U.K. pools gaining critical mass, and investment choices

U.K. investment pools formed seven years ago to streamline the investment process for local government pension funds are now building up sizable assets, as well as facing challenges that range from diversification to climate change reporting.

Local government pension schemes, or LGPS, "are still moving funds and the pools are still building up asset classes," said Colin Cartwright, an Aon PLC partner in London who consults with both LGPS and corporate clients. He expects to see more funds transferred into pools, and more asset class growth.

While many LGPS assets are managed by third-party managers, "the pool plays a really important role," said Philip Pearson, London-based head of LGPS investment for financial consultant Hymans Robertson LLP, which consults with the LGPS funds.

"Pools are driven very much by what the partner funds want to achieve," he said. Local government pension funds have "quite a lot of commonality, and I think (the appeal of pooling) is going to increase. Investment markets these days are so large and diverse that no one (pension fund) can provide everything," Mr. Pearson said.

Collectively, the 88 local pension funds in England and Wales known as local government pension schemes represent one of the U.K.'s largest defined benefit segments, with assets of £276 billion ($340 billion) as of April 2020, according to a House of Commons report published Feb. 23, 2022. Eleven local pension funds in LGPS Scotland add another £46 billion, the report said.

The pool concept started in 2015, when the government unveiled its agenda to increase the scale of LGPS investments for two main purposes: improving returns through scale and reducing investment costs, while also facilitating investment in U.K. infrastructure.

Under regulatory changes made in 2016, each local government pension fund must report on its approach to pooling investments, including through collective investment vehicles and shared services.

"All authorities must commit to a suitable pool to achieve benefits of scale," the 2016 government guidance said.

The resulting eight LGPS asset pools handling investments for their partner pension funds typically fall along investment philosophies or geographic lines, such as ACCESS, an acronym for A Collaboration of Central, Eastern and Southern Shires, with about £34 billion invested and 11 LGPS partner funds.

Two of the largest are Border to Coast Pensions Partnership, Leeds, owned by 11 local government pension funds with combined assets of £55 billion, and Northern LGPS, Droylsden, representing partner funds in Greater Manchester, Merseyside and West Yorkshire, with combined assets of about £53 billion. Other sizable pools include LGPS Central Ltd., Wolverhampton, with eight member funds and £49 billion in combined assets, and Brunel Pension Partnership Ltd., Bristol, managing £35 billion for 10 local government pension funds.

The first pool formed, London LGPS CIV Ltd., now manages £27.9 billion for 32 client funds in the City of London and London boroughs. Wales Pension Partnership, Carmarthen, with eight LGPS funds covering all of Wales, reported £21.6 billion in assets as of March 2021.

Another pool, the £22.8 billion Local Pensions Partnership, London, got an even earlier start, joining forces in 2016 with the Lancashire County Pension Fund to pool investment and liability management before the government's pooling mandate.

The eight investment pools differ by operational types. Some created investment services companies regulated by the Financial Conduct Authority, while others created collective investment vehicles governed by a joint committee representing local authority funds.

Pools typically have a mix of active and passive offerings and are continually rolling out more investment choices, as more assets are transferred by partner funds.

One recent example is ACCESS, which in March announced the addition of four externally managed fixed-income and equity funds, bringing the mix to £22.2 billion managed actively and £10.9 billion in passive funds.

LGPS pool portfolios that started out heavily tilted toward public equities are now looking for more diversification as more assets are transferred from partner funds, consultants said.

In March, Border to Coast Pensions Partnership launched a £1.4 billion internally managed fund that invests in listed securities exposed to alternative assets to give partner funds exposure to a diversified portfolio in sectors such as renewable energy, digital infrastructure, specialist health care, real estate and private equity.

An increasing shift by LGPS pools to private from public assets in recent years "is a really important trend driven by really valid investment rationale: diversification and additional return to earn by taking more risks," said Mr. Pearson of Hymans Robertson.

Private markets "are where our clients want to invest," said Jason Fletcher, chief investment officer at London CIV. The pool has set up six new funds in the past six months, including ones for renewable infrastructure and private debt, where interest has outstripped expectations, Mr. Fletcher said.

While every LGPS fund now has private market exposure, "it is not as clear cut as it was 10 years ago. Price and prospective returns have come down. It is still a fairly robust opportunity, (but) all other things being equal, competition will increase" for suitable investments, Mr. Pearson said.

For Border to Coast, the private markets program designed to give partner LGPS funds more investment options, including co-investments, "is a key part of our offering," said Mark Lyon, head of internal management. It is now looking for fund managers to invest £4 billion in a second round of private markets commitments that will bring the program to nearly £10 billion. The emphasis, Mr. Lyon said, is on long-term partnerships with managers, lower fees through scale, early engagement and co-investments. The process will also focus on how managers incorporate ESG and responsible investment considerations into their investment process, he said.

For Northern LGPS, "the vast majority of the benefits of pooling" are in alternative assets with potential for further economies of scale and combined resources to make increasingly direct investments in infrastructure and private equity, its 2021 annual report said. GLIL, its direct infrastructure platform launched last year, now has committed capital of £3.6 billion, including £50 million from the £24 billion defined contribution multiemployer plan National Employment Savings Trust, London. GLIL's infrastructure portfolio includes renewable energy production, energy transition infrastructure, schools, hospitals, trains, water and ports.

Most of the eight LGPS pools "are well into the second phase of consolidation, which is resulting in the deepening of relationships with managers on their roster," said Gavin Lewis, managing director and head of U.K. local government pension schemes at BlackRock Inc. in London.

"We are also beginning to see an increasing number of these pools moving into a third phase, adding value to their partner funds," Mr. Lewis said. "When appointing mandates, pools are placing greater importance on the value managers can add by negotiating attractive fees in return for solution mandates, access to unique insights and a reduction in operational complexity."

A 2019 government report predicted that LGPS investment pools could save £2 billion by 2033. According to an analysis by Brunel Pension Partnership, consolidation has saved £33 million since the pool's inception. With more than £31 billion of assets transferred from its 10 clients by the end of 2021, partner funds are seeing net fee savings of £13 million per year vs. the LGPS funds' pre-pooling levels, and that figure is expected to grow.

A third-party analysis done for Brunel estimated that total manager fees were 13 basis points less expensive than the market average.

Meanwhile, with 57% of partner fund assets transferred by the end of 2021, ACCESS reduced its investment costs by £29 million, a March update said.

Along with cost savings, the U.K. government is pushing LGPS pools to invest in its "big bang" agenda to boost investment in the U.K. and increase investment in economically overlooked or disadvantaged areas. A white paper published in February asked LGPS funds and asset pools to detail plans for increasing that local investment and to set a goal of up to 5% of assets invested. If all eight LGPS funds set a 5% goal, it would unlock £16 billion in new investment, the white paper predicted.

"Clearly, the government is hopeful that the LGPS funds will step up and finance the leveling-up agenda. I am sure they will if the investment opportunities are interesting," said Mr. Pearson of Hymans Roberson. With liabilities that extend for decades, "they are uniquely well placed to finance projects that might take five or six years," he said.

For many partner funds, such as the 11 in Border to Coast Pensions Partnership, one appeal of a pool, along with operational scale and access to investment opportunities, is stronger governance.

"Administering authorities are responsible for maintaining and managing their pension fund and then committees were choosing managers and doing asset allocation. It was a lot for the individual pension funds to focus on, and for many, without that benefit of scale," said James Sparshott, head of local authorities for Legal & General Investment Management in London.

"The (LGPS) funds absolutely are seeing the benefits of the pools, and also that they are supporting ESG investing and reporting," Mr. Sparshott said.

That ESG support is welcome as governance increasingly means sustainable investing, particularly when it comes to the transition to a low-carbon economy. "The LGPS are at the forefront of that. They are all taking different routes," said Mr. Cartwright of Aon.

As many schemes and pools set net-zero carbon emission targets in their existing strategies, they are also finding new strategies, "ensuring this issue remains at the top of the agenda," said Mr. Lewis of BlackRock.

Mark Davies, LGPS Central's investment director for active equities, agrees. "The direction of travel is we believe that all the partner funds will have an allocation to sustainable funds," Mr. Davies said.

Mr. Fletcher of London CIV noted that LGPS pools "were set up to improve returns and reduce investment costs. The key thing is making sure we get the returns." Now, he said, "I think they've hit the original target. I hope our scorecard in the future will be how we manage ESG."

Said Mr. Sparshott of LGIM: "I think the pools have done an incredible job of delivering on the government's original criteria. They are moving now toward investing in a whole range of asset classes that funds would never have been able to do on their own."

That "makes them some of the largest investors in Europe and the world. I think investment managers around the world recognize the opportunity to partner with the pools," Mr. Sparshott said.