scale on costs. With scale, pension fund trustees will be able to have a far bigger impact on the firms they invest in, which should help improve long-term returns.
In the shorter term, however, there is concern over how such extensive trading activity might impact the market. “There needs to be a degree of co-ordination, with various parties not trying to do the same thing at the same time,” said Craig Blackbourn, head of transition management Emea at Northern Trust.
“It will also be important to identify opportunities for crossing between pools. The role of the transition manager is not to generate alpha but to preserve asset value through intelligent execution strategies, and of course part of that role is to avoid information leakage. Authorities have resource constraints and will need services to help navigate these changes and their execution from the project management side.”
Consolidation is a well-trodden path in the corporate world with large multinationals setting up pools with proven benefits. “It was evident that there was a huge variation in what local government schemes were paying for the same asset management,” said Blackbourn. “There will be tangible cost savings but there will also be administration costs and the costs of getting there.”
An additional factor in terms of market impact is that market participants will be expecting these transitions. Buckland adds: “The LGPS is very transparent and everything is being played out in the open, meaning that all market players will be anticipating these not insignificant transitions, and will be looking to position themselves accordingly,”
On the other hand, the timeframes for implementation are long. “We believe that the liquidity challenge may have been overestimated,” argues Mitchell. “While there is no doubt that the total trades to execute are large in relation to the market, the extended timeframes for implementation and the many parties involved in each pool mean that it is unlikely that the pools will adversely impact each other, or the market, during the execution phases of their transitions if properly managed. Clearly, cross pool communication should aim to share broad activity detail to guard against this eventuality and more importantly to allow the pools to benefit from any crossing opportunities.”