Local authority pension schemes in the UK, which risk losing their professional investor status following the implementation of the Mifid II directive, are the only schemes of their type across Europe facing such a radical change to their investment scope.
The EU’s Markets in Financial Instruments Directive (Mifid) II, which comes into force on January 3 2018, meant a reclassification of local government pension schemes (LGPS) funds as retail investors. But new, relaxed, guidance issued by the Financial Conduct Authority (FCA) in July allows the funds to “opt up”, provided they meet certain quantitative and qualitative criteria laid down by the UK watchdog.
“This is a unique problem to the UK – it doesn’t occur anywhere else in Europe” – James Walsh, PLSA
James Walsh, Head of Engagement, EU and Regulation at the UK’s umbrella body for pension funds, the PLSA, said: “This is a unique problem to the UK – it doesn’t occur anywhere else in Europe because most EU countries don’t have similar defined benefit (DB) pension schemes. There are only a handful of countries that have some flavour of DB – the Netherlands, Belgium, Ireland and Germany – and these countries don’t have any meaningful DB schemes in the public sector. In fact, most EU states don’t have the same kind of work-based pension provision that we have in the UK.”
Matthies Verstegen, Policy Adviser at trade body PensionsEurope, concurred. “As far as we are aware, client categorisation has not yet been a problem for local authorities’ pension schemes elsewhere in Europe.” He added: “In principle, Mifid II categorises pension funds as professional clients, whereas local authorities are deemed retail clients. National regulators have a degree of discretion how to apply these rules in their jurisdiction.”
The European Commission instigated a review of MiFiD due to the increasing complexity of financial products in the wake of the 2008 financial crisis. But for LGPS funds, losing their professional investor status would mean that they would be unable to invest in complex investment strategies such as infrastructure – potentially triggering a fire sale of assets.
Schemes are now scrambling to ‘opt up’ ahead of implementation of the directive, with 87 out of the 89 LGPS funds writing to their investment managers asking to retain their status as professional investors.
Funds can use a template developed by the Local Government Association (LGA) and the Investment Association aimed at simplifying the process. The process involves completing and sending a letter requesting consent to be opted-up and a questionnaire of supporting evidence to their relevant investment managers.Once investment managers receive a request from local authorities to opt up, they need to assess if criteria for reclassification has been met before making a decision.
After lobbying from the LGPS Advisory Board, the LGA and the Investment Association, the UK watchdog softened the quantitative and qualitative tests for LGPS funds to opt up. As part of the quantitative test, authorities must meet two out of four requirements, which include having an investment portfolio of more than £10m and being an ‘administering authority’ of the LGPS – conditions most LGPS funds are expected to meet.
The qualitative test requires investment firms to assess the expertise, experience and knowledge of the authority in terms of making investment decisions and understanding risks. Local authorities need to demonstrate their capabilities in meeting this requirement.
Crucially, the FCA also acknowledges the typical LGPS governance arrangements as a collective, taking into account the expertise of committee members, officers, consultants and advisors.
Andrien Meyers, a Senior Policy Advisor to the LGPS’s Scheme Advisory Board, said: “We are very positive that all 89 LGPS funds will be opted up by the time Mifid II comes into force on Jan 3, 2018. All but two of the LGPS funds have started the process of sending letters asking their investment managers to opt them up.”
87 out of the 89 LGPS funds have written to their investment managers asking to retain their status as professional investors
Meyers, who is also CIO at the Lambeth Pension Fund, said: “At Lambeth, not only have we sent the letters, but we have also heard back from half of our investment managers confirming that they will opt us up.”
David Walker, head of LGPS Investments at Hymans Robertson, said firms deciding to opt up need to be aware of the implications of being either a retail or professional client.
He said: “If funds do decide to opt up, they need to weigh up losing the protection that they could have as retail clients. On the other hand, opting up to a professional client status would mean business-as-usual for most of them whereas with the retail investor status, a range of more complex areas will be restricted. These are generally illiquid investments such as those in infrastructure.”