Trevor Castledine: The challenges of pension pooling

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With pooling submissions all in, the industry is now awaiting HM Treasury’s response. This shouldn’t mean, however, that pools cease working on how to put their plans into practice.

Whilst size and investment have led the headlines, governance is one of the most important factors to get right.

This is difficult: Where to strike the balance between maintenance of sovereignty for administrating authorities and that of delegated authority within individual pools? Ultimately, if pooling is to be effective, there needs to be a strong focus on the topic of control and effective delegation.

In our case – the Local Pensions Partnership (LPP) – we understood early that getting the governance right for our founder shareholders was the first key feature.

Crucially, we set out to create a pensions service organisation in much the same way as global leaders like the Dutch fund, PGGM. This meant that our activities were focused on building an offering that had the right governance frameworks in place; not just how we could combine assets.

This common purpose was vital in bringing officers, councillors and board members together and aligning interests. It has also meant that there’s now a good understanding between Lancashire County Council and the London Pensions Fund Authority of the need to allow LPP to flourish on its own.

Testing times

Following our launch date in April, there has been an opportunity to test how this works.

All parties are still getting used to their new roles and that transition will take time. However, the relationships set up in the early days of the partnership remain extremely positive with a will to address issues as they arise.

Of course, in moving from a public sector to a group company structure there are clearly challenges – many being just day-to-day – which funds may not yet have considered.

For example, from the outset LPP staff were saying: “We used to do this in LCPF/LPFA” or “What is LPP’s policy or process on…?”. Still, we believe that by relying on (and training) internal resource rather than external advisers, it sets us up strongly for future growth, as we develop experience in-house.

Many pools are inheriting strong in-house investment teams. However, the increased volume of work and the additional governance burden that Financial Conduct Authority (FCA) regulation will bring will test us all.

Certainly, we, like many others, are looking at our resources to be comfortable that we have the breadth and depth of skills required.

Finally, more stringent requirements about risk and compliance monitoring and separation of responsibilities come into play with FCA regulation. Pools will be faced with the need to boost existing capabilities or even create new teams from scratch as we have found necessary.

Appropriate monitoring and reporting is needed to build and maintain the trust required for effective delegation as well as to satisfy the ongoing responsibility of each authority.

Significant enhancement of existing systems in order to keep track of each participant’s assets and performance is likely to be necessary and decisions will need to be made about consolidation of custodians.

Striking the balance between effective controls and the creation of another level of bureaucracy is tricky in practice.

However, it brings a huge governance uplift. New stakeholders, new boards, processes, policies and procedures, whilst challenging, are worth the journey; as the outcomes for members and employers will be far stronger.

Cost savings

Along with governance, performance must be considered. Whilst the headlines are trumpeting cost savings as a key motivator for the whole pooling initiative the focus should really be on after-cost returns and risk levels. But demonstrating cost savings is, of course, necessary.

So, what’s the plan? Consolidate external managers? Bring investment teams in house?  Move from active to passive management?

All of these options could be adopted by funds and all bring implications way beyond those of a simple headline fee reduction.

The regret risk, in terms of reduced performance, is high and all decisions will be judged with the benefit of 20:20 hindsight. This makes a clear plan and a well documented decision making process important.

More challenging is how to actually track and report savings. Some asset classes typically have lower cost bases than others.

For example, direct lending is typically some tens of basis points per annum more expensive to access than traditional fixed income.

However, many funds may well be increasing allocations to direct lending for perfectly sensible portfolio construction and yield-seeking reasons. So, costs will go up, even if savings, versus managers’ “rate card” fees, are achieved.

The costs tail should not be wagging the investment performance dog. Pools will no doubt be compared to each other based purely on costs, whether we like it or not. Changes in asset allocation might give the illusion of cost saving where none has actually been achieved.

Consistency should be important to all pools. Should savings be reported, therefore, based on a static portfolio? If so, should that be the current portfolio, the pool’s own target or some nominal “default” portfolio? Should the focus be on absolute fee levels (perhaps by asset class) rather than savings achieved?

Implementation challenges

The simple phrase “pooling assets” hides immeasurable complexity. Different asset classes suit different pooling solutions.

Some assets, like listed equities, are easily transferrable and have transparent, reliable values, whilst this is less true for other asset types.

There are transition costs as well as the risk of inadvertently transferring value. How will new investments be allocated between pool members? What about undrawn commitments to closed-end funds, either legacy ones or new ones? How to manage differing treasury and cash flow needs?

We are all at different stages of this journey and there will be many more questions over the coming months.

Lancashire County Pension Fund and LPFA started this process together several years before the government mandate and our asset and liability management model is now up and running. Whilst all pools have varying models, many of the questions faced are similar. What is important is that we are all reaching for the same goal and sharing our learnings.

 

Trevor Castledine is deputy chief investment officer at Local Pensions Partnership.

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Pensioner Photo (cropped): David J, Flickr.