U.K. eyes pooling public fund assets into 6 megafunds

Pension fund executives and global money managers take note: the U.K. government is further along in its mission to pool public-sector assets, potentially channeling billions of dollars of assets from externally managed allocations while cutting costs and creating efficiencies in the process.

This month, U.K. Chancellor of the Exchequer George Osborne announced further details of the government's ongoing quest to pool the assets of England and Wales' 89 local government pension schemes, the LGPS, which collectively have about £190 billion ($288.6 billion) of assets.

At the Conservative Party's annual conference, held in Manchester, England, Mr. Osborne said that he wants the assets pooled into six British wealth funds. The plan is that each will have at least £25 billion of assets, which will, in part, be allocated to U.K. infrastructure, he said.

Details on how assets will be pooled are yet to be revealed; more information is expected in November.

In a 2014 paper, the government estimated that pooling could save £660 million per year. In addition, the U.K.'s LGPS were asked in July to submit proposals on pooling of assets. A number of projects have emerged, and sources said there are plenty of examples from other parts of Europe, North America and Asia to look to for inspiration.

The plan has brought into sharp focus the potential effect on the global firms that provide investment management for these public-sector pension funds. About 16% of LGPS assets are internally managed in some way, sources said, meaning that third parties run the overwhelming majority of assets.

“Clearly the expectation from the government is that fees are going down, so that has an impact on fund managers,” said Linda Selman, Edinburgh-based partner and head of LGPS investments at Hymans Robertson LLP. “We would also expect that there is likely to be some consolidation of mandates — at the moment there is a very large number of mandates, particularly if you look at global equities, across the LGPS, and quite frequent turnover of those mandates — and changing your manager is quite costly.”

The expectation, she said, is a smaller share of hiring opportunities for money managers, and, on top of that, less churn of managers because those allocations are likely to be in place for longer periods of time.

Jeff Houston, head of pensions in London at the Local Government Association, which has been facilitating meetings between government officials, local authority representatives and money managers and consultants, said that without knowing the final makeup of the pools, commenting on the effect on service providers is difficult.

“However it would not be a surprise if asset managers end up with a smaller number of direct clients,” he said.

Although funds are still waiting on the what, how, where and when of the government's pooling requirements, money managers are getting twitchy.

One money manager, who requested anonymity, said pooling is a risk for the money management business model, especially for what he termed the “low-hanging fruit” allocations such as passive equities.

There is also an expectation that pooling of assets will lead to more investment capability being taken in-house.

“As new institutions come at the problem with new thinking, they will be able to design stronger internal capabilities out of that scale advantage,” said Roger Urwin, global head of investment content in Reigate, England, at Towers Watson & Co. He said there has been an “asymmetry” in the industry between relatively smaller and potentially less well-resourced internal investment teams at pension funds, and external money managers, which he said “has not been a healthy factor.”

However, “wherever we see progress in governance,” which is something that would come with pooled assets, “we see progress in internal functions. That carries implications for the asset management industry,” said Mr. Urwin, with more value created by internal teams rather than relying on external managers.

Pooling allows pension funds “to bring in-house more activities, and bringing in-house investment activities allows large funds to challenge established practices in the global financial services industry,” added Gordon Clark, director, Smith School of Enterprise and the Environment, Oxford University, England. “That is also a very important part of the game.”

Money managers should not fear the move too much, and rather should embrace it, he said.

“A smaller market in terms of players on the demand side, I think in some respects can only help the London-based asset management industry, as it will strengthen demand for more sophisticated products,” Mr. Clark said. “I think that is a good thing as it will equip clients with larger pension funds on the expertise to make those types of investment, and actually should be welcomed by the asset management industry as it gives life to innovation and further developments in products and services.”

Some already are eyeing new opportunities to work with their clients.

“For fund managers there will be winners and losers — but the attitude that we are seeing from (them) is that this is going to happen, and therefore they need to engage with it and help LGPS as much as they can,” Ms. Selman said.

The challenge for the investment consultants that work with LGPS is less pronounced, said Andrew Kirton, London-based EuroPac investments leader at Mercer Investments, which is “keenly interested” in developments as a provider of consulting services to local authorities.

“In terms of the services we provide, whether or not we see extensive pooling, it is about pooling assets, not liabilities. The investment of assets, the design of investment strategies, and evolution over time in relation to liabilities, is a field that I would imagine that there will be continuing need for (investment consulting.) That is a big part of what we do in the local authority sector.”

The case for pooling assets is strong, given anticipated savings and enhancement of investment expertise and asset allocation options. Sources said examples in Europe, North America and Asia-Pacific show that it can be done, and it can work.

“For too long some of the smaller funds have struggled to be effective investors,” said Mr. Clark. “All investors these days face very challenging times, which require a level of fees, depth and understanding of financial markets — public and private — that many funds find problematic,” he added. “Scaling up is an important way of adding value.”

He pointed to best practices used from economies of scale to be found in some of the groupings of assets in Canada, Australia and some of the big public sector plans in the U.S. His starting point on effective pooling of assets is well above that of the chancellor's £25 billion, and closer to the £50 billion to £60 billion mark.

Sources cited Swedish buffer funds AP1, AP2, AP3, AP4, AP6 and AP7; Sydney, Australia-based New South Wales Treasury Corp., which manages asset and liability portfolios on behalf of clients; and a program in Ontario, Canada, to bring together the assets of small public-sector pension funds.

What needs to remain in focus is the timeframe, sources added, and the complexity that will come with pooling the assets of pension funds that have different liabilities, boards and asset allocation strategies. Because this is not a merger of funds but asset pooling, administration, liabilities and other parts of the LGPS will remain separate.

Being large brings about its own challenges, such as hiring the right people, and ensuring a professional level of governance and sophistication that “matches best practice across the investment services industry,” Mr. Clark said.

And Ms. Selman warned of lessons learned elsewhere.

“Look at the AP Fonds — they were all set up separately, but are now beginning to combine some investments,” she said. “That is something we should at least look at (in thinking about pooling LGPS) — if you establish a number of funds that are each in the same sector and looking to do the same job, there is a risk that, at some stage, they start measuring against each other.”

That could lead to investment allocation herding, benchmarking, “and there is a risk that they won't be so able to take or express strong investment views. If it goes wrong and they underperform the other funds over the short term, then it could be difficult,” she warned.