We set out below our response to the Government’s recent Call For Evidence ahead of its Pensions Investment Review. We have only responded to questions where we believe we have important points to make or questions to raise.
Scale and consolidation
What are the potential advantages, and any risks, for UK pension savers and UK economic growth from a more consolidated future DC market consisting of a higher concentration of savers and assets in schemes or providers with scale?
What should the role of Single Employer Trusts be in a more consolidated future DC market?
What should the relative role of master trusts and GPPs be in the future pensions landscape? How do the roles and responsibilities of trustees and IGCs compare? Which players in a market with more scale are more likely to adopt new investment strategies that include exposure to UK productive assets? Are master trusts (with a fiduciary duty to their members) or GPPs more likely to pursue diversified portfolios and deliver both higher investment in UK productive finance assets and better saver outcomes?
What are the barriers to commercial or regulation-driven consolidation in the DC market, including competitive and legal factors?
To what extent has LGPS asset pooling been successful, including specific models of pooling, with respect to delivering improved long-term risk-adjusted returns and capacity to invest in a wider range of asset classes?
We believe the financial benefit so far, if measured accurately, would be found to be very limited. Returns will be little different from what they would have been without pooling, as many of the pools have been resource-constrained and have therefore chosen to use external managers. In many cases these will have been the same or similar as those partner funds used previously, so returns will have been comparable. The level of risk taken will not have changed either.
On the debit side, investment expenses, as reported in the SF3 dataset, rose from £971m in 2018 to £1,760m in 2023. This is a £789m increase in costs in the past five years, compared to the £360m saving claimed by the Government from pooling.
Five years is too short a time to make a judgement on the success of pooling in delivering superior risk-adjusted returns. The LGPS in aggregate has a good long-term track record of adding value through their investment decisions (e.g., over the last ten years the average LGPS return net of costs has been 6.5% (Source: SAB 2023 report) vs an average discount rate of around 4.4% (Source: GAD 2022 S13 report Chart 5.1) i.e., net value added from their investment decisions of about 2%. This is comparable to the Canadian Pension Scheme’s net value added of 2.2% (Source: Ambachtsheer, Journal of Portfolio Management, April 2021). While there may be other benefits to pooling, we do not believe it will deliver any higher net value added than that achieved under the current more fragmented structure.
We believe that models of pooling which have independent boards are more likely to succeed. Most of the pools today are hamstrung because they were set up under the Teckal exemption from public procurement. One of the conditions of using that is that partner funds have had to demonstrate control. The consequence is too many matters are reserved to the partner funds.
The new Public Procurement bill which will now come into law in February 2025 has clarified the financial services exemption to include both portfolio management and investment advice. We think partner funds could, if they wished, use this for the pools and relinquish much, if not all of the controls they currently have. Their remedy for unsatisfactory delivery of the objectives which as shareholders they set would be to change the Board.
It may be that some smaller partner funds have been able to use the pools’ greater expertise to invest in a wider range of asset classes. The pools in most cases have the resources to deliver a greater level of monitoring, but we doubt whether many funds have changed their asset allocation to take advantage of new asset classes available from the pools.
Costs vs Value
What are the respective roles and relative influence of employers, advisers, trustees/IGCs and pension providers in setting costs in the workplace DC market, and the impact of intense price competition on asset allocation?
Is there a case for Government interventions, aimed at employers or other participants in the market, designed to encourage pension schemes to increase their investment budgets in order to seek higher investment returns from a wider range of asset classes?
We believe that Government intervention of this kind would be a retrograde step which would conflict with the fiduciary duty of Trustees (DC) or their equivalents (LGPS).
We assume the reference to investment budgets really means investment risk budgets, as higher investment returns can only be achieved by setting a higher risk budget.
Both the 2012 Kay review and the 2014 Law Commission Report into the Fiduciary Duty of Investment Intermediaries make it absolutely clear that trustees must not “fetter their discretion” to invest on behalf of their beneficiaries. “They must genuinely consider how to achieve a pension for their members and must not simply apply a pre-existing moral or political judgement.” (Law Commission 6.12).
The LGPS comes under different legislation but expert legal opinion commissioned by the LGA (Giffin Opinion March 2014) is equally clear that the same applies. In his words, “the administering authority’s power of investment must be exercised for investment purposes, and not for any wider purposes.” (para 23).
The current statutory guidance on setting an Investment Strategy Statement states that ‘the appetite of individual administering authorities for taking risk when making investment decisions can only be a matter for local consideration and determination, subject to the aim and purpose of a pension fund to maximise the returns from investment returns within reasonable risk parameters.
Any attempt by the Government to try to influence or, worse, legislate to increase investment in assets offering higher returns would therefore be contrary to current law and statutory guidance.
We note that in practice LGPS funds tend to have a higher appetite for risk than the actuarial calculations demand, because they wish to keep contributions down. Higher investment returns through investing in higher risk asset classes will do this if successful – though of course there is always the risk that they may fail. Well-funded funds can bear the risk of failure to a greater extent, and may therefore have more appetite for risk than less well funded ones.
Investing in the UK
What is the potential for a more consolidated LGPS and workplace DC market, combined with an increased focus on net investment returns (rather than costs), to increase net investment in UK asset classes such as unlisted and listed equity and infrastructure, and the potential impacts of such an increase on UK growth?
In our view a consolidated LGPS might well lead to less domestic investment, because a more professional investment team will have more awareness of and more access to investments anywhere in the world. In a recent Pensions & Investment Article (August 15th 2024) Gordon Clark, senior consultant and emeritus professor at Oxford University’s Smith School of Enterprise and the Environment was reported as saying: “consolidation isn’t a recipe for investing locally. I think it’s a recipe for extending the geographical reach of investment, as well as the sophistication of investment products.”
We note from the latest SAB report that UK listed equities amounted to about 12% of total listed equities (6% of 51%). This compares with the market cap index weight of 3.5%. Linchpin’s clients tend to hold substantially more in U.K. equities, as our advice is that they make a better currency match for liabilities. However, this must be a decision for those with fiduciary responsibility and their advisers.
The same article also states that around 67% of LGPS funds’ infrastructure investments are in the U.K. We find it hard to believe this number will increase as a result of consolidation.
Venture cap and early-stage private equity investment is the area which would have the most impact on U.K. growth. However, the lessons from Silicon Valley are that to create a successful enterprise hub requires far more than just increasing the finance available to new enterprises. Much of this is the responsibility of the government e.g., more flexible employment law; tax incentives for private equity and investors; even a relaxation of health and safety regulations; changes to bankruptcy law.
If a coherent policy covering all these areas (bearing in mind that what is required to stimulate growth is not all consistent with Government policy elsewhere) were to be put in place so that an enterprise hub was created, in our view financial investment would follow. But experience elsewhere suggests that financial investment cannot lead the way.
We believe there is scope for improving the availability of debt finance for smaller and midsize local companies where banks have withdrawn from lending and private credit is focusing on lending to companies sponsored by private equity. This is lower risk and lower return and in many ways more suited to pension funds than venture cap.
From a Government perspective, incentives to pension funds to lend in this area are more likely to succeed than setting arbitrary targets. We are aware of some interesting new methodologies in this area which use AI.
What are the main factors behind changing patterns of UK pension fund investment in UK asset classes (including UK-listed equities), such as past and predicted asset price performance and cost factors?
The major factor historically has been the behaviour of consultants. In the private DB sector they have reduced equity allocations as a consequence of FRS 17 which put profits and losses of pension funds onto corporate balance sheets. But more importantly, they have moved away from UK specific mandates to global ones where the benchmark (currently) only has a 3.5% allocation to the U.K.
Their reasoning has been that the performance of global equities has been superior and investing globally offers more diversification. In our view the domination of the U.S., currently more than 70% of the index, and the top 10 stocks, more than 20%, has reduced the latter argument’s strength. We favour higher weightings to the U.K. because U.K. equities are better matched against clients’ GBP liabilities.
Other factors which have driven this shift are the ‘old economy’ weightings in oil and banks in the FTSE 100, which have underperformed ‘new economy’ technology. It is not possible to predict whether this will continue. However, we note that mid-cap UK companies (i.e., by size numbers 101-350), which do not have the same bias, have over the long-term delivered similar performance to the main US S&P500 index. Only over the past seven years have they materially underperformed. There is some reason for expecting them to outperform going forward, as their aggregate earnings growth is comparable, while they trade at much cheaper valuations.
The LGPS, unlike the corporate DB sector, has shunned government and corporate bonds over the past 10 years. That has been a logical response to the 2009-2020 period of very low yields, but also reflects the reduction in supply and much poorer liquidity in these markets. An unintended consequence of central bank’s Quantitative Easing, and specifically the Bank of England’s Asset Purchase programme, during the 2010-2020 period was to reduce market liquidity in the fixed income markets in the U.K.
In contrast, allocations to private credit have expanded. Since the Global Financial Crisis banks have increasingly withdrawn from lending as a result of stricter capital adequacy regulations (Basel II and Basel III). Companies have been forced to go to private lenders, either directly or as a result of being acquired (and leveraged up) by private equity. This trend is likely to continue globally including in the U.K.
Is there a case for establishing additional incentives or requirements aimed at raising the portfolio allocations of DC and LGPS funds to UK assets or particular UK asset classes, taking into account the priorities of the review to improve saver outcomes and boost UK growth? In addition, for the LGPS, there are options to support and incentivise investment in local communities contributing to local and regional growth. What are the options for those incentives and requirements and what are their relative merits and predicted effectiveness?
Improving saver outcomes is a valid objective of the Review. However, while boosting U.K. growth is understandably a Government objective, it is wrong in law to make it an objective for pension funds.
We explained above (Cost and Values Q2) that it is emphatically not the Government’s role to ‘fetter’ the discretion of those with fiduciary duty to pensioners. We repeat what Giffin said in his 2014 expert legal opinion: “the administering authority’s power of investment must be exercised for investment purposes, and not for any wider purposes.” (para 23). Pension Trustees and their LGPS equivalents should not in any way be forced to consider the Government’s wider objectives.
We also note that the cost of any failure of an LGPS fund would fall on the local Scheme Administrator, as there is no Crown guarantee, as was clarified by legal opinion in 2015 (Giffin Opinion September 2014 para 18). It is therefore essential they have the discretion to take all investment decisions without being fettered.
In our opinion the law precludes any attempt to establish a requirement to invest in U.K. assets.
We are also sceptical that it would improve saver outcomes. There is no reason to expect U.K. assets to outperform those elsewhere in the world.
Nor are we in favour of establishing incentives unless it is done as part of a broader programme to establish an enterprise hub. LGPS funds are generally keen to invest in local communities if the opportunity presented is on a viable scale and can be expected to deliver an adequate financial return. Our concern is that incentives would distort the market and lead funds to make investments which then disappoint. We also very much doubt that they would have much, if any, effect.
The barriers to local investments are those of scale and conflict of interest. We would support initiatives such as GLIL (in infrastructure), managed by LPPI but invested in by funds from other pools too. We doubt it makes sense for each pool to set up local funds in each asset class. We would therefore encourage DCLG to make it explicit that funds could invest in other pool’s products. In due course this would deliver centres of excellence for investing in U.K. assets which all LGPS funds could, if they wished, participate in.
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