Time to take back control
The UK local authority pension fund sector1 has changed enormously over the years and today is characterised by increasing oversight, market complexity and externally managed investment strategies.
Once renowned for its in-house approach to investing, the sector has long since delegated active control over the investment process to consulting firms, while still retaining responsibility for pension payment obligations. Actuarial valuations published this year revealed large and widespread funding deficits across the sector. Since then, fund members and stakeholders have been lobbying for more transparency and accountability for the investment strategy, but there are still a number of key issues that need to be addressed.
One of these is that pension funds continue to seek advice from the same small pool of consulting firms.
Research indicates the top three consulting firms advise 85% of FTSE 100 (private sector) pension funds2, which is quite concentrated. But the local authority sector is even more prone to this concentration of advice, with the top three consultancies advising closer to 90% of the pension funds3.
Further compounding this is the consultancies offering a ‘bundled’ service relationship of actuarial, investment consulting and manager selection advice: little wonder that questions on conflicts of interest have been raised in the Myners review (2001) and Morris review (2005).
Consultancies were appointed by pension funds to develop investment strategies that were bespoke to each pension fund. But empirical studies conclude this is not being applied in practice, despite the sector’s move from peer group referencing to liabilities-based investing. In fact, a US-based study4 noted that “most institutional portfolios are tightly clustered, with total portfolio volatility falling in the 10-11% range… regardless of the funds liability structure, sponsor strength or funding status”.
Data from the local authority sector5 suggests similar investment strategies are being implemented across pension funds, with the average asset allocation remaining broadly static from 1996-2005. As a result, most funds maintained their high allocation to equities during the equity market downturn of 2001-2003 and, over the past year, have been actively increasing their allocation to bonds in order to match the liabilities profile at a time of historically low yields.
The consulting firms have also grown the manager selection side of the business and the first thing to note is that it is big business: around 90% of local authority pension funds now have the majority of their assets managed externally. But how have they fared at manager selection? It should be expected that given the breadth of the investment manager universe, and the large number of pension funds, that a diverse range of investment managers would be selected to manage fund assets. Except that is not the case. In fact, 60% of local authority pension fund assets are managed by just five investment houses – the same five as three years ago.6
What also followed was that local authority pension funds, once so keen to retain and develop investment resources, downsized their in-house investment departments and, in the process, lost the investment skill and experience they had historically nurtured and relied upon for managing the investment process. The pension funds, for all intents and purposes, are now just processing and reporting on externally managed investment activities. The ability to substantively influence the investment strategy is marginal.
This move to externally managing, or outsourcing, the investment process was also expected to produce better investment performance for the pension funds, although the size of funding deficits across the sector would suggest this was not the case.
Consequently, consultancies are under increasing pressure to justify the advice they provide.
The general adoption of the ‘Myners principles’ by local authority pension funds has placed the focus on them to explain how they manage their investment process. And however well-meaning, it may have served only to impose a prescriptive methodology for pension funds to adhere to, creating a defensive environment in which compliance now ranks equally with managing the investment process.
Fifty years ago the investment environment that pension funds operated in was entirely different. The investment process was predicated on a conceptual investment framework developed by the pension fund and the assets were managed by established in-house investment teams with a broad range of skills, experience and knowledge to draw on.
The investment universe was small, consisting of those securities generating an income; namely gilts, debentures and preference shares. Asset allocation was a function of the securities selected on the basis of their sustainable yield. Given the limited flow of information (information had a long shelf-life) trustees were able to make informed decisions. The big move into equities only took hold in the 1950s7 when dividend yields rose above those on government bonds.
Equities provided the possibility of dividend growth, whilst gilts offered the prospect of capital loss if interest rates rose. Risk was ‘the loss of capital’ or ‘a company not paying a dividend’.
However, as investment markets became more sophisticated in the 1970s modern portfolio theory became prominent in developing investment strategies. Diversification became the new mantra, and in the 1980s this led pension funds to move from in-house asset management to outsourcing of this function to balanced fund managers, a process that gathered momentum in the 1990s.
The rise to prominence of consultancies, increasing use of benchmarks and acceptance of relative risk became the key influences on the development of investment strategies as they are today. It is only in the last few years that a pension fund’s liabilities profile has become a consideration in the day-to-day management of the assets.
There is an overwhelming need for pension funds to re-establish control of the investment process with significant potential benefits attached. And a lot can be learned from the way pension funds managed their investment process 50 years ago.
For example, if they are to actively reestablish control there is a need for a clearly defined conceptual investment framework setting out how the pension fund will invest. It is likely to include factors such as a focus on the long-term investment objective, whilst also being aware of the market environment and range of possible outcomes. It will include a clearly defined investment philosophy that runs counter to the diversification mantra, and may result in a portfolio significantly different to what the market is holding. And it will require the fortitude to withstand periods of underperformance. This is no different to what pension funds expect from the investment managers that manage the assets.
Trustees and management must accept, understand and be committed to the conceptual investment framework.
The ownership of decisionmaking between trustees and management will be based on how proactive the investment process is and how regularly the trustees meet. For instance, the more pro-active the investment process and less regular the trustee meeting, the greater the amount of decision-making responsibility transferred to management.
Trustees will need to ‘get behind’ this approach if the investment process is to be managed effectively.
The pension fund may end up holding a portfolio considerably different to what the sector is invested in, but one that is consistent with the conceptual investment framework. By improving the investment skills and knowledge of trustees, with the full support of management, the investment process will receive most of their attention rather than the increasing demands of compliance.
Pension funds are likely to continue to rely on consulting advice, but this will be to ‘support’ the investment process. The ideal scenario for pension funds is an in-house environment that encourages open debate and a free flow of ideas facilitating a proactive approach to managing the investment process. External advice should be challenged for its robustness, the quality of underlying assumptions and expected outcomes.
However, this can only be done if pension funds have the critical mass of in-house investment skill and experience to make this happen. And a strengthened in-house investment resource provides the pension fund with the necessary confidence to manage the investment process rather than being wholly reliant on external advice.
At present pension funds have finite resources, and a governance budget is the best way to manage these resources effectively. The budget should be directed to those components of the investment process likely to add the most value and will include investment manager fees as part of the selection process. It is well to remember that all costs, whatever the size, have an impact on investment performance.
Implementing a budget across all external activities controls pension fund costs and instills discipline.
Critically, control must be re-established across the range of external relationships, given their influence on the investment process, on terms that acknowledge the pension funds requirements. These relationships should be actively managed and transparent and reviewed annually, even on an informal basis. Formal reviews should be undertaken of those long-term relationships that have never been formally reviewed. The longer the relationship, the more likely the pension fund is not receiving a best-practice service provision. To this extent pension funds should make themselves aware of current best practice in the markets operated in by service providers and adjustments made to contractual arrangements as required.
It is opportune, and long overdue, for UK local authority pension funds to review their investment process and actively seek to re-establish control.
I have touched on a number of reasons why the existing process of external management has not worked and how the past offers a clue to the future. A successful pension fund investment process is identified by a strong conceptual investment framework and vibrant in-house investment capability. Only when a pension fund has reached this point has it truly re-established control.
Paul Kessell is a member of the investment team at London Pensions Fund Authority
1The sector comprises 99 pension funds with a market value of approximately £100bn. (Source: WM Company)
2Pension Advisor Review, October 2005
3Pension Funds Performance Guide - Local Authority Edition 2005
4Leibowitz and Bova (2004)
5WM Annual Review: UK Local Authority 2004/2005
6WM Annual Review: UK Local Authority 2004/2005
7George Goobey was manager of Imperial Tobacco Pension Fund and credited with establishing the ‘cult of the equity’