Why pension funds should invest locally to drive impact and returns

Over the past 12 months we’ve been crunching data obtained through Freedom of Information requests on the holdings of UK Local Government Pension Scheme (LGPS) funds. It was part of our research for the recently published white paper, Scaling-Up Institutional Investment for Place-Based Impact. The aim was to explore whether pension funds could make appropriate financial returns by allocating capital closer to home so investment could become more aligned to the development needs of members’ communities – what we called Place-Based Impact Investing (PBII).

To get there, we would need compelling evidence to show PBII could withstand scrutiny from some familiar refrains – we knew we’d encounter age-old arguments about higher costs, fiduciary conflicts, added complexity and higher risk with no guarantee of higher returns. In short, we’d need to challenge the well-versed logic used to explain why capital is so routinely allocated across the global markets.

Our analysis of LGPS holdings revealed just how little of the money paid into LGPS funds is invested back into the local economies it comes from – and even less when it came to allocations with an actual intention to contribute to local economic growth.

As of March 2020, just 2.4% (£7.7bn) of the total £326bn LGPS funds were allocated to sectors we considered most capable of driving local economic development, such as housing, SME finance, clean energy, infrastructure and regeneration.

‘Investing in listed funds in key sectors – those well placed to drive local economic development and levelling up – have delivered superior performance’

Moreover, we could only identify 1% of LGPS total assets (£3.2bn) that were directly invested in these sectors within the UK. It was striking to compare this investment to the £10bn allocated by LGPS funds to FAANG holdings (Facebook, Amazon, Apple, Netflix and Google).

“Place” is rarely considered in the investment strategies of the LGPS, one of the UK’s largest pools of institutional capital. Of the 98 funds, we only identified six with investment intentions alluding to place. Only one pension fund, Greater Manchester, had made a specific target allocation to local investing.

However, during the course of our research – through surveys and interviews – LGPS funds overwhelmingly embraced the concept of PBII. It was understood that if PBII could lead to more prosperous local economies and communities, local authority revenues would be enhanced, generating a virtuous circle of good pension fund returns and strong local multiplier effects.

In the long term this could help deliver inclusive prosperity and sustainability, delivering stronger local economies and greater financial stability for the local authority members of the pension funds.

There is a clear, well received, sustainable development case to be made for PBII, but this would be meaningless unless we could present a compelling financial case. We couldn’t lose sight of the fact LGPS funds and pension funds more widely have responsibilities, first and foremost, to their members as pension fund managers.

In March, some sections of the pensions industry voiced these age-old arguments in response to a government proposal to make it easier for trustees to invest in sectors such as private equity and venture capital by loosening the cap on fees charged by asset managers.

While a place-based lens would consider these sectors ideally placed to provide finance that could drive local sustainable development, it was suggested additional performance fees would make them more expensive than fixed fees on listed assets and this would ultimately be passed on to savers with no guarantee of return.

But this point of view is not backed by the numbers (see table). Our analysis demonstrated investing in listed funds in key sectors – those well placed to drive local economic development and levelling up – have delivered superior performance. Indeed, it pointed to highly attractive risk-adjusted returns delivering 1.5 to 2 times on the FTSE 100 with less variability even after fees.

Far from inhibiting returns, these investments would be more attractive than mainstream assets. Furthermore, many would be cashflow generative and countercyclical, providing portfolio diversification benefits for pension funds.

This establishes a compelling financial case for adopting a place-based lens, which could prove timely for the UK economy and the communities it should serve. As our white paper points out, place-based inequalities are more extreme in the UK than in most comparable economies and have existed for generations. Meanwhile, the pandemic, coupled with Brexit, have moved this seemingly intractable reality to the centre stage of public debate.

The government has responded by way of its levelling up agenda, which some estimate the cost of delivering it at £1trn over the next 10 years. It would seem, therefore, vital to develop a clear rationale and path for how private capital can be mobilised alongside public investment.

Among the conclusions of our white paper, was that if all LGPS funds were to allocate 5% to local investing, this would unlock £16bn for local investing, more than matching public investment in the £4.8bn Levelling Up Fund and associated government initiatives.

The decentralised geography of the LGPS, alongside the local investment decision-making powers of each fund, appear to make this pool of institutional capital extremely well suited to this endeavour. PBII is emerging on a rising tide of interest in how flows of capital can enhance ESG performance and contribute to SDGs.

Those clinging on to the old refrains that have served to legitimise a disconnect between ‘capital’ and ‘place’ look set to be given a run for their money.

Sarah Forster is the CEO of The Good Economy