John Harrison: Hidden risks in the pooling process

The implementation date for LGPS pooling next year is approaching rapidly. Many of the pools are busy recruiting their boards and senior staff and planning suitable investment administration arrangements, whether using external platforms or building their own. As we approach the end of 2017, we will no doubt have greater clarity on the way in which each pool plans to operate and the people who will be accountable for delivering the restructuring.

Given time pressure on LGPS officers involved in creating the new pools is intense, it is inevitable that much of the sector’s efforts will focus on critical issues, such as recruitment, staffing levels and the investment administration platform. However, there are other, perhaps less obvious, risks that will also need to be managed through the transition to the new world.

Accountability

One key risk is the continuity of management accountability through the implementation process. This is relevant for all the new pools, but perhaps most important for the pools that will assume immediate responsibility for internally managed capabilities, such as Border to Coast and LGPS Central. Any transfers of staff between the authorities and the pools will need to be carefully coordinated to ensure continuous management of the internally managed assets.

The transfer of experienced investment staff to the pools has the potential to create an additional risk for all administering authorities. While the pool will become accountable for manager monitoring, many other investment responsibilities will remain with the authority. This includes asset allocation and the management of liability risks.

Authorities need to ensure they retain or acquire internal resources with the knowledge and experience to guide committees through the complexities involved. Where this is not possible, they may need at least temporarily to rely on external resources, either from their pool or from advisers.

Sub funds

In terms of asset allocation, a live issue within the sector is the number of sub-funds that each pool will offer. It is widely recognised that there is a potential trade-off between flexibility (having more choices) and cost savings (consolidating into a smaller number of larger pots). Less widely discussed is the behavioural risks associated with having too much choice. This could result in delays in decision-making while the options are considered—academics refer to this as “over choice”.

It may also lead to poorly timed switches, particularly between single manager sub-funds. History shows that even the best managers suffer periods of poor performance and that successful long-term investment requires a willingness to stick with good managers through tough times. How easy will that be when the pool is reporting better quarterly returns from similar mandates with other managers?

Transition

The biggest hidden risk, however, is in the transition process itself. Given the scale of the assets involved and the uncertainty of market conditions at any point in time, a mistimed or mishandled transition could impose transaction costs that dwarf the pool’s estimated set-up costs.

The management of this risk has to include the option for the transition to be deferred in adverse market conditions and access to the skills needed to judge whether this should apply. The temptation will be to “outsource” the task to a transition manager in the belief that this is a commoditised service. My colleague at Allenbridge, Steve Webster, has undertaken an extensive review of transition management providers in the last few months. His report, due for publication later this month, shows that this is far from the case.

There are marked differences between providers in the range of capabilities offered and the reporting information provided to clients. Processes may also differ materially, particularly in fixed interest securities, foreign exchange dealing and the management of out-of-market risk. It will be important that the pool or fund initiating the transition fully understands these differences when assessing the suitability of any transition management service.

There are a number of other key areas that will have a direct impact on the transition cost for an individual LGPS fund.

• Tax: While it may be possible for UK equity assets to be transferred in-specie between legacy investments and pooled funds without paying stamp duty, the same might not be the case for taxes in other jurisdictions, such as financial transaction tax in the EU and stamp duty in Hong Kong and Ireland.  Indeed, pooled transfers can even incur double stamp duty, so careful planning is required.
• Swing pricing: While designed to protect ongoing investors, arrangements to increase or decrease pricing relative to NAV often lack transparency.
• Attribution of costs: It is inevitable that some participants in a pool will require proportionately more realignment. There may also be differences in the timing of the transition, with some funds benefiting from first mover advantage. Pools will need to be clear about how transition costs will be both calculated and allocated to the participating funds.

None of these risks is insurmountable, given thoughtful management and effective oversight. The important point is to be aware of them so that mitigating steps are put in place.

John Harrison is managing director, investment advisory at Allenbridge & independent adviser to Surrey Pension Fund.