Will concentrating LGPS assets into ever larger megafunds make them fit for the future?

The blitz of over 30 questions followed the chancellor's Mansion House speech on 14 November. Her focus was megafunds or more properly, mega pools.

The consultation – which closes to responses this Thursday (16 January) – has 18 proposals covering Local Government Pension Scheme (LGPS) asset pooling by compulsory consolidation; UK and local investment; and governance.

Essentially, the proposed reforms follow the direction of travel of the work of the past decade in tackling fragmentation and the post code lottery in LGPS investment performance.

What is the LGPS?

The LGPS is a statutory funded public service pension scheme. It differs in legal status from trust-based pension schemes in the private sector as it is established under statute and not under a trust. It also differs from most other statutory public service pension schemes which are unfunded.

It is one of the largest defined benefit (DB) schemes in the world and is the largest DB scheme in England and Wales, with 13,802 active employers, 6.49 million members and assets of around £350bn.

Investment performance has been extremely strong. Over the medium term, the average fund has delivered a return of around 7% per annum. It has seen a real return of 2% per annum over the past five years and 4.5% per annum over the past ten years. Longer term results are stronger still at almost 8% per annum, some 5% per annum above inflation. Last year employers put more than £9bn in contributions into the LGPS.

As at 31 March 2022, the LGPS had a very good overall funding level of 107%, as indicated by the Isio's Low-Risk Funding Index for LGPS (England & Wales).

Since 2015, the 86 administering authorities (AAs) – the councils and other bodies that run LGPS schemes – have come together in eight groups of their own choosing to move towards managing their investments through eight LGPS asset pools.

As of 31 March 2024, £178bn (45%) of LGPS assets were invested through these pools, with a further £107bn (27%) of assets managed by the pools outside of pool investment vehicles. Building on the work of the previous government , the review's aims to accelerate and expand the pooling of LGPS assets. All of this has essentially been voluntary to date.

The move to pooling of assets has already had a number of notable successes.

For example, Surrey Pension Fund created a Financial Conduct Authority (FCA) regulated entity, ‘Border to Coast' with ten other local authority partner funds.

Neil Mason is LGPS senior officer [a recommended new dedicated LGPS role included in the governance proposals in the government's consultation] at Surrey County Council.

He comments: "We are recouping our costs either by savings in management fees or through the ability to access private market allocations with dual benefits: the cost saving through scale and the access to specialist dedicated investment capability. This allows us access to investment opportunities that would otherwise not be open to us."

What's in the new consultation?

In November 2023, the previous government set out its expectation that AAs should pool all listed assets as a minimum, by March 2025, on a comply or explain basis. And the proposed reforms build on that.

The four key proposals in the consultation are:

1.     AAs – see here for list – must delegate their investment strategy to their pool.

2.     AAs will also have to take their principal investment advice from their pool.

3.     The pools must be investment management companies authorised and regulated by the FCA, with the expertise and capacity to implement investment strategies, manage assets internally and to give investment advice to their LGPS partners

4.     AAs must transfer legacy assets to the pool.

The 18 proposals also include recommendations on governance, including a new biennial governance review process for LGPS funds as well as requirements on due diligence and conflicts of interest.

Each AA will also have to set a target the pool's investment in their local economy, working in partnership with Local and Mayoral Combined Authorities to identify the best opportunities to support local economies.

The government consultation notes that some pools have, so far, made very limited progress transferring assets from partner funds to the pool. It says others have created large numbers of sub-funds, often with multiple sub-funds for the same asset class, reducing the potential benefits of scale (see table below).

In practice, AAs have adopted a range of approaches from full delegation to no or very limited delegation; and from significant alignment of investment strategies to no alignment. Many AAs continue to set tactical asset allocation and select investment managers.

Overview of existing LGPS pooling models

Source: LGPS (England and Wales) - Fit for the future

Still more savings to make

According to the LGPS Advisory Board's 2023 annual report, total investment management costs decreased by £141m (-7.6%) from £1,868m, primarily driven by a £188.5m net decrease in performance fees. Management fees increased by £106m, transaction costs increased by £15m while other [investment] costs decreased by £71m.

Total administration and governance costs rose by £28m, with administration costs increasing by £12.1m, and oversight and governance costs increasing by £19.7m. "Other" administration and governance costs decreased by £3.8m.

There is still fat on the flesh. According to the LGPS Advisory Board "the average management fee is 43 basis points (bps), up from 34bps the previous year. There has also been an increase in performance related elements. At 21bps, the average fee 20 years ago was half the current level".

A huge number of asset managers have signed up to its code of transparency – 162 by my count - although it is not clear how many have a bite of the rich LGPS pickings. With so many asset managers around it is surprising that competition has not brought down fees more substantially.

Basic investment management fees alone in 2022-23 were a staggering £1,320.3m with an extra £181.6m in performance fees.

Therefore, it seems credible for Van Lanschot Kempen UK head of client solutions Nikesh Patel to estimate that "the shift from being a fund investor to being a strategic partner to these funds – a co-investor or even direct investors – could shave up to 70% off the private markets portion of the fees, which will be the largest portion of the fees being paid on these combined assets.".

In addition to investment, the LGPS currently uses 29 separate law firms as opposed to just six firms of auditors and four actuarial firms.

Reaction from the LGPS

The reaction from those that work within the LGPS has been mixed.

"In an ideal world we wouldn't start from here," comments the director of one large local pension authority. He says: "In broad outcomes and performance in aggregate things look reasonable. At the detailed level this is uneven and inconsistent. The interaction of the number of funds with the pools perhaps makes delivering the original intentions of pooling more difficult than it ought to be in an ideal world."

He adds: "The current pools will all need to change to varying degrees. The proposals set out a much better defined division between the role of funds in setting strategy and pools in terms of execution. This should create a more consistent approach to how pooling is delivered."

He concludes: "The government has set a clear (and testing) timeline of delivering the transfer of all assets and the creation of new capabilities by the pools of March 2026. How achievable this is will depend on the varying starting points of the different pools and funds. For our pool, it seems achievable but it's going to be hard work. Some aspects will roll in after the 2026 deadline as for example funds complete their strategy review cycles under the new arrangements for advice."

Expert reaction

Advisers also have mixed views.

"The LGPS does a very good job under intense scrutiny, whilst facing substantial cost and resource pressures," comments Society of Pension Professionals (SPP) public sector group chair Kirsty McLean. She adds: "The SPP has previously stated that we would like to see how pooling has, will and might continue to work, before proposals to further centralise LGPS investments are pursued."

There are also concerns that the costs associated with merging funds are significant in the short term.

Aon partner Colin Cartwright warns: "The number of employers will still remain unchanged, and so, for example, the level of actuarial work relating to ensuring they pay suitable contributions will not necessarily reduce significantly through merging funds – and the management of so many employers and members, some of who require local connection with the fund, is likely better with the status quo."

Despite some concerns, there is optimism about potentially exciting local investment opportunities which could create growth. Hymans Robertson head of LGPS investment Iain Campbell points to what has been achieved in Manchester through investments made by the Greater Manchester Pension Fund.

Campbell says the key is time. He explains: "These things do not happen overnight, especially when you're investing in areas less developed than Manchester. The risk of money rushing into this space, either due to government pressure or competition between the pools to be seen as leaders (or at least not the laggards), could well lead to significant losses and damage to local areas."

He also says this is a "humungous" expansion for the vast majority of pools. He says: "To take in such an increase in assets, whilst developing the capabilities to advise on investment strategy and invest locally, is a huge undertaking and may serve as a significant distraction from the day job of the pools – achieving the required levels of risk and return for their funds."

Isio partner Steve Simkins adds: "There are a number things that could be improved across the LGPS. For example, having many smaller funds creates a postcode lottery which can lead to inconsistent treatment of employers and members."

He says: "The creation of the new mega pools doesn't obviously help with these things. They are primarily designed to help the government with gaining greater influence over the assets."

Van Lanschot Kempen's Patel says: "Creating a coherent aggregate portfolio strategy from a collection of illiquids drawn from 80 local authorities and eight pools will be challenging, and may require a reorganisation of the portfolio that could take a decade or more."

Cartwright senior adviser Ian McKnight agrees there will be portfolio disruption. He notes one such example: "Existing illiquid holdings will cause portfolio deviations meaning pools might not be appropriate for some underlying funds."

Mercer head of LGPS investment Tony English also has concerns. He says: "There is a risk of a disorderly and costly transition to the new arrangements, regardless of the outcome of the consultation exercise, given the tight deadlines and potential existential risk for some pools may lead to reactive decisions being taken in advance of the consultation outcome, which could lead to sub-optimal outcomes."

He adds: "We are not in agreement with the extensive reforms proposed with regard to pooling – we'd argue this is a sledgehammer to crack a nut."

There is also a risk of placing too high a proportion of LGPS fund assets with an ever-decreasing range of asset managers. Aon's Cartwright warns: "If those selected managers underperform the negative impact is greater than if a wider group of asset managers was used. Underperformance could vastly exceed fee savings."

Additionally, the Association of Consulting Actuaries pensions in public service committee spokesperson warns: "Looking at the LGPS only through the lens of costs can lead to some important other factors being missed. The scheme has "local" at the heart of it and with over 20,000 employers in the LGPS this is an important aspect. The current structure allows local employers to engage with their LGPS fund to help manage and understand pension costs. It also facilitates local democratic accountability for each fund, a vital part of the local governance arrangements given any changes in scheme costs will feed through to the local taxpayer."

Conflict of interest

There is also a risk that the government's UK growth agenda could conflict with the best interests of pension scheme members.

Irwin Mitchell partner Penny Cogher warns: "Investments might be directed towards projects that support national economic goals but do not necessarily align with the highest ESG standards or the financial interests of the members. Or they could align with the social part of ESG but potentially less so with the environmental part of ESG, depending on the infrastructure that might be involved and how its environmental impact is assessed."

She adds: "The reforms emphasise boosting local investments, which could conflict with the broader goal of maximising returns for members. Administering authorities will need to balance local economic growth initiatives with the fiduciary duty to achieve the best financial outcomes for pension scheme members. The LGPS reforms will require strong governance frameworks to manage the larger pooled funds effectively."

LCP partner Tim Gilbert fears the proposals may also mean employers pay too much into schemes. He says: "Greater pooling without any reduction in contributions over the long-term focusses in the wrong areas, and would mean employers continuing to contribute unnecessarily to already well funded schemes."

A duty to embrace the proposals

But the final word must go to a pensions specialist at the a LGPS ‘coalface'. Surrey County Council's Mason says he is "encouraged" by how much the government has already listened to the LGPS community but says the "devil will be in the detail".

He says: "The LGPS does need to address some of the specific requirements in the consultation such as the need for internal management , FCA regulated entities and the definition of what is meant by ‘local' investment; also, the relationship between Funds and pools as owners and customers – the devil will be the detail."

Mason concludes: "Overall, as long as the LGPS works as a community and supports each other, we can move forward and create the benefits that the government is searching for. But we must not lose sight of the LGPS members and employers in all of this. If we do, we will be doing them a disservice. Ultimately, If the reforms are a benefit to our members and employers the LGPS has a duty to embrace them."

Stephanie Hawthorne is a multi-award winning journalist and former editor of Pensions World (1989 to 2017)