Analysis: Local government pension funds’ passive plan: the £178bn ownership question

The UK government’s idea of making the 89 funds in the Local Government Pension Scheme (LGPS) with combined assets of £178bn (€225.4bn) switch to using passive investments for listed assets and pooled ‘collective investment vehicles’ (CIVs) has led to a range of views about what it means for the funds as owners of, and engagers with, companies.
Some feel the plans – whose consultation ended earlier this month – could provide a boost for stewardship. Others see them as completely wrong.

The government is proposing the changes, reckoning it can lead to some £660m in savings per year across the funds based on an analysis by consultants Hymans Robertson. Hymans found that while some funds have consistently performed well – thanks to active management – the funds in aggregate have performed “no better than the index”. There is no suggestion that the funds should be merged. Each fund in the system has its own funding level, cash-flow and balance of active, deferred and pensioner members, which it takes into account when adopting its investment strategy.

It’s argued CIVs would provide economies of scale while going passive would reduce investment fees.

One critic of the proposals is Lord Smith, the former Labour government minister who currently chairs the Environment Agency, the public body whose £2.2bn pension fund is one of the leading responsible investors in the UK and a proponent of active management.

“It is going in the completely wrong direction. It is a knee-jerk response to some badly administered local authority pension funds,” Smith said at an event organised by UKSIF, the UK Sustainable Investment and Finance Association. He also said: “More in the private sector know the success of the Environment Agency Pension Fund than in the public sector.”Speaking at the recent RI Europe 2014 conference, Mark Mansley, Chief Investment Officer at the Environment Agency Pension Fund, questioned whether the fund would have been able to make its almost 25% of sustainability-themed investments via passive investment structures.

UKSIF itself said the LGPS proposal flew in the face of a recent UK Law Commission review on fiduciary duty proposed by the Kay Review, which it said was likely to lead to increased active management at the portfolio level as the best way of considering and mitigating long-term sector and company specific risks: “The use of simple passive management at the asset class level cannot address these issues. The consequences of this evolving position are of great significance for the consultation. The nature and suitability of simple, low-cost passive investment without a material stewardship element for pension funds may well now be open to challenge.”

PIRC, the governance research firm which is the research and engagement partner to the 60-member Local Authority Pension Fund Forum (LAPFF), says the Hymans report “provides no consideration of the corporate governance policies and practices operated by a pension fund in the stewardship of fund assets” and the UK’s Corporate Governance and Stewardship Codes. The introduction of CIVs, it adds, could weaken this “significantly” amongst LGPS funds – “historically a group of investors who have developed and applied ESG principles”.

PIRC adds that it is unclear under the proposals how active ownership in terms of company engagement and proxy voting will operate and at what level, whether that be at the fund, CIV or asset manager stage.

Another concern is that a passive approach would not reflect individual funds’ concerns about holding stocks that they are concerned about.

“Some stock selection is essential,” PIRC argues, “to avoid financial and reputational issues of holding a particular stock with unacceptable governance arrangements or ESG concerns.”

But Colin Melvin, chief executive at Hermes Equity Ownership Services, the engagement services provider that’s ultimately owned by the BT Pension Scheme, told RI that the plans could “increase ownership leverage” by reducing fragmentation: “I see it as good for stewardship.”

The National Association of Pension Funds (NAPF), the industry body, slammed the government’s “narrow vision” for focusing on reduced costs rather than asking how the funds can secure liabilities and reduce deficits. While acknowledging the substantial savings, the NAPF says they are a tiny proportion of the funds’ collective £47bn deficit. The NAPF wanted the government to focus on identifying good and bad performance at the fund level.

The London Pensions Fund Authority (LPFA), for its part, has proposed what calls a “wider partnership model” based on Asset & Liability Management (ALM).“The consultation rightly identifies the need for change, but wrongly prescribes a narrow solution,” the LPFA says – adding that a single asset class CIV would create a new tier of entities and attendant bureaucracy “without proper incentives to focus on the underlying liabilities”.

Instead it is putting forward an ALM model as the optimum structure to cut costs and give direct access to asset classes, like infrastructure and housing, which better match fund liabilities. Deputy Chairman Sir Merrick Cockell said: “Our model can happen within existing legislation and we are already working with like-minded funds to develop a partnership.”

There is little detail in the proposals about the CIV structure would work in practice. One model under consideration is the tax transparent Authorised Contractual Scheme. A CIV for the London Boroughs is pencilled in for launch in early 2015.

The CIV idea is being seen in some quarters as the UK’s version of tax-efficient pooled fund structures found elsewhere in Europe, such as Ireland’s Common Contractual Fund (CCF) or Luxembourg’s Fonds Commun de Placement (FCP).