Barnett formula, LGPS reform and generating revenue

In a change to James’ regular markets briefing, we asked CCLA’s chief investment officer to reflect on some of the challenges facing local authorities today.

R151: The Scottish referendum had generated much discussion about local authority finance. Where do you think it all leaves the Barnett formula?

JB: In the heat of the debate on Scottish independence, leaders of the main UK political parties committed to sharing “resources equitably across all four nations” and avowed commitment to “the continuation of the Barnett formula” – but it is generally recognised that what was a short-term solution to funding arrangements in the 1970s is now in need of material revision, particularly if tax raising powers are devolved within the UK.

Under the formula, a portion of any additional resources in England are passed as block grant to Scotland, Wales and Northern Ireland, but if an area uses new devolved tax-raising powers, the block grant is reduced by the amount that would have been received for the area of taxation of which they are taking control. The Barnett formula therefore needs to be adjusted to take account of devolution of tax and spending accountability, and not just between regions but also within regions. Meanwhile, the Barnett formula takes no account of factors such as need or density or differential spending within regions although these are often cited as key reasons for it to be maintained.

Yet the Barnett formula is well recognised and any attempt at reform will need to take the public with it involving engagement and transparency and it is likely that there need to be an independent assessment of the fair means of allocating resources raised by the UK government to reflect need, density and population, both between regions and within regions.

R151: Local authority pensions is another area of change. Does it make sense to have passive only pension funds in the LGPS?

JB: Equity investors like the idea of outperforming but recognise that being consistently ahead is very challenging – and active fees often seem to reward the manager and not the risk taker. Passive management has grown in popularity because investors recognise that a properly specified index is hard to beat, and minimising cost-leakage is really important – but investors do reckon that they can do better. Very large funds typically hire a number of active managers, but this practice can quickly become self-defeating, as the effects of the managers pure stock selection skills diversify away rapidly, and the fund is left effectively with a very expensive index fund overlaid with a small number of ‘style tilts’.

Reflecting this challenge, a 2009 performance evaluation study done for the Norwegian sovereign wealth fund came to the conclusion that the fund would be better off simply building a set of Style Factor portfolios themselves. Finance academics and practitioners have long since identified a number of factors that out-perform the broad equity market, on average, over time, and disciplined investors can on paper, with enough time, beat indices quite easily, as indeed can monkeys throwing darts. This is because virtually all ‘price indifferent’ strategies outperform and all non-cap-weighted strategies have value and small size tilts. Yet many active or so-called smart beta strategies under-deliver. The challenges that need to be addressed are high costs, limited scalability and liquidity, low sustainability and poor portfolio construction. If these issues are answered, market cap weighted indexed investing is a poor way forward for pension funds.

R151: Local authorities increasingly look for ways to generate revenues – what opportunities do you think they could explore?

JB: In squaring the circle of spending and revenue generation, much of the central government attention has been on austerity, yet focusing on cost containment offers no scope for future growth in scale or quality of service provision, whilst demand is ever rising. No surprise then that local authorities are increasingly focused on generating revenues, and they look well placed to provide local services on a price-competitive basis with private enterprise, and to work with private enterprise in new form public/private initiatives. On the service front, taking private contract revenue for tasks that local government already provides to the community with a high standard is an obvious opportunity. With private/public initiatives, arguably key wins would be the provision of low cost housing and low carbon energy, serving the needs of communities and also generating revenue.

Local authorities can also enable growth in the private sector. Much is said about the rising tide of self-employment yet for many this is a route forward founded on need not choice, and local authorities could consider providing co-operative-style premises, core business services, and support such as business planning and accountancy, in exchange for a fee and a stake in the future. Truly this would be local authorities helping communities and communities helping local authorities.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla