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No mergers for local government pension schemes, but radical investment management changes proposed

The UK government has ruled out merging the pension funds that make up the Local Government Pension Scheme (LGPS) and will instead focus on cutting investment management costs as part of reforms designed to cut the cost of public sector pensions in England and Wales to the taxpayer.

Local government minister Brandon Lewis said that the proposals, which have been published for public consultation, could ultimately save £660 million in management costs each year. These savings are based on moving to 'passive', rather than 'active' management of listed assets such as bonds and shares; and using a common investment vehicle allowing participating funds to invest in 'alternative' assets, such as infrastructure.

Pensions expert Nick Stones of Pinsent Masons, the law firm behind Out-Law.com, said that the proposals were an "easy win" for the government, which had avoided putting forward the more radical structural reforms called for by some respondents to an earlier call for evidence on public sector pension reform. However, he said that it would defeat the purpose of the proposed reforms if a move from active to passive asset management resulted in inadequate returns.

"Active fund management has always been a judgment call, although more expensive, it has the potential to deliver better returns on the underlying investment – and therefore produce a higher value to the pension fund," he said.

"However, if the empirical data that the government has based its proposals on holds true, the cost savings it has identified raise some interesting questions for pension funds in the private sector. If public sector pension funds have achieved transparency in costs and performance that provide accurate performance data suggesting the need to switch to passive fund management, then there is no reason why private sector funds should not consider the same," he said.

The consultation will run until 11 July, and the government will use the responses to inform its final proposals for reform.

Passive asset management involves the investing of assets to mirror a market index, resulting in a return comparable to the overall performance of the market being tracked. It is usually much cheaper than active management, where a fund manager is employed to make decisions over which investments to buy and sell and when. Active management traditionally allows investors to achieve much higher returns, but can also expose investors to the risks of underperformance.

A report produced for the government (106-page / 1.2MB PDF) said that there was "no evidence" that the funds held in the LGPS had outperformed regional equity markets over the ten years to 2012/13. It said that this was "consistent with both UK and global evidence which suggests that any additional performance generated by active investment managers is on average insufficient to overcome the additional costs of active management".

By instead moving to passive management of the listed assets held by the LGPS, such as bonds and shares, the report estimates eventual annual savings on investment fees of £230m and an additional £190m on transaction costs. These assets would be accessed through a common investment vehicle, allowing local authorities to bring together their investments in order to use their combined 'buying power' to invest more efficiently.

The report also recommended the creation of a common investment vehicle to invest in 'alternative' assets; non-listed investments such as infrastructure, private equity, property and hedge funds. Authorities that wish to invest in these assets currently use a 'fund of funds' approach to achieve the scale needed to make these investments, but said that this approach was inefficient due to the several layers of fees involved. By adopting the proposed approach, the report notes that the LGPS could save an additional £240m a year.

Nick Stones said: "The idea of an investor club for alternative assets sits squarely into areas of interest we are seeing from clients especially in investments such as infrastructure.  Using experienced gained it is feasible to bring likeminded investors together and benefit from economies of scale and greater costs certainty".  He said that he believed that this was an area where LGPS could benefit from practice and thinking already developed for the private sector.  

Consideration was also given to merging the current 89 local schemes into five 'super pools' as part of its report. Although the report concluded that this approach could ultimately lead to significant savings, it said that the merger itself could take around 18 months longer to implement than common investment vehicles and result in the loss of local control over investments.

The London Pension Fund Authority provides LGPS services to some London local authorities and to charities and not-for-profit groups, running a £4.63 billion pension fund. Although LPFA chief executive Susan Martin praised the government for opening the discussion on the future of the LGPS, she said that it was missing a "significant opportunity for deficit reduction" by focusing only on asset management. 

"Whilst we are very disappointed that the consultation only sets out detailed proposals for collective investment vehicles (CIVs), we are pleased that it invites 'any feasible proposals for the reduction of fund deficits'," she said.

"Our proposal for Super Pools of LGPS goes further than CIVs, including both asset and liability management, enabling the LGPS deficit to be tackled from both ends ... With deficits within the LGPS standing at around £80bn, we should be doing everything we can to deliver optimum performance on behalf of the taxpayer. The minister's recommendations are a good start and we would encourage him to go the last mile," she said.

Editor's note 08/05/14: the story was changed to correct a description of the LPFA.

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