Consolidation, shift to alternatives, seen for U.K. pension funds

Proposals to restructure the U.K.'s Local Government Pension Scheme system could consolidate about £150 billion ($235 billion) in pension assets and ease the way for billions of pounds to be shifted into alternatives from equities.

While LGPS reforms have been debated for years, several recent developments — including the U.K. government's austerity measures — helped to push three key issues to the top of the agenda, industry sources said:

• the consolidation of the 89 local authority funds under the LGPS umbrella;


• the introduction of an organization similar to the Pension Protection Fund — the U.K. equivalent of the Pension Benefit Guaranty Corp. — for public authority plans that have funding levels below 40%; and


• the revision of existing investment regulations.

Brandon Lewis, U.K. member of parliament and parliamentary under-secretary of state for communities and local government, is likely to seek comment from those affected by any potential regulatory changes later this month to review the three issues.

“The search for 'value for money' in the investment process is endless,” said Mike Taylor, chief executive officer of the £4.6 billion London Pensions Fund Authority, the largest fund within the LGPS.

The London Pension Fund Authority is a leader in the push for reform.

Investment regulations affecting local authority pension funds are out of date, Mr. Taylor said. The regulations limit risk-taking by placing barriers to specific investments, rather than a prudential approach to risk from an overall portfolio standpoint.

For example, pension funds in the LGPS can't invest more than 30% of the total portfolio in limited partnerships, yet the rules technically would allow for a fund to be invested entirely in public equities, which potentially could be far more risky, sources said. Furthermore, while direct use of derivatives is not allowed, pension funds can use such instruments within certain pooled funds.

According to estimates by the National Association of Pension Funds, local authority pension funds need to diversify their portfolios and likely will shift about £7.7 billion into alternatives — a 25% increase — within the next three to five years. The change will come mostly at the expense of equities, which could be reduced by about £5.7 billion within the same period. The remainder will probably come from fixed income.

An NAPF paper published in May found that current regulations are “overly prescriptive” and “do not meet the needs of (local authority) funds in enabling them to effectively manage their investment risks.”

LGPS investment regulations should be revised “to better reflect the framework that exists in the private sector where a fiduciary duty is placed on the funds and they have a clear obligation to effectively manage their investment risks and meet their long-term funding objectives,” according to the paper, “Local Government Pension Scheme 2013: Investing in a Changing World.”

Debate on the future of local authority pension funds also converges on the appropriate structure of the LGPS in order to gain efficiency, sources said.

Mr. Taylor favors consolidating the existing local authority pension funds into five or six funds. “Currently there are 89 separately managed funds worth £150 billion across England and Wales,” Mr. Taylor said. “We don't know what the right answer is, but it's not 1 or 89.”

Consolidation “does save money in a time of austerity,” he added.

“In the long term, the average smaller fund does seem to underperform the average larger fund,” said Mark Packham, London-based public sector pension leader at PricewaterhouseCoopers.

Another reform option being considered by officials at some of the individual funds is the increasing use of pooling vehicles for services including investment consulting and asset management. Labeled collective investment funds or framework funds, these tend to pool assets to take advantage of economies of scale while leaving asset allocation decisions to the funds themselves. In contrast, fund consolidation would also result in a merger of asset allocation decisions.

The government should facilitate “an open debate on the case for schemes working together to drive efficiency,” according to the NAPF paper. “It is clear that the LGPS is at a critical juncture in its history,” according to the paper.

A third proposal focuses only on local authority pension funds with deep deficits, according to Mr. Taylor. “Certain schemes are in a mess because they've been mismanaged,” he said. “Therefore, more work needs to be done to establish why those schemes are in difficulties and whether having something similar to the PPF would help.”

Local council governments are unlikely “to go bust,” said Mr. Packham, author of “Reconfiguring the London LGPS Funds” published in 2012. “Taxpayers would have to pick up the bill. ... Ultimately the investments of the LGPS are made on behalf of taxpayers, so it's essential that a good rate of return is achieved. If there are assets that are difficult to obtain or manage under existing regulations, then it's important to have the regulatory flexibility.”