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 USbased
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
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 inhouse
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 longterm
relationships that have never
been formally reviewed. The longer
the relationship, the more likely the
pension fund is not receiving a bestpractice
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
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
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’

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