Common-sense overlay

Brendan Maton spoke to Jo Ray, who runs the pension fund of Lincolnshire County Council on England's east coast, about the fund's common-sense approach to in-house and external asset management

The pension fund administered by Lincolnshire County Council for a range of public sector employers, on England's east coast, is nearing the end of a search for an investor in alternative assets and strategies.

The mandate will be worth 15% of the fund's total £1.2bn (€1.36bn) and for many years its officials have been propositioned by commercial asset managers with plenty of unusual ideas for this very broad category.

But few of those notions came to pass through the tender process: a point of frustration for Jo Ray, financial adviser on pensions and investments at the Council.

"We got a lot of responses that looked to promise the kind of returns we were after by the most conservative means," she says. "We sent out a brief asking for people's best ideas after all those interesting conversations. But in the tendering process managers do not want to be seen as an outlier."

The paradox of making a formulaic response to a call for novel ways of thinking is not lost on Ray. The teams that respond to tenders (RFPs), just like in-house lawyers, are not paid to be imaginative. If asset managers were cars, RFP teams would be the safety belts. Ray has some sympathy, however, because the procurement process for public bodies in the European Union is neither easy nor at times helpful to any of the parties involved: sellers or buyers. In her words: "It can be a complete nightmare. We have outsourced our own searches so that we don't have to handle all that box-ticking internally. It was soaking up too much of our staff's time."

JLT in Manchester is the consultancy that now handles most of Lincolnshire's mandate searches (a customary review of global custody provision is currently in train). The twist in the alternatives search is that the successful manager has to accept a portfolio of private equity worth approximately £90m, or half the total brief. Over time, and in discussion with the fund, that private equity portfolio can be altered. Ruled out of the mandate was a crude liquidation of the current holdings by a new manager eager to pursue its own agenda with cash. Equally ruled out was a simplistic allocation to alternatives such as hedge funds and commodities. "We didn't want to box the manager in," says Ray. "They can allocate quite flexibly as and where they see advantages - for instance profiting from the cheapness of credit in 2009. We couldn't do that opportunistically in-house because it would take two meetings and six months to get approval from the investment panel."

The slowness of decision-making at board level is a problem of occupational pension schemes officially recognised in the UK 10 years ago with the publication of the Myners Report.

Less readily discussed is the conservatism of responses by commercial asset managers when offered a genuinely open brief. Four years ago another similar size scheme, the Superannuation Arrangements of the University of London (SAUL), was baffled by a lack of responses from major players to its call for a genuinely diversified alternatives strategy (Morgan Stanley Investment Management won the brief in the end). The experience of Lincolnshire suggests that in spite of a slew of conference speeches and position papers on the merits of diversification, even schemes with in excess of €1bn in assets still struggle to get the new ideas they want materialising in hireable form.

This is more galling for the likes of SAUL and Lincolnshire because they both have a record of open-mindedness. Having issued a brief for an absolute return fixed income manager last year, for example, the east England scheme decided to appoint Ben Fox of Goodhart Partners, a manager of managers based in London. For those in the know, Fox has an impressive track record going back to his days at Fidelity. But Goodhart remains a less familiar name to many simply because it prefers its track record to travel by word of mouth rather than the heavy marketing of larger rivals.

Fox complements BlackRock, which runs a similar portion of the fund's fixed income holdings on a passive basis. The split itself tells a very modern tale. The two briefs were born out of one: a mandate for Aviva Investors to outperform a global bond mandate by 1% net of fees. Ray explains that the investment panel had misgivings about continuing with active management in this field after index-like results from Aviva. The decision to pick a genuinely absolute return manager alongside a tried and tested passive name can be viewed as this decade's version of core-satellite.

The desire to soften if not erase indices as benchmarks and then separate passive from absolute-return investing is evident in other asset classes too. For equities Lincolnshire employs three active managers for global ex-UK briefs: Threadneedle, Schroders and Neptune. All have licence to roam the world unconstrained in search of opportunity. Their differing styles are expected to provide some diversification. Meanwhile, the in-house team at Lincolnshire itself runs UK equities passively in-house.

The exception to this division would be a long-held enhanced global equity mandate run by Invesco.

The latter two are the largest and longest-running mandates within the fund. The in-house team has been going since 1989 and achieved outperformance on an annualised basis of 0.31%. Some pension funds might be jumping out of the chair in consternation at this figure: tracking ought to be as close to zero as possible. Yet commercial index-trackers always incur a fee. If they try to compensate for it on clients' behalf via a stocklending programme, new risks are introduced. Many pension funds will be only too aware of these after the credit crunch. But staff salaries are reasonable, especially as the team does more than just portfolio management. The biggest single cost for the mandate is the office Bloomberg terminal. Ray explains that her team makes a bit of profit by occasional tactically buying and selling around official changes to the index's constituents. By staggering its necessary purchases, the fund can shave off the odd basis point. "I call this a common sense overlay," she says.

Given the in-house team's evident success, why not do more by this means? Ray replies that they did track European equities for three years but were not so familiar with the universe and hence the application of their own, homebrewed overlay. In short, the effort was not worth the trouble.

Ray is a pragmatic woman (the fund switched to an MSCI benchmark for UK equities because it was cheaper than FTSE, the dominant licensor and domestic pension funds' favourite). The direct investment management duties are divided among a team of four, with most of the work carried out by herself and colleague in the investment department, Nick Rouse. Apart from Bloomberg, the major outside help comes from a broker the fund has stayed loyal to for two decades, although he has changed from firm to firm during that time. "He feeds us ideas on the economy, particular stocks and themes. Others have taken an interest in us but as we don't trade that much, they soon fall away."

Loyalty has also played a part in the Invesco brief. "We've had the same client relationship manager - Hugh Ferrand - since the mandate's inception," says Ray. Do client relationship managers really matter in the grand scheme of things? Ray believes they do: "If performance is good then it's not such an issue but people build relationships. If there is the same person every year doing the building, you get continuity and that is important when it comes to explaining what has happened with the portfolio."

The Lincolnshire fund is preparing to do some explaining of its own as an era of austerity sweeps through the UK. A reputed half a million jobs are expected to be shed from the public sector nationwide. Findings from an initial report by Lord Hutton this autumn recommend a cut in benefits for future workers in local authorities. Investmentwise, the former will hurt schemes harder: fewer jobs mean lower contributions. Because the scheme is in deficit, slimmer revenues would not alleviate the deficit, leaving the investments having to work harder. Looked at from the side of the liabilities: at the last valuation (2007), the scheme was set for positive cashflows for another 20 years; if gilt yields remain in their current miserable level and job cuts materialise, that period could shrink to four years.

Ray's first concern is to reassure scheme members. "Nobody is going to lose their pension," she states categorically. She is right because this is part of a scheme governed by statute. The Local Government Pension Scheme (LGPS) is not destined for the Pension Protection Fund whatever happens. Under the worst scenario, central government would bail out a failing administering authority.

But if there is to be no ultimate cataclysm, much pain is nevertheless on the cards. Thanks in part to poor yields and a recognised rise in expected longevity, total contribution rates are up from 19% in 2007 to potentially 30% from 2010. It is noteworthy that the cost of past service liabilities has leapt from 4.2% of the total figure three years ago to an estimated 12.3% now. Ray fears that smaller bodies might fail if the public sector shrinks and the business simply isn't there to fund salaries let alone pension contributions. "The question is to make the rise affordable," says Ray. "We are not here to put companies or small organisations out of existence."

She points out that in the history of the Lincolnshire fund, there has never been a case of an admitted body failing. She adds, however, that the last few years have been extraordinary times. For many smaller employers, especially those in the private sector taking on liabilities as part of an outsourcing deal, insurance exists to cover those liabilities in the event of company insolvency. The two alternatives are the fund acting like a creditor and receiving assets in lieu of payments; or the outsourcing authority picking up the tab. The latter is probable and Ray's team are already in discussions with weaker covenant authorities in the County to prepare for such a scenario.

A positive resolution to the dilemma relies much on the price path of long-term bonds, but also loops back to the fund's increasing allocation to unconstrained mandates and especially absolute return. In order to help the employers in the Fund plan their expenditure on pensions, the Council is implementing a "freeze and wobble" plan for the most secure employers. It wants to reassure those bodies with strong covenants that their contribution rates will neither rise nor fall by more than 1%. For that to happen, good returns regardless of market fortunes are in order. Over 40,000 people in this rural county, from Grantham out to Skegness and Spalding up to Caistor are relying on the in-house team and their external managers. This is the collective task the successful candidate for the new alternatives brief joins.


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