It was teatime at the House of Lords, and a crowd of 120 pension officials, consultants and investment managers were sipping prosecco and munching on finger sandwiches and cakes in the cozy, glass-enclosed Cholmondeley Room and Terrace, overlooking the Thames on a recent cold, gray February afternoon. They had come to celebrate the launch of the U.K.’s newest public pension fund, London CIV, which is bringing together the pension funds of 31 of the capital’s 33 boroughs to forge what its backers hope will be a £23 billion ($33 billion) colossus.
“London CIV’s ambition is simple,” the fund’s nonexecutive chairman, Lord Bob Kerslake, told the gathering. “It is to be the investment vehicle of choice for local authority pension funds, through successful collaboration and delivery of compelling performance.” He asserted that the new fund would save more than £30 million a year in management costs, a tidy sum at a time of modest investment returns.
The formation of London CIV is just the first stage in a historic consolidation of Britain’s local public pension plans. The process will affect millions of workers and retirees, and shake up relationships governing the management of some £200 billion, one of Europe’s largest pools of institutional assets.
Chancellor of the Exchequer George Osborne set the process in motion last year when he called on the 89 municipal and county pension funds in England and Wales that make up the Local Government Pension Scheme (LGPS) to combine their funds into six large pools of roughly £25 billion each. (Scotland and Northern Ireland have separate pension regimes and aren’t affected, and a portion of the assets of the English and Welsh funds can’t be pooled effectively because they are tied up in long-term assets such as real estate.) Such big groupings, Osborne contends, should be able to achieve significant savings in management fees and other costs, which some industry experts estimate could be as high as £300 million a year. More important, the chancellor believes bigger funds would be better able to make investments in infrastructure, enhancing the U.K.’s roads, railways, power network and other facilities while generating solid long-term returns for retirees.
“At the moment, we have 89 different local government pension funds with 89 sets of fees and costs,” Osborne explained in an October 2015 speech at the Conservative Party’s annual conference. “It’s expensive, and they invest little or nothing in our infrastructure.” Consolidation, he said, “will save hundreds of millions in costs and, crucially, they’ll invest billions in the infrastructure of their regions.”
Osborne ordered the funds to propose partnership arrangements by February 2016, setting off a speed-dating scramble among local authorities to find neighboring or like-minded town or county halls willing to form alliances. Although London CIV has already begun implementing its consolidation plan, having initiated the process on its own four years ago, most of the other 56 local authorities affected — from Cornwall in the southwest to Northumberland in the northeast — are still struggling to get out of the starting blocks. In February the authorities filed proposals with the government to form eight new asset pools, which would vary widely in size, from £13 billion to £35 billion or more. It’s not yet clear whether Osborne will endorse those plans, many of which diverge from the broad size targets he sketched out.
It’s not just the uncertainty that concerns pension officials. Many fund managers have deep misgivings about the entire process, fearing the government is using pension funds for its own ends to the detriment of plan members. The real rub stems from a line in Osborne’s October speech that characterized the new pension pools as “British wealth funds.” He made no mention of the funds’ fiduciary duty to their members.
Kieran Quinn, chairman of the Greater Manchester Pension Fund management council, bluntly expresses the concerns of many when he says of the government, “If you’re going to direct how and what and where we make investments, are you going to underwrite our failures?” The £17.6 billion Manchester fund, the country’s biggest existing public plan, is proposing to join forces with the funds of Merseyside (which includes Liverpool) and West Yorkshire (Bradford and Leeds) to form a £35 billion pool dubbed Northern Powerhouse. Manchester has been investing in infrastructure for 20 years, and in the six months since Osborne laid out his vision, 14 local pension schemes have sought its help on infrastructure investing.
“The issue for boroughs is to find infrastructure projects to invest in that deliver returns for the fund,” says Hugh Grover, CEO of London CIV. “That’s where you find politics bumping up against fiduciary duty.”
Funds’ concerns about independence were heightened in November, when the Department for Communities and Local Government (DCLG), which is working with Osborne’s Treasury to drive the consolidation process, announced it would propose legislation giving the government the power to intervene in funds’ investment decisions if it believed a fund wasn’t complying with regulations and government guidance. Some fund executives fear the government could use this authority to dictate future infrastructure investments.
“There appears to be no limitation on the nature and content of any ‘guidance’ which might be issued within the proposed regulations,” Steven Taylor, assistant executive director of pension investments at the Greater Manchester fund, wrote in his response to Osborne’s consolidation request. The government’s powers “are thus far too extensive and there is a lack of a clear administrative avenue/opportunity for a proposed intervention to be challenged on the grounds of going beyond ‘oversight’ into detailed micro-management of a fund.”
As with any corporate merger, Osborne’s consolidation plan poses a threat to existing executives and working arrangements. Although pension fund directors and their overseers on local government councils have been told they still will be able to set asset allocation targets at the local level, they will lose the ability to select and monitor external investment managers. London CIV has begun to staff up only at the pool level, hiring six individuals, including CEO Grover, a COO, an investment oversight director and a program director.
Industry executives question the supposed efficiency benefits of bulking up. “The real rationale behind this isn’t about cost, at the end of the day,” says Graeme Muir, a veteran pension actuary based in Glasgow, Scotland. “Once all the assets move to a pool, it will take years” to see savings. Muir works for pension consulting firm Barnett Waddingham, which advises roughly a quarter of the 89 funds, and he worries that the funds don’t know what they are getting into because many of the details of consolidation have yet to be decided. “People have signed up without knowing the rules of the game,” he says. “There will have to be compromise, here, there and everywhere.”
Michael Jensen, CIO of the Lancashire County Pension Fund, should be a natural ally of Osborne. The £5.6 billion Lancashire fund agreed last year to join forces with the London Pensions Fund Authority (LPFA), which manages the legacy retirement funds of a citywide government that Margaret Thatcher abolished in the 1980s. With a combined £10.2 billion in assets, the funds believe their greater scale will allow them to better access both illiquid and direct investments, improving performance. Yet Jensen shares some of Muir’s concerns about the consolidation agenda. “When government first came out with this plan, they made wild assumptions of cost savings,” he says.
Some industry executives believe cost saving should take a backseat to fixing the looming funding gap in the LGPS: The entire scheme has only 80 percent of the assets needed to fund future pension payments. “If we really want to save money, we should be focusing on the £47 billion deficit,” says Joanne Holden, head of the U.K. public sector in Mercer’s Manchester office. “The savings are tiny compared with their deficits.” To rebuild assets lost in the global financial crisis, LGPS employers have raised their contributions from an average of 15 percent of payroll in 2005 to 23 percent last year, according to Muir, but the funding gap persists. “Everybody is focused on consolidation, while the deficit is getting worse,” says Brian Strutton, chairman of the LGPS board’s cost management committee and national secretary of the GMB, a union that represents public sector workers.
The deficit, although sizable, should be put in perspective, however. The LGPS is at least a funded system. By contrast, the other large U.K. public pension plans — including those covering workers in the National Health Service, civil service, firefighters, police and teachers — are all pay-as-you-go schemes with no investment pool and an estimated £1.3 trillion in unfunded pension liabilities.
The massive pooling of local authority pension funds is bound to produce winners and losers among asset managers and consultants. London CIV has already selected four managers for nine planned subfunds — Allianz Global Investors, Baillie Gifford, BlackRock and Legal & General Investment Management — and allocated £500 million to an active global equity fund managed by AGI and £300 million to a diversified growth fund run by Baillie Gifford. With tens of billions of pounds set to migrate in coming years, asset managers have a lot on the line, particularly given the government’s desire to promote more internal management of funds.
“It’s an uncertain time for asset managers,” says Mercer’s Holden. “We’ve seen some of them offer lower fees.” Investment consultants, who no longer will be needed to select, monitor and terminate managers for dozens of smaller pension funds, are likely to see their assignments shrink.
Other potential losers include 5 million active and retired LGPS members, whose savings could fall between the very large cracks that will open during the massive transfer of assets from local authorities to new pension pools. Heightening this concern is the winnowing of transition managers over the past few years, which has reduced the number of active players from nine to five. “Market capacity has shrunk, and if government is at its word, in 24 months we’ll be doing a huge amount of transition,” notes Lancashire’s Jensen.
“It is critical we recognize the potential market impact of trading the sheer amount of assets,” says Ben Jenkins, global head of transition management at Northern Trust Corp. in Chicago. “Depending on how the transitions are handled, the consolidation could present a severe liquidity challenge with the potential to disadvantage the LGPS funds and their participants.”
The LGPS is one of the largest defined benefit systems. If it were a single plan, it would rank sixth in Willis Towers Watson’s annual ranking of the 300 largest pension funds, behind the California Public Employees’ Retirement System and ahead of China’s National Council for Social Security Fund.
The scheme took its present form in 1974, when the U.K. reorganized its system of local government into county councils and the 33 London boroughs, creating 81 funds in England and eight in Wales. A few were organized around particular workforces, such as the Environment Agency Pension Fund, which manages retirement money for the staffs of three government agencies, and London’s LPFA, which manages the pension plan of the now-defunct Greater London Council and a related educational authority.
The idea of an LGPS merger was first proposed in a March 2011 study by an independent commission led by Lord John Hutton, who held several ministerial roles in the Labour governments of Tony Blair and Gordon Brown. Two years later the Department for Communities and Local Government began to look at consolidation as a means of improving investment returns, mitigating the growing LGPS deficit and helping plans attract better staff and manage more money in-house. In May 2014 a DCLG report determined that a merger of the entire LGPS into one mammoth fund was not warranted, concluding instead that a small number of collective investment vehicles could be created more quickly and simply.
Osborne turned that idea into official government policy in his October speech at the Conservative Party conference. Bigger pension pools could finance large U.K. infrastructure projects, he said, citing the planned High Speed 3 train network in northern England and Crossrail, an east-west train line being built under central London. Shortly after Osborne’s speech the DCLG ordered local pension schemes to find partners by February 19.
Getting to Osborne’s desired size of £25 billion is proving difficult, however. The eight Welsh pension funds naturally came together, but they have only £13 billion in assets and may need additional partners. On the other end of the scale, the Border to Coast Pensions Partnership brings together 13 counties with £36 billion in assets; the Northern Powerhouse proposal put forward by the pension funds of Manchester, Merseyside and West Yorkshire would have £35 billion in assets, and they are in talks with Lancashire and the LPFA about adding their £10 billion-plus to the pot. The other proposed alliances are Access, which includes seven southeastern counties surrounding greater London; Brunel Group, which comprises nine counties stretching from Buckinghamshire, just west of London, to Cornwall, at the country’s southwestern tip; LGPS Central, which covers eight counties in the English Midlands; the Local Pensions Partnership (Lancashire and the LPFA’s name for their combine); and London CIV.
The government has not yet responded to the proposed poolings, but LGPS officials expect it to do so before July, when the pools are slated to submit detailed final plans for consolidating their funds. Osborne’s timeline calls for all the pools to be operational by April 2018.
The London boroughs’ experience indicates how lengthy and complicated the consolidation process can be. In 2012 the Leaders’ Committee of the London Councils, an overarching body that brings together the capital’s boroughs, created London CIV with the aim of driving down the cost of pension management. It took two years for the councils and their lawyers to establish governance procedures and investment structures for the collective investment vehicle.
The London borough pension funds currently have nearly 90 investment firms managing money under some 250 separate mandates. Distilling that multitude of products and relationships into a large, streamlined pool won’t happen overnight. London CIV has announced plans to introduce nine subfunds, including two for passive U.K. equity, two for developed-world ex-U.K. equity, two passive emerging-markets funds, one diversified growth fund and two global active equity funds. Those funds are expected to eventually hold £6.1 billion and generate cost savings of £2.8 million a year compared with existing arrangements. So far, London CIV has launched two of those funds: the equity funds, managed by AGI and Baillie Gifford, respectively. Next it plans to add a second global active equity fund, also to be managed by Baillie Gifford.
The individual borough pension funds will be able to allocate money to the various London CIV funds according to their individual strategies and risk appetites. The collective vehicle aims to offer passive fixed-income funds later this year or next year, although a lack of commonality among the boroughs’ existing approaches toward this asset class is “likely to require more intensive search and selection,” CEO Grover wrote in London CIV’s February submission to the government. Four multiasset funds are due to follow by 2017. By April 2018, London CIV expects to be managing 70 percent of the member boroughs’ assets, or some £19 billion. It expects eventually to manage more than 90 percent, or £23 billion.
The urge to merge pensions is not just a British thing. Australia launched a mandatory pension system with a network of defined contribution plans in the mid-1980s. By June 2002 it boasted 2,500 superannuation funds in the corporate sector and 76 covering public sector workers. That sprawling system has consolidated dramatically over the past ten to 15 years, driven largely by economic and technological forces rather than government policy. Today, Australia has only 32 corporate superannuation funds and 19 covering public sector workers. Retail funds, which are sold to the general public, have dwindled from 254 in 2002 to 148 today.
The process isn’t finished. Within a decade there may be as few as 100 funds in total, says Nick Sherry, a pension policy and design consultant and former Labor Party senator who helped establish the superannuation system in the ’80s. System assets have grown strongly, meanwhile, rising to A$2.1 trillion ($1.6 trillion) at the end of 2015 from A$500 billion in 2002. At a 10 percent annual growth rate, Sherry predicts, assets will reach A$3.5 trillion by 2025.
In Sweden consolidation has been hotly debated for the past few years. The government established five so-called buffer funds in 1999 to supplement the pay-as-you-go national social security system. In 2011 the then-ruling Moderate Party wanted to change the structure to resemble that of an insurance company, under which the management of liabilities and capital is integrated. Its proposal to merge the five buffer funds into one giant fund (a number that was later revised to three) was debated for three and a half years. Last year the Social Democratic government of Prime Minister Kjell Stefan Löfven gave up the idea in the face of heated opposition from buffer fund managers, academics, labor unions and employers. “It’s a stupid idea to centralize,” says Mats Anderson, CEO of Fjärde AP Fonden, the buffer fund better known as AP4. “Our fund is $40 billion, and we should not be bigger than that.”
In the U.K. outsiders helped spark the consolidation debate. In November 2010 two Canadian pension funds – the Ontario Teachers’ Pension Plan and the Ontario Municipal Employees Retirement System (OMERS) — purchased the 68-mile rail link between London and the Channel Tunnel for £2.1 billion in a 30-year deal. The sale prompted the U.K. government to consider ways of encouraging the country’s own pension funds to take ownership of British infrastructure. “Government naively thought we just need U.K. pension schemes to invest in infrastructure,” says Mike Weston, chief executive of the Pensions Infrastructure Platform (PiP) and former CIO of the pension scheme of the Daily Mail and General Trust. (The publisher owns a majority of our parent, Euromoney Institutional Investor.) But the government was unable to identify a pipeline of projects or structure them in a way that would make them attractive to the country’s many small pension schemes.
In 2012 the National Association of Pension Funds, rebranded in November as the Pension and Lifetime Savings Association, created the PiP through a collaboration of ten pension schemes, including the Pension Protection Fund, an entity similar to the U.S.’s Pension BenefitGuaranty Corp.; British Airways’ pension fund; the Railways Pension Scheme; and Glasgow-based Strathclyde Pension Fund, one of Scotland’s largest funds.
So far, the PiP has committed £1 billion to U.K. infrastructure. Its efforts include a February 2015 co-investment with the Aviva Investors PiP Solar PV Fund and a public-private-partnership fund with Dalmore Capital that’s backing the construction of the Thames Tideway Tunnel, a giant £4.2 billion sewer running under the river.
Currently, only 0.5 percent of overall LGPS assets are allocated to infrastructure, with most of the investment coming from the larger funds, which have an average allocation of about 2 percent. That’s a modest proportion compared with an average allocation of 2.8 percent for 28 U.S. public pension funds that invest in infrastructure, and a pittance compared with global leaders like OMERS, which has an allocation of 19.4 percent.
In a bid to get the local pension plans more involved, the government in October established the National Infrastructure Commission, led by Andrew Adonis, a former Transportation secretary and minister of Schools. The commission has identified several priority projects, including High Speed 3, which will link the northern English cities of Liverpool, Manchester, Leeds, Sheffield, Newcastle and Hull, and the development of a smart electricity grid to boost energy efficiency.
The need for infrastructure financing is great, but many experts question whether such projects are suitable for public sector pension plans. Consultants and asset managers say infrastructure can be appropriate if it provides cash flows that cover the regular payments funds owe to their pensioners. But drawing-board projects aren’t guaranteed to deliver such stable cash flows, particularly from complex and costly undertakings like the northern high-speed rail line, which could face lengthy construction delays and big cost overruns, says Mark Packham, director of government and public sector in the Bristol office of PricewaterhouseCoopers.
“If government is just after cheap, dumb capital, they’re not going to get it from pension schemes because they have pension plan obligations to meet,” says PiP’s Weston.
At London CIV, Grover is hearing from a number of infrastructure managers who are interested in partnering with the new pension pool. “In principle, if there’s a lot of international money chasing U.K. infrastructure, we’re competing against them,” he says, adding that these are “people with years and years of experience.” There is no consensus among the London boroughs about the best infrastructure strategy, he says. Many believe the influx of foreign money into U.K. infrastructure leaves little value for domestic pension funds. Others believe their first duty is to provide returns to their members, not to support government policy. They may find infrastructure an attractive asset class, but they would be just as happy to invest in Asian projects as U.K. ones.
Arguably, local infrastructure projects are the last thing public pension plans should invest in, says Vittorio Lacagnina, who oversees capital raising in real assets across North America and Europe for Australia’s Queensland Investment Corp. Such projects are closely correlated with local economies, which can magnify the risk for public pensions, he says. “Pension funds need a diversified portfolio of infrastructure assets that can withstand different economic cycles,” he explains.
Philip Dawes, head of U.K. institutional at Allianz Global Investors, doesn’t think assets like affordable housing, which is often cited as a good project for public pension funds, are in fact infrastructure. “I don’t believe local authorities should be investing in these things,” he says. “They need matching assets.” Dawes, whose firm offers infrastructure debt rather than equity, says a national infrastructure platform would be the best way to pool local authority assets, rather than having six or seven pools competing for projects and driving up prices. But creating such a platform would require specialist resources and lots of time. “You are then bearing the risk of sourcing and originating transactions yourself,” he explains.
The Greater Manchester Pension Fund has been investing in infrastructure for 20 years and maintains an allocation of 3 to 4 percent, but it bristles at the idea of being told by the government to invest more in the sector. Politicians have short time horizons dictated by the electoral calendar, whereas pension funds need investments that can generate solid returns over decades, says chairman Quinn. “Government needs to understand it isn’t free money,” he notes. “Pension funds require a return on their money.” That said, Manchester does believe in pooling its assets and plans to keep growing the asset class. In October the fund set up a £500 million infrastructure investment pool with the London Pensions Fund Authority. That vehicle has made two investments so far, taking a stake in a Scottish wind farm and investing £55 million in a 200-home property development in East London.
On a cold day this winter, Fiona Miller was nursing a hot cup of coffee in the bright lounge of the Grange St. Paul’s hotel, a few steps from the famous London cathedral. After a career in large-scale project management in both the public and private sectors, she moved to pensions five years ago to head the now-£2 billion retirement fund of Cumbria, a northwestern English county that borders on Scotland. She had come down to London to meet with government officials about the proposed Border to Coast partnership that Cumbria is leading.
There were only two days left before the February 19 deadline for filing the pooling plan with the government, and Miller, surrounded by documents and a laptop, looked like she had yet to catch her breath. “The chancellor’s statement that local authorities had six months to propose their consolidation came out of the blue,” she said. “There was very mixed feeling. A number fervently believed we were doing a good job.” But Miller quickly formed a working trio with Mark Lyon of East Riding, a county on the Yorkshire coast, and Philip Triggs of Surrey, a wealthy county southwest of London. Lyon brings the experience of managing 80 percent of his pension fund’s assets in-house, in tune with the government’s objective of using the new pools to combine expertise and keep pension costs down. Triggs drafted the governance and structures of Border to Coast.
Although the team managed to deliver its partnership proposal by the deadline, Miller still has serious concerns about the consolidation process. The government’s infrastructure edict is at the top of her list. “We believe that allocation to infrastructure is a fund decision and the government shouldn’t intervene in that decision,” she explains.
Miller also worries about the DCLG’s proposed power to intervene in fund investment decisions. To make the pools work effectively, the government is adopting a so-called prudent-man approach with a less regulated framework. Although that framework provides for greater discretion in how pools invest, it creates a lot of uncertainty, notably about the government’s ability to intervene. “We’re worried that the level of intervention is far-reaching and it hasn’t been explained to us what would trigger intervention,” Miller says. She and her colleagues have seen only a vague reference in draft regulations to government intervention if pooling criteria are not adhered to correctly. Further details are not expected until later this month.
The final cost of the U.K.’s pension pooling project will not be known for years, well after the first assets are slated to be transferred, in April 2018. Although the government and consultants have been estimating a range of savings, they have been reticent to quantify the cost of moving some £150 billion of assets, which will include legal and governance advice and implementation as well as staffing and transition management.
The Border to Coast proposal says the “initial setup and ongoing operational costs” for the partnership “are expected to be significant.” London CIV estimated that it had spent between £2 million and £2.5 million on setup costs — office space, investment and support staff, consulting and legal fees, and the establishment of new fund and governance structures — by the end of January, after it transferred pension monies into its first subfund.
“In the short term the costs of implementing change and transitioning assets are likely to exceed the savings,” says a January report from the Joint Working Group of Local Authorities, also known as Project POOL, coauthored by 24 funds with help from consulting firm Hymans Robertson. The report says there are eight LGPS funds with a combined £50 billion that manage a significant amount of their assets in-house, and they are likely to suffer higher costs during the transition because those funds will be shifted initially to external managers. That is ironic considering that a stated goal of consolidation is to encourage funds to manage more of their assets in-house.
Northern Trust’s Jenkins, whose firm stands to win a large portion of the work of transitioning assets from current mandates to the new partnerships, estimates that LGPS’s asset migration costs alone could run between £50 million and £70 million.
The costs of transition should become clearer by this summer, when pension authorities are due to present their detailed blueprints — covering fund and governance structures, projected economies of scale and expected fund performance — to the government. “All of this needs to be done between now and July,” says Susan Martin, executive director of the LPFA. “There will be challenging discussions; some may change pools; we may see some shift between now and July.”
Consultants Hymans Robertson underscored the challenges in its report with the Joint Working Group of Local Authorities. “The transition costs will be significant and risks involved in a transition of assets on the scale required are high,” it wrote. “Nothing on this scale has ever been done before.”
Northern Trust’s Jenkins is seeing firsthand the confusion of consolidation. People know the world they’re leaving, but they don’t know quite where they’re headed, and there are plenty of vested interests — those of plan members, pension managers, transition managers and the government — that have to be managed along the way. “Everybody will have to work together to make this seamless,” he says. •
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