Last week saw the closure of the “Local Government Pension Scheme (LGPS): Fit for the future” consultation which sets out the UK Government’s ambitious plans to overhaul the investment governance arrangements of LGPS. The review focuses on three areas; 1. asset pooling; 2 governance; and 3. UK and local investment. This article reviews how some of the proposals impact the Administering Authorities (“AA”) and pools, discussing whether we believe the changes will transpire to be beneficial for members and highlights where we feel, fundamentally, further consideration is required.
In summary, the proposal set outs the following requirements:
Asset pooling
- AA’s to be required to fully delegate investment strategy implementation to their pools;
- AA’s would be required to take ‘principal advice’ on investment strategy from the pool;
- Pools are to develop internal investment management capabilities and be regulated and authorised by the Financial Conduct Authority (“FCA”); and
- All AA assets to be transferred to the management of the pool.
Governance
- AA’s will be required to prepare a governance and training strategy;
- AA’s will be required to identify a senior LGPS officer with overall responsibility for management and administration of the fund; and
- AA’s are to participate in a biennial independent governance review.
Local Investment
- AA’s need to formalise their objectives and target allocation to local investments;
- Local investment plans will need to be developed with AA’s to identify and put forward suitable investment opportunities;
- Pools will assess and manage local investment opportunities
Given the obvious direction of travel, the whole exercise is structured so as to result in more centralised control of the asset allocation of the total LGPS asset pool. How this will impact investment returns, only time will tell, but there is the real possibility that the changes could cause some tensions between optimising portfolio efficiency and the focus on funding locally based investments.
It’s clear that the proposals draw some alignment with other consolidation frameworks, such as the likes of the industry wide pension schemes that have developed within Europe, in which the investment management function and related decision rights have been centralised. Whilst comparisons can be made at a high level, there are some distinct differences laid out in the detail, which in our opinion, need addressing to make the model sustainable so that the independence and effectiveness of the AA’s are maintained into the future. The need for independent advice and oversight at both an AA and pool level is an obvious start, to ensure accountability is clear and investment decisions are truly value-additive.
The proposed model will inevitably lead to weaker control and lack of ownership for AA’s. However, as the review currently stands, further clarification is required as to whether an AA’s fiduciary duty is effectively discharged by simply setting high level objectives and delegating implementation – a concern shared by LGPS Scheme Advisory Board (“SAB”) as set out in their response to the consultation. It would be very surprising if this were the case
One of the biggest changes outlined, is the fact that pools will be required to provide ‘principal advice’ to the AA’s on their investment strategy. Under this proposed approach we foresee an inherent conflict of interest, unless appropriate independent advice and oversight is utilised by the AA. AA’s should have the ability to set their own asset allocation based on independent advice rather than accept the advice set by the pool and importantly, where these differ, it should be the responsibility of the AA to determine the outcome. It is also notable that the vast majority of experience and skill within strategic and dynamic asset allocation lies within the private sector.
In our view, advice provided by the pools should not be the sole view available to the AA’s, with advice also provided by independent, professional advisory firms. We have seen this model work very effectively within the private sector. In such an approach, accountability is clearly defined at outset with ongoing monitoring ensuring that any policy implemented is maintained over time. With the real risk of variability in policy changes across LGPS, and without a clearly stipulated overseeing eye, we again see a requirement for ongoing oversight.
The rationale for pools to implement an investment strategy is to a degree, understandable from the perspective of both the AA and the pool. The AA’s are effectively able to delegate investment decision making and the Pools are able to deploy a strategy at a greater scale. To draw comparison within the private sector, asset consolidators have been implementing value-add decisions to funding positions for DB schemes on the same basis. However, the framework in which these decisions are made differ for two key reasons; 1. competition exists between consolidators, whereas a pool would be the sole provider that any given AA has access to; and 2. Oversight from an independent party is standard practice with ongoing monitoring ensuring decisions being made are fundamentally in the best interest of scheme members and sponsors.
From the government’s perspective, it makes complete sense to implement in the way the review proposed, as more concentrated asset pools provide the opportunity to invest in ways which are more desired by government. We would question whether this is in the best interest of members and sponsors.
From a governance perspective, the requirement for increased governance and training along with the requirement to identify a senior LGPS officer is, in our view, needed to support the changes. However, one could argue that this is not far enough given the marked changes being proposed, and equally that the role of senior LGPS officer concentrates too much power within one unelected individual. Boards could make more use of professional governance firms which house accredited professional trustees who are well placed to support officers and pension staff with what would be a significant undertaking.
There are some concerns also regarding implementation of pooled assets. In its current form, the AA’s will not have the ability to allocate between passive or active allocations, this could have consequences with an AA implementing their views on areas such as Environmental, Social and Governance (“ESG”) priorities, for example. Similarly, regarding local investments further clarification of how exactly it would operate is required; of course, local investment might increase economic growth in more deprived areas and support local communities, however, if this come with a lower return than available elsewhere, then who ultimately decides it is a price worth paying? Furthermore, the definition of ‘local’ can only be described as vague, at best. The requirement to invest ‘locally’, in our view, should never override the fiduciary duties of the AA. Therefore, if an AA or pool beliefs there to be a better risk adjusted return, with a higher chance of a better outcome for members, from an investment outside the UK then this should take precedent.
The majority of pools will need to undergo a significant transformation, in what could be a very tight turn around, such that they can establish themselves as FCA approved investment managers and expand their knowledge base to the wider areas to be covered. The development to manage these matters internally may require significant change to personnel and investment processes. Whilst we eagerly await the government response and/or amendments, we can’t help but think more work is needed.