Local Government Pension Scheme: Opportunities for Collaboration, Cost Savings and Efficiencies

Local Government Pension Scheme: Opportunities for Collaboration, Cost Savings and Efficiencies Cheshire West and Chester Council s Response

Local Government Pension Scheme: Opportunities for collaboration, cost savings and efficiencies Cheshire West and Chester Council s response Cheshire West and Chester Council ( The Council ) in their role as the administering authority for the Cheshire Pension Fund ( The Fund ) welcome the opportunity to respond to this consultation The structure of the Local Government Pension Scheme and opportunities to reduce administration and investment management costs. The consultation document sets out 5 specific questions, each of which we respond to separately below. The consultation also invites any feasible proposals for the reduction of fund deficits. Consultation Questions Q1 Do you agree that common investment vehicles would allow funds to achieve economies of scale and deliver savings for listed and alternative investments? Please explain and evidence your view. In principle yes, we believe that common investment vehicles (CIVs) would allow funds to achieve economies of scale and deliver savings. From our own experience the investment industry typically structure their fee basis on an ad valorem basis and all things being equal we would therefore expect a reduction in investment fees from economies of scale from a greater weight of assets being invested through the CIVs. Whilst we believe that fee savings can be achieved through pooling assets passively, the biggest savings will come through pooling actively managed assets. We are less convinced about the cost benefits of pooling passively managed assets into a CIV as many Funds currently do this cost effectively in house or benefit from efficiencies e.g. crossing opportunities through investing in existing pooled structures which are larger than any LGPS CIV would be. We are firm advocates that active management has a place in a portfolio for LGPS funds and that effective active management can deliver excess return above benchmark net of fees. We do not believe that the CIV should be vehicles solely for passive management. This view will be expressed in more detail in our response to the passive versus active consultation point in question 5. Whilst not wishing to question the findings of Hymans Robertson s analysis, we would question whether the headline full savings quoted could be achieved as they assume a full transfer of bonds and equities to passive management across the LGPS. As advocates of active management we do not believe that such an outcome is optimal. As an investor in Fund of Funds structures in both the private equity and hedge fund asset classes, the Council is mindful of the additional layer of fees inherent in such structures. All things being equal we would therefore welcome any reduction in fees that a CIV might be able to achieve in direct comparison to a fund of fund approach. However, as investors in Fund of Funds structures, we are also mindful of the benefits and added value that these structures can provide investors, for example (but not limited to) access to the best underlying managers, diversification, active asset allocation decisions, due diligence and risk assessment of underlying managers etc. 1

We would not want these attractive benefits to be lost or diluted through the introduction of a CIV and would expect these qualities to be mirrored through the CIV s governance and operational arrangements and delivered to the same quality that we have evidenced from our existing Fund of Fund managers. It remains to be seen whether these services can be delivered for the 0.35% suggested in the consultation document. We welcome the opportunity that a CIV structure may offer smaller LGPS funds by providing them with access to a wider investment and manager universe (particularly in alternative asset classes), which may historically have been inaccessible to them either due to size of investment or limited oversight and governance budget. Q2 Do you agree with the proposal to keep decisions about asset allocation with the local fund authorities? Yes, we strongly agree that asset allocation decisions should remain with the local fund authorities. The LGPS is not a single homogenous mass and regional funds will have marked differences between them in terms of funding levels, maturity profile of membership, number and type of employers, cashflow profiling etc. Similarly the characteristics of individual LGPS funds and the diverse range of employers within each Fund are now arguably making the previous one size fits all approach to investment strategy increasingly tenuous. It is therefore totally appropriate that investment and funding strategy decisions are made locally and tailored to reflect the individual characteristics of each Fund and its employers. It is each individual Fund s asset returns (net of fees) relative to their own liabilities that is key to improving funding levels and ensuring the solvency of each fund. Keeping investment strategy, asset allocation and strategy implementation decisions with the local fund is also critical to maintain local accountability and retain the direct link to elected councillors, the Administering Authority and local employers. We note and welcome plans to make available more transparent and comparable data to identify the true cost and the relative success of implementing local investment and funding strategies. Q3 How many common investment vehicles should be established and which asset classes do you think should be separately represented in each of the listed asset and alternative asset common investment vehicles? We feel it is difficult to comment on how many CIVs to establish at the outset but a sensible start might be to create one CIV for all passively managed assets, be they equities or bonds. As advocates of active management, a small number of separate CIVs could be set up for actively managed asset class e.g. one CIV for actively managed listed assets such as equities and bonds. It would also feel appropriate to have a stand-alone CIV for alternatives due to their very different characteristics, for example through investing in longer term physical assets. As noted in the response to question 1 we are advocates of active management and our primary objective would be to ensure there are sufficient range of investment choices for Funds, in terms of asset classes, regions, investment styles and strategies. As advocates of active management we would also want the CIV to access the best of breed investment managers in each asset class. 2

LGPS funds have implemented very successful investment strategies and if these have been proven and evidenced to be successful we do not see why these approaches cannot be continued. Indeed learning from and following the successful LGPS funds could have a marked positive outcome across the LGPS if it is replicated by the lower performing Funds. These objectives however clearly need to be balanced, too much choice might have a negative impact on achieving the desired economies of scale whilst also placing too much administrative and governance pressure in setting up and administering the CIVs. Too little choice and Funds might feel that they do not have enough flexibility to implement their desired strategy. There should also be considerations around capacity constraints if too few options are in the CIV. Furthermore, too restrictive a choice could lead to increased manager and concentration risk across the LGPS. In terms of what should be separately represented in each of the listed and alternative CIV s, on balance our thoughts are laid out in the table below. At the outset we would suggest a plain vanilla or core offering combined with the flexibility to add additional (more esoteric) asset classes and strategies such as liability driven investing should there be sufficient demand from LGPS funds. Equities Bonds Alternatives UK equities Global equities (incl EM) Global equities (excluding EM) US equities European equities European equities (excl UK) North American equities Emerging market equities Pacific Basin equities Japanese equities UK Government Bonds UK Index Linked Bonds UK Corporate Bonds Global Fixed Income Emerging Market Debt High Yield Absolute Return Fixed Income Private Equity, Infrastructure, Property, Hedge Funds, Timber, Commodities, Secured Loans 3

Q4 What type of common investment vehicle do you believe would offer the most beneficial structure? What governance arrangements should be established? We recognise that we are not experts in the legal and regulatory structure of CIVs and DCLG will undoubtedly receive expert advice from within the investment and legal industries as to the most beneficial structure for any proposed CIVs. However we can comment on the characteristics that we would expect to see in such a CIV: Appropriately regulated Direct Ownership of Assets by investors Tax efficiency and transparency Segregation of liability at sub-fund level Cost efficient Flexible (broad range of asset classes and investment strategies) Flexible (allow additional asset classes and strategies to be added) Moreover we believe that as a secondary objective (subject to the characteristics noted above being met) an LGPS CIV should be domiciled in the UK and not (for arguments sake) in Ireland or Luxembourg based vehicles. On balance we consider that similar to the proposed London LGPS Collective Investment Vehicle, the CIV should be structured as an Authorised Contractual Scheme (ACS). This UK equivalent to the Irish and Luxembourg tax transparent entities would meet all of the characteristics set out above. Furthermore we concur with Squire Sanders view in the LGPS Structure Analysis Paper December 2013 that a Qualified Investor Scheme (QIS) is the most appropriate model to use for an ACS, since it preserves the maximum flexibility and has the least regulatory burden because investment in a QIS is open only to qualified investors. Governance Arrangements The highest possible governance arrangements will be critical for the success of what will inevitably be high profile and ground breaking new investment vehicle(s). The CIV operator should be governed by a strong Board of Directors, appropriately skilled to manage such a business. Organisationally we would expect the CIV to be structured similar to industry best practice with a suitably skilled Investment Committee, Professional Advisors, Risk Committee, Compliance Committee, Audit Committee, Independent administrators/custodians/auditors etc. Investor representation will be critical at the Board level of the CIV operator although we do not believe that the CIV operator itself should be a body representative of the LGPS. The priority for the operator should be to attract the best individuals with the appropriate qualifications, experience and skillsets. FCA authorisation requirements should help achieve this. The CIV operator should be accountable to an oversight or governance body that is representative of LGPS funds. Their terms of reference would include the appointment and removal of Directors, the appointment and removal of auditors of the company, agreeing the Articles of Association of the company. This body would also set the strategic direction of the operator and ensure that the interests of the LGPS and the CIV operator are aligned and give LGPS greater control and transparency over the management of its assets. 4

Q5. In light of the evidence on the relative costs and benefits of active and passive management, including Hymans Robertson s evidence on aggregate performance, which of the options set out above offers best value for taxpayers, Scheme members and employers? Funds could be required to move all listed assets into passive management, in order to maximise the savings achieved by the Scheme. Alternatively, funds could be required to invest a specified percentage of their listed assets passively; or to progressively increase their passive investments. Fund authorities could be required to manage listed assets passively on a comply or explain basis. Funds could simply be expected to consider the benefits of passively managed listed assets, in the light of the evidence set out in this paper and the Hymans Robertson report As commented earlier we believe there is a place for both active and passive management within an LGPS portfolio. We truly believe and have evidenced that strong active management can add value above index returns and (critically) net of fees. For example over a 5 year period our global equity manager has added 3.2% per annum above the benchmark returns, over a 3 year period, a separate global equity mandate has added 3.2% per annum above the benchmark returns, over 5 years our bond manager has added +2.7% per annum above the benchmark returns and our property manager has also added value above the benchmark of +3.9%. All of these returns are net of fees. Please note that these examples have not been cherry picked at the expense of other managers who have not delivered. All of our active managers who have been running money for a long enough timeframe to make a meaningful evaluation of their performance (3-5 years) have added value net of fees. In absolute terms we estimate active management has added 86.5m (net of fees) to the value of the Fund over the 3 year period ending 31 st March 2014. This outperformance is considerably higher than the savings that could be achieved through passive management. Indeed this outperformance has helped to improve our funding level as at the 2013 valuation and contributed to reducing upwards pressure on employer contribution rates. This added value improved the funding level by circa 2%. We recognise that for every winner there must be a loser and that with the sheer scale of LGPS assets under management, spread across a diversified range of investment managers, they effectively represent the market. There is no surprise therefore that aggregate LGPS returns might closely mirror the market s returns. But it feels counter intuitive to potentially forgo the excess returns that many LGPS consistently achieve with a race to the median (or perhaps more correctly a race to the market-cap weighted return). 5

One would hope that the creation of a suitably skilled and resourced LGPS CIV could replicate the success of the outperforming LGPS Funds and provide all Funds with access to a range of skilled active managers in a more cost effective way. A strong governance framework is a key feature of any successful pension fund and it follows that a strong governance framework is key if a Fund is to benefit from the positives that active management can provide. Through all stages of the lifecycle of an investment, from the original manager selection and due diligence process, through to having a robust and effective monitoring framework in place, governance is critical. Provided the CIVs are sufficiently resourced they should be able to replicate these characteristics within a governance framework which would create the right environment to select strong performing best of breed managers and then to monitor these managers effectively. Allowing all Funds access to managers selected and monitored within a robust framework should provide the ideal environment to deliver enhanced returns in aggregate across the LGPS through improved and consistent governance. An additional benefit would be that by effectively ceding the manager selection and ongoing monitoring to the CIV, this would free up limited investment governance resource across LGPS Funds that could be redirected to consider other strategic matters. We expect many advisors responses will comment on the flaws of passive asset allocation particularly when based on the traditional market cap weighted indices and especially if allocating capital to bonds based on levels of indebtedness. The Pension Fund Committee have acknowledged there are risks associated with investing passively. The nature of market cap weighted indices is that an investor is compelled to hold investments that it might otherwise avoid due to concerns around regions, industries, competition, obsolescence, excessive leverage and other factors. We agree with this thesis and that investing purely in a passive manner can result in sub optimal outcomes and we are against compulsory or mandatory allocations to passively managed assets. We do however believe that passive management has a place and that a combination of passive and active management (where there is strong belief that value can genuinely and consistently be added) can provide favourable outcomes for LGPS funds. In considering the limitations of traditional market cap weighted indices we would also welcome that any passive management options within the CIV be extended to include alternative indexation approaches or smart beta. In terms of the 3 specific options set out, as we believe that the LPGS is not one homogenous mass, each LGPS fund will have its own characteristics and investment strategy decisions should be made locally and tailored to each Fund s specific needs. One size does not fit all and therefore we do not believe that requiring Funds to invest a specified percentage of their listed assets passively will provide optimal solutions. 6

Taking the third option last, this has been the historical approach which has worked well for some Funds (including the Cheshire Pension Fund) where investment decisions, including whether to invest actively are taken within a robust governance framework. However, the range of outcomes identified in the Hymans Robertson report would suggest that this historical approach has clearly not worked for all Funds. Despite some reservations that a comply or explain regime could be misinterpreted as implicit endorsement or preference for passive management or the use of CIVs, we agree that on balance, from a governance perspective, Funds should be required to manage listed assets passively on a comply or explain basis. This should encourage the correct environment of challenge when making or reviewing decisions to invest in actively managed assets. As Funds are so different and will have different investment objectives it is not appropriate that one size fits all and therefore it is probably not appropriate to have a one size fits all reference point against which to comply or explain e.g. a starting assumption that all Funds should be 100% (or any other arbitrary %) invested passively. Deficit Management Whilst we welcome the possibility of cost reductions and savings that could be achieved through the introduction of CIV and/or greater use of passive management, we also still believe that the biggest issue facing the LGPS is poor funding levels and deficit management. We would welcome that the Government continues to explore opportunities to improve funding levels in the longer term, and that the Shadow Advisory will support the Government by (a) developing a shortlist of feasible options for managing deficits and (b) conducting further research on the costs and benefits of the key options for reform. As respondents to this consultation are also invited to submit any feasible proposals for the reduction of fund deficits, we would like to share with you our approach to improving funding positions by managing and reducing the volatility of funding levels. We believe that having a robust risk management framework is critical to managing deficits and we have approached this risk management in a number of ways over the last few years. All of which have the objective of reducing or the avoiding bad outcomes for the Fund and employers that have historically contributed to poor Funding levels. Firstly, to remove the volatility in funding levels (driven by an allocation to equities not untypical for an LGPS fund), we made the strategic decision to re-allocate 15% of total fund assets into Absolute Return Products to capture equity like returns but without the volatility and to reduce downside risk. Secondly we then worked with our advisors to develop an innovative de-risking strategy where the asset allocation dynamically de-risks to pre agreed allocations to growth and defensive assets once pre-agreed funding level triggers have had been hit. This allows the Fund to capture significant gains in funding levels (and bank any excess gain). All of this is underpinned by modelling which ensures that any de-risking is only actioned if there is no upwards impact on contribution rates or significant reduction in the likelihood of success of achieving the employers long term funding objectives. Likewise there are pre-defined re-risking should funding levels decrease. 7

In the short time that this de-risking system has been in place, two triggers have been breached and the Fund has had the processes and the governance and risk management framework in place to recognise improvement in funding levels and move some 430m of assets from growth assets to defensive assets. Without impacting employer contribution rates or reducing the likelihood of success in achieving the employers long term funding objectives. A common theme in this response is that each LPGS Fund has their own characteristics and each employer or group of employers also has differing characteristics in terms of funding levels, maturity profile of membership, time horizon in the LGPS, covenant, cashflow profiling etc. From a risk management perspective the one size fits all approach is becoming increasingly tenuous and administering authorities need a robust risk management framework to capture and fully understand the risks that individual employers bring to the Fund and how the Fund s risk profile can change very quickly e.g. major outsourcings. Such a risk management framework allows funds to be proactive rather than reactive to events and tailor and adapt investment and funding strategies as appropriate. Whilst we welcome DCLG s ambitions to reduce investment management fees, the size of the improvement in funding level that we have de-risked and protected, supports our view that, while fees are clearly important, the key to the long term sustainability of the LGPS is deficit management. A 430m improvement to funding levels that we have protected, equates to the impact of removing all investment management fees completely for a period of 20 years. Our experience since implementing the de-risking strategy also reinforces our view that investment strategy and asset allocation decisions must remain with the local fund authorities. It also emphasises our view that while the CIVs will hopefully provide the building blocks for Funds to implement their investment strategies, there should also be recognition of, and the flexibility to allow, funds to implement solutions which are appropriate to achieve their own objectives but which may not be achievable through a CIV. 8