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  • William Bourne

Comment on the LGPS Pooling Consultation

The Government has finally issued its long-awaited pooling consultation. As ever, it is a mixture of the expected and the more surprising. Some of it makes good sense, at least on the assumption that pooling is here to stay. Other proposals can only be described as incoherent, both because they are at odds with other elements of Government policy, and because they lack a grounded rationale.

The consultation starts with the trumpeting of £380m of savings so far. And yet SF3 data* shows that LGPS costs have risen by 14.3% annualised over the last five years. Investment costs (88% of the total) have more than doubled over this period, while AUM only rose by 41%. There are other reasons behind this – e.g., the move to more expensive private markets – but prima facie it does not stack up against DLUHC’s claims of investment implementation savings.

As expected, the Government wants liquid assets to move to pool sub-funds by March 2025. This will require substantial compromises by funds and a greater focus on the overlying strategic objective rather than who is appointed as manager or the precise level of risk. That is no bad thing, but it does assume that pools have teams with the calibre and experience to select managers well. Never forget that investment performance value added or subtracted will dwarf any cost saving, and manager selection is notoriously difficult.

The Government wants pools to increase in scale to £50bn up to £100bn in AUM, partly to encourage internal management. It justifies this by using one research paper which looked at 11 international pooled funds selected among other criteria ‘with a preference for large assets under management.’** It did actually look at one smaller fund (size US$20 to $50) which had one of the lowest costs and best performance levels. The paper demonstrates that scale can be helpful in reducing costs but does not in any way make the case that it is essential. I note that the funds in the Wales pool, the smallest of the eight by AUM, have over the same five-year period only seen a 7.3% increase in costs, half the average across the whole LGPS. On a bps basis they have actually fallen slightly. It is not so clear that scale is the only route to bringing costs down.

Internal management is one way to bring costs down where scale can help. For example, LPPI, a pool which has gone significantly down the route of internal management, has both the highest cost levels (as calculated from the underlying funds) and over five years has increased them by the most. Greater scale is clearly needed to bring these down. But scale of this order also has its disadvantages. It makes it more difficult to implement niche strategies and presents another challenge to the levelling-up agenda, because the need for a minimum size will reduce the opportunity set further.

The March 2025 deadline then poses the ugly question of fiduciary duty. What is a partner fund to do where the pool does not have a suitable product? For example, the ACCESS pool only has one active and one passive equity fund which can be considered even partially aligned to climate change transition, and none which are designed to invest in the positive side of climate change. This will not make for a diversified portfolio and makes it difficult for partner funds to reconcile fiduciary duty with this proposal.

Which brings me on to the next point: I find it disappointing that the consultation has come down on the side of encouraging pools to use other pools’ products, but not allowing funds to do so. The proposals are better than the uncertainty of the status quo but, in my view, they miss a trick by forcing unhappy bedfellows to stay together. Even if a fund chooses not to move pools or place assets elsewhere, having the option to do so makes it easier to reconcile pooling with their fiduciary duty. I’m also concerned that the chain of oversight from fund to their own pool to another pool to (possibly) an underlying manager becomes overly long and complex.

However, the proposal which really concerns me in this consultation is that funds should have 10% in Private Equity. DLUHC tries to justify this on past performance, something which we are warned against in all disclaimer statements. The fact that they are encouraging retail DC pension funds to put 5% into Private Equity is even more reprehensible.

Private Equity’s returns over the past 15 years have benefited from much higher leverage and a very low cost of finance. As the NAVs are only calculated once or twice a year, perceived volatility is lower, which makes risk-adjusted returns appear better than they are. An illiquidity premium also needs to be factored in, as well as the much higher fees that private equity charge. There is a lively debate whether private equity really outperforms public equity if all these are taken into account, but the point I would emphasise is that the cost of finance has clearly changed dramatically for the worse in the past 18 months.

Another reason for expecting lower returns is that the valuation of exit transactions must come down in an environment of higher inflation and higher interest rates. The PE industry will argue that current NAVs are sufficiently conservative, but it is clear from the discount on listed PE investment trusts that the market does not believe them. I certainly expect private equity returns to be lower than the 12% or so they have been historically.

Another problem with the Private Equity proposal is that it directly contradicts the Government’s attempts to revive the London Stock Exchange. If an LGPS fund is forced to put 10% into private equity, it is likely it will come out of listed equity. The LGPS has on average about 20% of its equities in the U.K. (compared to the 4% weighting in the global indices), so a disproportionate amount would come from the London Stock Exchange.

PE has further disadvantages that it is by its nature illiquid and does not deliver steady cashflow. If a fund were to find itself with insufficient liquidity and had to make sales in a hurry, perhaps to pay pensions, it would have to sell listed investments such as government bonds. That did not end happily in the LDI crisis last autumn.

I have not commented in detail on some of the other proposals in the consultation, such as levelling-up. Suffice it to say that I hope DLUHC is willing to listen to industry practitioners. The LGPS is too important for its six million pensioners to let some policy wonk with the Minister’s ear formulate policy. Anyone remember the fixation on passive investments seven years ago?

* Data for 12 months to 31/3/2017 and 31/3/2022 as published by HM Government.

**LGPS: Pension Pooling in the UK. Copyright 2021 p12 Respondents.

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