PENSIONSANDSAVINGS.COM

2 May 2014

• Cost of local authority pension contributions could be cut by over 10%
• Proposals to save council taxpayers £660m a year on investment fees
• Conclusion that active managers are not worth high fees may be contentious
• Pooling assets could allow more money to go to boost infrastructure

Councils paying over £6bn a year into staff pensions: Contributions to local authority pension schemes in England and Wales have quadrupled since 1997 to £6.2bn a year. The scheme benefits have been redesigned from April 2014, moving to a career average, rather than final salary scheme, which is expected to make long-term savings, however the Department for Communities and Local Government is looking for ways to control the costs. Cash-strapped councils and hard-pressed council taxpayers will welcome any further cost-savings that can be achieved.

Councils and boroughs each running separate funds: Currently, the 100+ pension funds for councils and boroughs across England and Wales, with a total of £178billion in assets and 4.68million members, are run separately, each with its own investment managers, asset allocation and advisers and separate procurement arrangements.

Investment management and administration costs are very high: Local authorities report the costs of pension fund investment as £409m a year, which amounts to 6.6% of the total annual council contributions. However Hymans Robertson have analysed this in more detail and suggest that the annual cost is actually £790m (nearly double the reported figure) and this still excludes transaction costs and performance fees for alternative assets.

The DCLG has put forward proposals that it believes could cut these costs by £660m a year: The Department for Communities and Local Government has issued a consultation that suggests pooling of assets could achieve huge savings for local taxpayers. You can link to it here – https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/307923/Consultation_LGPS_structural_reform.pdf?utm_source=Economics+Press+Releases&utm_campaign=06d513b9c8-FTT_chown_lawson&utm_medium=email&utm_term=0_82d79daab2-06d513b9c8-

Pooling assets to achieve economies of scale and cut fees: By pooling the local authority pension assets into two large Common Investment Funds, significant savings are expected to be achievable. That will offer passively managed equities and bonds at a much lower investment management cost than is paid each year to the current individual scheme managers. The DCLG proposals should save £660m a year. This is more than 10% of the annual cost of pension contributions each year, amounting to a saving of £141 per member per year.

Two funds proposed – one for passively managed equities and bonds and one for alternative assets.
Using passive investment expected to save significant sums without jeopardising performance: Each individual fund also chooses its own investment managers for conventional assets such as equities and bonds. Again, fund management costs tend to be higher for smaller funds than larger funds. The DCLG also believes that the costs of managing these assets actively, rather than just using passive investments, have not been justified by superior performance over time. Moving from active fund management to passive fund management is expected to save a total of £420m a year. £230m of this will be from reduced investment management fees and £190m will be due to lower transaction costs, as passively managed investment funds tend to trade less often than active managers.

Many asset management firms may disagree: The conclusion that it is not worth paying higher fees for active management is highly contentious. Many investment management firms claim to offer superior performance by adding manager expertise to outperform indices. Academic evidence supports some outperformance over time, but many studies have concluded that active managers have been unable to demonstrate consistent enough outperformance to justify higher fees. Passive management will not outperform indices, due to its costs, but the lower fees charged by passive managers can often lead to better performance relative to active managers who underperform. This is likely to prove the most contentious part of the proposal and it could be that some funds will still want to invest some of their assets with active managers in the hope of adding extra value. They will still be allowed to do so and it will be of interest over time to see how they perform relative to a passive Common Investment Vehicle.

Fees for alternative assets highest, especially with fund of funds: Local authorities have invested significantly in alternative assets such as hedge funds and private equity in recent years, seeking higher returns to help overcome large scheme deficits. The costs of investing in such assets are often very high as they require specialist management. The DCLG says alternative assets account for under 10% of total assets, yet they represent more than 40% of the investment management costs. Without a large asset pool, individual funds are unable to invest enough to meet the minimum requirements of many hedge fund or private equity managers, so the schemes have had to use fund of fund vehicles, which add an extra layer of fees. Using a Common Investment Vehicle for all alternative assets would allow councils to invest directly in alternative funds, instead of having to use funds of funds. This is expected to save £240m in investment fees each year.

Investing more assets in infrastructure could help boost the economy as well as providing good returns: The same problem arises with infrastructure investing, as smaller funds are generally unable to achieve sufficient size for a meaningful investment. Infrastructure tends to have return characteristics that enhance expected returns for pension funds. The assets have a long-term return profile and are often inflation-linked, which helps with the duration and liability matching that pension schemes require. If smaller funds’ assets can form part of a larger pool, they can access a wider range of investments, as well as achieving economies of scale that reduce the investment management costs significantly. Using pension fund assets to boost the economy could be a win-win, if the asset returns help overcome deficits as well as generating growth. It makes sense to use local authority assets in this way and cutting the costs of such investment will enhance long-term returns.

Could be a model for private sector smaller schemes too?: These proposals are of interest to the wider pensions industry too, since the principle of pooling assets could help a number of other smaller schemes who are struggling with high ongoing costs and large deficits. It will be interesting to see the responses to the consultation.