As someone who has closely followed the growth of low-cost indexing, the aspect of it I find most surprising is how, until now, the debate has focused almost entirely on personal investors. In terms of managed assets, institutional investing is far bigger, and yet the merits of institutions switching to passive strategies is rarely discussed. That, I suspect, is about to change.
The Local Government Pension Scheme is one of the biggest of its kind in the world, with 92 separate funds across the country, more than 5.5m members and around £280bn under management. It has a fiduciary responsibility to deliver the returns needed to pay scheme members’ pensions, and also to protect local taxpayers and employers from high pension costs.
Quite how seriously the LGPS take that responsibility is open to debate. Michael Johnson at the Centre for Policy Studies, for example, has warned in a series of reports that the system faces a crisis; that it has consistently overpaid active fund managers for poor returns; that it will eventually be unable to fulfil its obligations; and that urgent reforms are required to make it fit for purpose.
Interestingly, there’s a similar debate going on in the United States, where several states are struggling with pension deficits. One example is Maryland, where the state pension scheme has recently admitted paying $87.4m in previously undisclosed private equity fees in the calendar year 2016. But a local think tank, the Maryland Public Policy Institute, says the real number is far higher.
Like many public pension schemes, Maryland has a relatively high allocation to alternative investments, and yet over the last 10 years it has only delivered an annualised return of 4.3%. In that same period, a basic 60/40 passive portfolio of US stock and bond funds would have delivered an average of 6.4% a year.
According to the MPPI’s calculations, the state could save $481m a year by switching to a low-cost passive strategy. “This would be a safer and more responsible way to run a public employees’ retirement fund, a spokesman said, “than to pay huge sums to investment managers on Wall Street to deliver mediocre results.”
Four years ago, a report commissioned by the Department for Communities and Local Government and produced by Hymans Robertson recommended that the LGPS also switched to passive funds for equities and bonds. Such a move, it said, would save £230m a year in investment fees and a further £190m in lower transaction costs.
Thankfully, the Government did act on one of Hyman’s Roberston’s recommendations, by asking LGPS funds to put forward proposals for reducing costs by pooling their investments. We’re now starting to see the first such pools emerge and the savings are likely to be huge.
Perhaps unsurprisingly, though, the recommendation that the LGPS moves away from actively managed funds for listed assets has largely been ignored — partly, one suspects, as a result of the concerted lobbying from the big asset management companies and investment consultancy firms which followed the report’s publication.
In fact, research by Reuters into the holdings of the ten largest LGPS scheme has shown that their allocation to hedge funds — one of the most expensive and poorest performing asset classes of all — has actually been increasing.
In recent months we’ve also seen a number of LGPS funds paying for so-called “downside protection”, particularly using derivates. Again, these complex strategies don’t come cheap, and there’s little independent evidence that, even before costs, they are any more effective than simple diversification and rebalancing.
Nine years into the bull market, the LGPS should be in rude health. If, as Michael Johnson claims, the system is creaking now, goodness knows what a mess it will be in if markets were to fall, say, 30 or 40%.
That’s why we need a full and frank debate about local government pensions. It should encompass not just the benefits of passive investing, but also the influence of large consultancy firms, as well as training and resources for trustees.
Local government has seen cuts an restructuring across a whole range of public services, and with little sign of an end to austerity in sight, it’s time to expose the LGPS to far greater scrutiny than it’s had until now.
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