Department for Communities and Local Government Eland House Bressenden Place London SW1E 5DU Submitted via email to LGPSReform@communities.gsi.gov.uk 27 September 2013 Re: Call for evidence on the future structure of the Local Government Pension Scheme Dear Sirs, BlackRock is pleased to have the opportunity to respond to the Department for Communities and Local Government s call for evidence on the future structure of the Local Government Pension Scheme (LGPS). BlackRock is one of the world s pre-eminent investment management firms and a premier provider of global investment management, risk management and advisory services to institutional and retail clients around the world. As of 30 June 2013, BlackRock s assets under management were $3.86 trillion ( 2.53 trillion). BlackRock offers products that span the risk spectrum to meet clients needs, including active, enhanced and index strategies across markets and asset classes. Products are offered in a variety of structures including separate accounts, mutual funds, ishares (exchange-traded funds), and other pooled investment vehicles. BlackRock also offers risk management, advisory and enterprise investment system services to a broad base of institutional investors through BlackRock Solutions. In Europe specifically, BlackRock has a pan-european client base serviced from 22 offices across the continent. Public sector and multi-employer pension plans, insurance companies, third-party distributors and mutual funds, endowments, foundations, charities, corporations, official institutions, banks and individuals invest with BlackRock. BlackRock welcomes the consultation and are supportive of the need to reform given the importance of the Local Government Pension Schemes in providing retirement income for local government employees across the UK in a sustainable and cost effective manner. We emphasise that while the existing structure is working, we see opportunities for improvement in a number of key areas such as; investment strategy, governance and economies of Scale. We have benchmarked the models for scheme governance in terms of whether they bring improvement in terms of; risk, governance and transparency. Our overarching observation is that reforms should be structured around a robust risk framework and note that there has been no mention of this in the call for evidence. We appreciate the opportunity to address, and comment on, the issues raised by the call for evidence and we are happy to continue to work with the Department for Communities and Local Government on any specific issues that may assist in contributing to its final consultation. Yours sincerely, Andrew Tunningley Managing Director 1
Introduction BlackRock manages 11.0bn of assets on behalf of 44 funds within the LGPS. In preparing this response, we have not looked to provide a breakdown of these relationships and provide specific data points as this would only represent assets under management at BlackRock rather than across the wider universe. We should note that metrics in this space are difficult to access, but any changes should be fully supported by empirical evidence. Our evidence focuses on what we have observed as good or best practice and we have provided opinion on our client base across the spectrum. At one level, we would concur with choice of high level objectives: dealing with deficits and improving investment returns. However, any review should go further and require more specificity around the objectives. In particular: With respect to dealing with deficits, there would be value in greater transparency and objectivity in the measurement of deficits. In many countries and for other client types statutory funding requirements exist and help aid visibility between schemes and crucially heighten the demand for the understanding of risks, pace of funding and investment risks taken. With respect to improving investment returns, we again highlight the need to capture risks taken to achieve the returns and note that it is the net of fee return which matters. Accordingly, our overarching observation is that any reform considerations should be structured around putting in place a comprehensive and robust risk framework and note that there has been no mention of this in the call for evidence. We believe that the challenges faced by the Department for Communities and Local Government are: 1. To determine a clear set of agreed, measurable investment assumptions and working practices across schemes; 2. To establish a framework to aid comparison of one scheme against another; and 3. To enable the management of the schemes to be held accountable for decisions made. More specifically in our response, we would draw out our thoughts on some key areas: 1. Investment Strategy: measures and implementation each step of the investment decision making process should be reviewed to drive the best long term risk adjusted returns to members. 2. Governance and People: how to make the right decisions and deliver on the objectives of the scheme. 3. Economies of Scale: consider carefully what the objective benefits of economies of scale really are and how they can best be delivered. 2
Investment Strategy Risk and return objectives - the starting point for establishing the key investment requirements of pension schemes, be they public or private, is to establish a clear set of objectives for risk and return, against which all investment decisions can be aligned. For defined benefit pension schemes, this means to establishing the nature of the liabilities, the funding levels and funding rates. Given the number of schemes that there currently are, thought should be given to any other variable factors that may be introduced. Are these clear and consistent across the funds and therefore comparable? For example, the number of actuarial bases currently used means that the funding level, risk tolerances and contribution rates are ultimately not comparable between schemes. Only when a common definition of funding level has been achieved, can the impact of contribution rates on funding levels and investment return requirements be understood. This will also provide a framework for addressing cross subsidisation issues. If merging of schemes is also being considered, an interesting consideration would be whether schemes are grouped by geographical location or funding level, which would ultimately impact contribution rates. Schemes need to define the risk and return profile of investments, with clear parameters to limit unnecessary exposures. Investment theory would define efficiency as achieving high returns per unit of risk. Through this lens the review should encourage the adoption of a consistent framework for evaluating returns in relation to risk. For example, asset liability risk, liquidity risk and political risk should be considered as well as the more common market risks. Only then can the subject of diversification of risks be judged at the local level and then the total scheme level. Given the current level of diversification of the LGPS at an overall level, a consistent risk framework will help to address more complex questions such as unknown costs, for example are active management fees ultimately being paid for passive exposure? Strong risk-adjusted investment returns are a key factor in dealing with deficits and the structure of the LGPS framework should be aligned to this objective. Choice of investments - in setting investment strategy we encourage our clients to consider a wide range of investments as diversification can lower risks without necessarily reducing returns. Clearly, larger schemes with in-house expertise have more capacity to apply to a wider choice. Amalgamation of schemes at the asset level could accelerate this capacity across all schemes. However, in our experience the key is governance and not specifically size and those accountable for decisions having access to the right multi-asset strategies or funds. Manager selection - is a common challenge we have seen with smaller and more disparate schemes as the reliance is placed on third parties to appoint managers and develop investment strategy which introduces additional costs. Use of third parties can lead to decisions being determined by factors that are not aligned with the fund in question but rather limited to the capability of the supporting party. Fees - the final consideration we have observed has been on the fees and the weighting given to the final investment choice. Fees should include all investment expenses (advisory, investment management, custodial and transactional). We believe it is important for schemes to place greater importance on the net of fee return to ensure that the right investment decision is made. Lack of clarity, understanding and direction in strategy design can potentially lead to the need to chase shorter term performance returns and potentially indirectly introduce volatility and minimal thought to the risks that are in the overall portfolio. 3
Governance and People A robust governance structure is core to running a successful pension scheme. Our experience of working across pension fund clients, be they local authority clients or from our broader client base, has shown that both the skill set and ability of individuals and governance models vary significantly. For example, the more traditional Pensions Manager role often has a dual role versus the dedicated role of a Chief Investment Officer for the pension schemes. For example, we have seen success in some of Canada s and the Netherlands largest pension schemes which have well-developed governance structures that allow them to operate in the best interest of members and provide solid returns. The ethos they have followed is to manage their schemes as a corporate business, with clear targets, fewer top-down restrictions and the ability to employ investment talent globally. In addition, this type of structure allows for career progression and provides a competitive reward package to attract individuals at the correct level of experience and expertise. With all business structures, we would expect the level of talent that a scheme can attract to have a significant impact on the long term success of a scheme. Adopting an appropriately resourced investment team i.e. a structure with a CIO function to set and implement strategy decisions that they are held accountable for, coupled with a review of all decisions and any assumptions used will drive transparency. In addition, consideration should be given to putting in place risk management tools that aid transparency across all schemes. There is an on-going need to raise the competency level of those making investment decisions and being able to therefore, achieve the liability objectives of the scheme. We have also observed that pension schemes who meet with their managers regularly are those that have a well-established governance structure with investment professionals at the heart. Their agenda typically is to discuss and debate the investment strategy and the running of the scheme as well as to challenge their advisors and fund managers in a way that we would suggest all schemes should. Economies of Scale Whilst numerous data sources suggest that economies of scale and efficiencies can be introduced through a larger scheme size, other considerations must be carefully worked through. In particular schemes must ensure they have a full understanding of the risks as well as any potential benefits of change. In our experience, the first area of interest and a significant driver of the decision making process is the fees payable. Fees for any strategy are determined through a number of driving factors with size of investment forming part of the decision making process. We have seen larger schemes benefit from this dynamic given the proportional allocations of investment sizes including the increase in coinvestment. Large funds with internal teams can also benefit from spreading systems and internal infrastructure fixed costs over a larger pool of assets. Secondly, our experience of working with larger schemes on strategy or investment design has shown greater flexibility and tailoring of investments, direct participation in capital intensive investments i.e. infrastructure that could potentially allow a scheme to have a positive impact on their local area. This does not imply that the smaller schemes are inherently at a disadvantage, as we currently offer a wide range of pooled fund investments that allow for similar exposures to be gained to a pre-defined set of investment criteria however, these can be limited dependent on capacity and minimum investment size for more niche investments. Larger schemes do face broader challenges as to the overall structure of the pension scheme. We have seen many approaches from the creation of pooling structures for underlying schemes to invest in, to merging of pension schemes with an amalgamation of liabilities. We have not seen any clear advantages to either approach and both present challenges. These challenges have included 4
the process of unitization, which can be an inhibitor to economies of scale and the additional transition costs (although one off) of bringing schemes together. Conclusions In our experience the common characteristics of successful schemes include the development of clear risk focused objectives which are measureable, along with a clear governance and team structure to implement, monitor and evolve their investment framework. We would also note that we believe there is a difference in the number of hours spent on the pension scheme dependent on size of scheme and the quality of individuals involved demonstrated by the level of contact and meetings we have with the respective clients. We particularly observe that schemes that are c 10bn and above in size appear to be able to devote sufficient time and resources. We believe that over time, large funds with the capacity to employ more time and expertise towards investments, demanding better risk management and risk systems and operating at lower costs should lead to better outcomes. It is also important to be aware of the operational complexity of bringing about this level of change. To conclude, one of the challenges cited in the call for evidence has been the need for greater transparency and clarity. Putting aside the considerations around the number of resultant schemes post any reform, setting out a clear framework that can be adjusted relative to each schemes set of liabilities would potentially achieve this. Key factors we would call out are: risk and return expectations, investment restrictions, risk tolerance levels and an expected asset allocation mix with criteria for efficient use of capital. We would welcome any further discussion on any of the points that we have raised here. 5