Taking stock of funding options
By Paul Gosling
Local government administration of pension funds is strictly regulated. But does this drive councils’ pension fund committees to concentrate on what the regulations tell them to do, at the expense of the big picture?
A recent survey by fund advisors Mercer found that almost half of European companies’ pension funds do not regularly review their investments. Such negligence is prevented in the UK local government sector by requirements that councils regularly review performance returns and the quality of management, backed by statutory duties on disclosure [see box].
But the question is whether councils are equally rigorously reviewing their investment options. Emily McGuire of Hewitt Associates – consultants to local government pension schemes – is not convinced that enough do. “They do have a requirement to review performance on a quarterly basis,” she says. “But this is generally monitoring performance management relative to a benchmark, rather than relative to liabilities.”
McGuire argues the real issue is not how one fund performs compared to others, but whether it is achieving returns of 1.5% to 2% over gilt yields – the performance required to match the growth in scheme liabilities. She says this is a particular issue because of the dependence of most schemes on equities and property, two asset classes badly affected by the current financial turmoil.
At present, local authorities in England and Wales are currently considering the most recent three yearly actuarial valuations carried out as at the end of the 2006/7 financial year (Scotland’s three yearly valuations were conducted as at April 2008), which will determine future contribution rates. But McGuire feels that closer attention to asset values needs to made on a more frequent basis.
“They [councils’ pension committees] should look at how their assets are structured in order to deliver relative to liabilities,” McGuire suggests. But she believes council and councillors are getting the message. “This is beginning to change. It’s more common now in the corporate sector, where there is more focus on liabilities. I think councillors are interested. Investments do have a major impact [on councils] and a major impact on council tax. There is a very great interest on the investment side and an interest in improving things.”
The challenge, suggests McGuire, comes down to the resources, including councillors’ time, that are devoted to oversight of funds’ investment strategies. “In many cases it needs more resources,” she argues. “They do a lot with the time they have. But the time and effort needs to increase. I do think people need to spend more time on their investment issues – at officer and councillor level.”
Councillors’ most committed engagement with investment decisions is often connected to their ethical concerns and keenness to promote the local economy. Specifically, there can be pressure from councillors to use their pension funds to support local economic development by investing in new start and expanding local businesses and in local regeneration projects. Providing this is done sensibly and at the margins of a fund’s assets, this can be expected to avoid legal challenge.
John Hastings – partner at another leading fund consultancy, Hymans Robertson – explains that some London boroughs are investing parts of their pension funds in a private equity development fund for the city. But with only £2m or so invested out of a fund of about £600m, this might be regarded as an acceptable and limited exposure to high risk, high yield projects. “The problem,” Hastings adds, “is that they are challengeable.” There might, therefore, be a court case at some time that clarifies the extent to which councils can allocate some of their funds that achieve wider environmental and economic purposes, while, hopefully, achieving positive financial returns.
But there are potentially conflicting pressures between the requirement to maximise investment returns and doing so in ways that are ethically principled and sustainable in generating long term commercial returns. Local authorities may be keen to adopt ethical investment principles, avoiding armaments and cigarettes shares. This is fairly safe, suggests Hastings, providing the policy is not extended to cover energy companies.
Weapons and tobacco stocks do not account for a very large proportion of total stock exchange values: oil and energy stocks do. With armaments and tobacco companies, a council might reasonably argue that not investing in them is justified on the grounds that there are concerns about the sectors’ long term viability. “If you took that attitude with oil or energy stocks, that’s a problem because they’re a high component of the [FTSE] index,” explains Hastings. “It could be argued this is a perverse decision because it could have more impact on returns.”
Rob Lake, senior portfolio manager, environmental, social and governance issues, at ABP Investments – a leading pension fund manager – endorses the view that the principles of sustainability are compatible with a strategy to generate lower risk, long term returns. “ABP firmly believes that integrating environmental, social and governance factors into its investment processes will help to improve risk-adjusted financial return,” says Lake. ABP engages with companies in which the funds invest to enhance the sustainability of returns, making investments lower risk, he explains.
But, says Hastings, a council’s pension fund committee is most likely to focus on recent performance and whether a fund management mandate should be renewed. A committee may also raise questions about the level of exposure to particular asset classes, such as whether to have a slightly higher or lower exposure to the property sector. “In terms of stocks and sectors, pension funds delegate day-to-day responsibility to investment managers,” says Hastings. “It would be perverse for them not to do so. Most pension committees recognise they know nothing about how to manage a portfolio of assets. It’s a profession.”
Councils must also consider whether to administer their pension funds as standalone funds, or whether to amalgamate with other authorities – delegating responsibility to another administering authority – to achieve scale advantages in fund management. Some funds have as many as 130 employers involved, many in the private sector, with former public sector staff included under TUPE (Transfer of Undertakings Protection of Employment) protection.
Norfolk County Council manages a pension fund on behalf of 90 different employers. Bob Summers was director of finance at Norfolk, with responsibility for the fund, until he retired last year. He says that the increased complexity of pension funds in recent times has to be acknowledged in order to ensure that funds are properly managed. “I was for 15 years administrator to Norfolk funds and the complexity now bears no relationship to that I recall 15 years ago,” he says.
As chair of CIPFA’s pension panel, Summers is determined that local authorities raise their game in pension fund administration. “There’s no doubt that local government pension funds are well managed,” he says. But he is determined that the tougher obligations on pensions trustees in the corporate sector should be at least matched with improved governance arrangements in the local government sector. Summers accepts that members in many councils do receive training on how to operate on a pension fund committee, but wonders if this is adequate and believes it should be subject to specific and stricter obligations.
“Nowhere is there a requirement that spells out the knowledge, skills and competence you must have to adequately fulfil the role of a member of a pension committee,” argues Summers. He says that while it is important that funds employ high quality fund managers and investment advisors, this is not a substitute for intelligent and engaged oversight on the part of councillors and senior council officers. Above all, he says, administering authorities need strategies to achieve the level of returns they require.
Consequently, Summers is leading a CIPFA research project to consider what more needs to be done, particularly when consideration is given to the £122bn of assets in local government care. “It is important that you employ external professional advice, but it’s equally important that you have sufficient knowledge and skills to understand the advice that the professionals are giving you,” says Summers. “The expert client role, in other words.”
The CIPFA pension panel is bringing together DCLG, the Audit Commission, the National Association of Pension Fund, the fund advisers (represented by Hymans Roberston) and CIPFA to provide clearer guidance on how administering authorities can improve fund management and oversight. The preferred solution now being considered by the panel is to create a minimum skills and training obligation on all members of pension fund committees, with an even higher threshold for the chairs of the committees. But Summers readily accepts that while such requirements can be justified in terms of the need for expert stewardship, getting co-operation from the councillors in some local authorities may be difficult. The burden in terms of time and enthusiasm in what is often seen as one of the least exciting local government committees could prove an impossible obstacle.
Summers suggests that the solution may be to adopt a self-assessment and self-regulatory approach, with councils asked to give more serious consideration in the first instance to how they can achieve a minimum standard of pension fund governance. Beyond that, Summers believes that transitional arrangements are likely to be needed to reach an eventual destination of higher knowledge and skills.
But Summers has no doubt that it is essential to move fund administration and governance onto a new level. “We are talking about very considerable sums of money,” he points out. “There is a very considerable risk if funds are not properly managed. This is work in progress. But it’s a question we are going to have to find a way around.”
Box
What the law says
Councillors are legally required to review performance returns quarterly and the quality of management at least annually; the LGPS administering authority must publish a pension fund annual report; and it must annually review mandates. An administrative authority must draw up a Statement of Investment Principles, including the extent to which, if at all, they make investment decisions based on social responsibility; the types of investments held; the balance between different types of investment; fund risks; the expected rate of return; the exercise of rights attached to investments; and the extent to which the fund complies with CIPFA’s 10 principles of investment practice. Each LGPS Administering Authority must also publish a governing policy statement. This must state whether the authority delegates its functions in maintaining a pension fund to a committee, sub-committee or council officer. It must state the frequency of any committee meetings and the structure and membership of the committee. There should be information specifically about the fund’s governance arrangements. Issued guidance states that each administering authority should have a committee of elected members with responsibility for the management and administration of the pension fund. Councillors are advised to undertake training in the oversight of pension fund management, under the recommendations of the Myners Review of Institutional Investment. Ensuring that this training happens is a responsibility of the suitably qualified officer appointed by a pensions committee to oversee day-to-day management of the pension fund.