The outlines are now becoming clear of what is probably the biggest shake-up in local authority pensions since their launch before the second world war.
The original motivation for the plan to combine the existing 89 schemes into six or seven ‘superfunds’ was to cut costs. But this is too modest an ambition.
The changes offer a unique opportunity to create a series of world-class British investing institutions. The new Local Government Pension Scheme funds could set new standards of governance, performance and costs.
Similar outperformance [to the New Zealand Super Fund] by the new LGPS would clearly help reduce funding deficits and any residual burden on the state or council taxpayers from unfunded pension commitments
To do so successfully, however, they will need to learn from the best across the rest of the world.
We have used our experience in working with some of the largest official investors to examine a number of the leading sovereign wealth funds and government-backed pension schemes.
These range from Norway’s giant £550bn sovereign wealth fund to New Zealand’s £14bn superannuation fund. All generate enviable returns, but use a wide range of investment approaches.
We have distilled their experience into some research, ‘A study of global best practice in government funds: The opportunity for the LGPS’, which could usefully inform the structure and ethos of the new LGPS arrangements. The report proposes principles for governance, performance and costs.
Governance
Any new investment pools should have clarity of objective, independence of action and transparency in operation.
The standards set by, for example, the Alaska Permanent Fund and Australia’s Future Fund are instructive here. Both set out clear return targets, but also pay at least as much attention to risk, all within a long-term framework.
This is particularly important for the new local authority pools as, by their nature, they will need to promote a long-term culture in their relationships with their investments.
Performance
Creating the conditions for good performance is at least as important as reducing costs. Studies of possible peer groups suggest well managed funds can add significant value above and beyond their management fees.
The New Zealand Super Fund is a good example of an institution generating high returns despite incurring higher than average costs for its size.
Fees charged by the fund in the latest financial year were about 0.45 per cent of assets. Those costs make it among the more expensive in our sample.
Even so, annual outperformance of its ‘reference portfolio’ of between 3 per cent and 4 per cent over the past five years puts it among the top performers.
Any similar outperformance by the new LGPS would clearly help reduce funding deficits and any residual burden on the state or council taxpayers from unfunded pension commitments.
Costs
Given sufficient size and professionalism, substantial cost savings can be made in the new investment pools. However, it is important to recognise there is inevitably a three-way trade-off between size, cost reduction and performance.
Norway’s giant fund pays wafer-thin costs, but outperformance is correspondingly small.
By contrast, costs for Victorian Funds Management Corporation, a state-owned fund manager for public sector schemes in Australia, are significantly lower than those of the current LGPS, yet it has generated substantial outperformance.
Our research suggests it achieved annual alpha of around 1.3 per cent above its benchmark on average over the most recent five years.
What is significant here is that VFMC is both similar in size to the proposed UK pools and also manages funds for a number of state and local bodies akin to what is envisaged in the UK.
Raising standards
The LGPS is already well run. However, the changes now underway provide the opportunity to raise its standards to world class.
Putting the above principles at the heart of the new LGPS funds would give them a much better chance of meeting their objectives: cutting costs, maintaining investment performance and raising the governance and management of local government pensions to the level of the world’s best.
Achieving this will leave them ideally placed to meet the needs of their ultimate clients: LGPS members, who require the best possible pensions at the least possible risk.
Gavin Ralston is head of official institutions at asset management company Schroders
