The UK government’s much anticipated proposals for the management of local government pension scheme assets have been released following Chancellor Rachel Reeves’ speech at the Mansion House. The aims are to achieve higher returns for pension fund members and boost UK economic growth through creating larger pension funds referred to as ‘pools’, better governance and more local investment.
There is much to be liked: a clear investment process, trying to ensure that those making decisions are well equipped to do so and encouraging the pools to work together to facilitate investment in a wider range of asset classes. There was also relief that investment in the UK was encouraged, not mandated, and that there are to be eight pool groupings (at least in the first instance) and not just one or a handful of mega funds.
However, some contentious assumptions have been made and some challenges underestimated.
Australia and Canada have led the way
The UK authorities have enthused over the large and successful Australian and especially Canadian public sector funds. The view has repeatedly been expressed that if UK public sector funds can be set up to resemble these funds, then investment performance will be better and the UK will benefit more generally. While there is agreement that most UK public sector funds are too small and that the Canadian investment teams are to be admired, there are a few catches.
First, there is no indication that the top management of the enlarged UK funds will be paid anything like as much as the top management of the Canadian funds, so the talent pool will be quite different. Second, the Canadian funds have benefitted greatly from their investments in private assets, notably infrastructure, and the UK government is very positive on UK pension funds investing in private assets. However, this strong performance is in the past and the famed Yale and Harvard endowment funds, which were the front runners of this investment approach, are no longer outperforming in the current tougher times for private equity.
In a similar vein, the government has cited successes by the Canadians and Australians when encouraging UK funds to invest in high-growth companies ‘including venture capital and growth equity’ and has suggested an ‘ambition’ of 10% in private equity. While this is not unreasonable for some funds, the guidance appears to give the impression that success is inevitable, which is not how investment markets work.
Investing locally and providing an asset allocation capability
An area where very strong direction is being given is so called ‘local’ investment. The proposals would require the pools to carry out due diligence on potential local investments put forward by the existing funds. Although the obvious potential conflicts of interest are acknowledged, these investments appear to be projects historically financed by local government from taxation and are in danger of breaching a fund’s fiduciary duty.
More positively, the various stages in the investment process are clearly set out, along with who is responsible at each stage of the process. Manager selection is clearly the domain of the pools and the investment objectives will continue to be determined by the existing funds. While the responsibility for the strategic asset allocation is contentious, the real issue is the ability of the designated parties to carry out the stated activities.
This is most acute at the asset allocation level. At present, the funds follow the advice of their professional advisers, in particular their investment consultants and independent advisers. The former generally have sizeable teams of specialists who carry out economic and financial research, scenario testing and modelling work. In contrast, the pools have limited, if any, resource in this field. Even if the pools were able to build up credible teams, I think the cost for a pool to do this could be prohibitive. A specialist operation shared by all the pools might be a viable solution.
Tight deadline and limited resources
A major challenge is the timescale set by the government of 31 March 2026 for the new order to be in place. Hiring investment strategy specialists of suitable quality will not be easy and it might make more sense for the pools to provide support on investment strategy for at least the first few years, rather than being the principal adviser. Similarly, I doubt it is viable within the time set for the pools to build up the resource required to carry out due diligence on the presumably very large number of local investment proposals put forward.
I would also suggest that the emphasis on in-house investment management is excessive. For example, management of passive funds is very much a matter of scale, and it seems to me unlikely that a pool could carry this out as cheaply or as well as the likes of BlackRock. I would hope that coverage of niche areas such as agriculture will be outsourced, together with certain aspects of investment strategy.
At the end of the day, investment performance will be crucial and the pools will need to be held accountable. Financial Conduct Authority authorisation is no guarantee of satisfactory performance and it is fair to say that manager selection to date has generally been disappointing. In my view, the proposed requirements that the boards of the pools should include one or more representatives from the underlying funds and that asset performance and transaction costs are published are inadequate and need to be strengthened.
Colin Robertson is the Independent Adviser to two local government pension funds and is a former Global Head of Asset Allocation at Aon.
Image source: UK Treasury