Viewpoint: The pension conundrum

The Local Government Pension Scheme is under strain – Tom Jeffery argues that it needs to be looking at investment alternatives and changes to infrastructure in order to maintain its independence.

The equivalent of 16 per cent of the UK work force are members of the Local Government Pension Scheme. Yet its financial basis is unsustainable, the Centre for Policy Studies recently argued. This is partly due to historical neglect of the asset base, partly due to increased lifespans, but also due to unexpected management costs.

Many expect a surreptitious bailout – some even invoke the transfer of £28bn of Royal Mail Pension Plan assets to the Exchequer in 2012 when the gap between its assets and liabilities became crippling. George Osborne has additional ideas, specifically pooling 89 LGPS funds into British Wealth Funds with a focus on infrastructure. Eight LGPS funds in the Midlands announced in January that they would create a £35 billion multi-asset investment pool, and LGPS Board set forward a similar strategy that month. Could deficit-crunching returns actually be found in infrastructure, however, and is it appropriate that the Chancellor should dictate where local government’s pensions are invested?

With turbulent times ahead for the global economy, alternative investments such as private equity are where long-term capital is finding returns. Managers this year are buying and selling companies in sectors like energy infrastructure, medical technology and consumer services in the emerging markets. For their trouble, they traditionally took 20 per cent of a fund’s returns alongside a two per cent management fee – the “two-and-twenty” structure.

In exchange, these funds outperform public stocks by “at least three per cent per year” according to the (scarce) reliable data. It is the size of the asset under management, and the length of commitment, which has made this calculus work for institutional investors. Industry data provider Preqin found in 2013 that for public pension funds, private equity had outperformed publicly-listed stocks and shares net of fees by four per cent over three, five and ten-year horizons.

There is a case, therefore, for much more radical pooling of LGPS funds to provide the economies of scale and corresponding reductions in the cost of asset management that would help it meet its existing commitments. However, the LGPS has not seized the opportunity in alternative investments. In 2014, the majority of LGPS assets were managed by four investment banks, and allocations to private equity were 1.9 per cent. That year, the government announced it would move to passively invested vehicles – essentially cutting out fund managers and fund management fees. A former LGPS CEO told Modern Investor he was “not a big fan” of the asset class. This has been due to fears of getting invested assets back in the next financial downturn: forgetting that thanks to their long time horizon private equity investments generally outperformed other asset classes during the last financial crisis.

By contrast, the California Public Employees’ Retirement System (CalPERS) has 9.8 per cent of its total assets allocated to private equity. California has used the size of its public pension systems – CalPERS has $278.6 billion assets under management – to demand transparency over its investments. A current bill before the state legislature demands at least yearly reports which “make specified disclosures regarding fees and expenses”.

It’s an industry in transition, and the most significant change is investors with internal investment staff cutting out managers. Four per cent of CalPERS private equity investments are direct – including a 12.7 stake in Gatwick Airport – and these were generating annual returns of 21.1 percent in 2014. The pressure is on for the ‘sleeping giant’ of pension funds to wake up. It needs more active, not passive, investment strategies to get the sustainable returns it needs. If it wants to keep its independence, meanwhile, securing investment talent with an informed approach to alternatives will be essential.

Tom Jeffery writes about social policy and alternative investment. Get in touch with him here.

    1. Tom Jeffery says:

      Hi Peter – thanks for reading. The two-and-twenty fees structure hasn’t traditionally been negotiable – it’s the cost investors would sustain for the returns provided. In narrowly economic terms performance of private equity has justified the costs. As I point out above however, pension funds in particular are spearheading a shift towards smaller management costs but also greater involvement in management of their assets. I argue that LGPS should be using its size to get a better deal – not just in terms of returns or asset management costs. It should also be gaining expertise in investing directly to attack its deficit and ensure its independence.

    2. Peter Lloyd Jones says:

      A 20% fee in additional to a management fee seems excessive. I assume this a Success Fee. There is substantial public monies involved. If it is necessary to pay a Success Fee, and I have serious queries, then I consider 10% to be adequate as both inducement/remuneration.

    3. Colin Meech says:

      A move to ‘alternatives’ would not be the solution for the LGPS. They are high in costs with no corresponding returns to match the demands of the scheme. The LGPS needs the following
      Firstly – cost transparency RPMI dedicates staff to cost investigation
      Secondly – check the investment strategy and is it the cheapest option and delivers a better return – it if does not
      Thirdly – change the strategy – eg – active to passive. On top of which it needs scale the CIV’s are one approach and we need to see if these deliver.
      Transparency of cost isn’t necessarily a panacea, the opposite of transparency is definitely a problem. And its a problem for the LGPS. This is what the CIO of Railpen has to say about private market costs, “When we looked at the fees that we apparently paid… into the pooled vehicles that we used to invest primarily in private markets… hedge funds etc, we found that if we added those up and dug as deeply as we could to find them all, the total was actually about four times what we thought it was.” All pension funds need to think about pulling every lever available to them in order to improve returns. That’s cost, that’s asset management, that’s structure.

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