Forging the Future

The Scottish government plans to encourage Scottish Local Government Pension Scheme funds to invest in national infrastructure to boost the nation’s economy in the wake of Brexit.

Cabinet secretary for finance and the constitution Derek Mackay (pictured) used his speech to delegates at the LGC Investment Seminar Scotland, which took place in Edinburgh on 27-28 October, to advocate investment in infrastructure and hinted at plans to drive more collaboration, possibly even including pooling, among Scottish funds.

International pension funds invest in Scotland but our funds are nervous. They have to ensure that they invest in the best investments but I am sure that they can do more

Mr Mackay said: “International pension funds invest in Scotland but our funds are nervous.

“They have to ensure that they invest in the best investments [to achieve returns for their membership] but I am sure that they can do more.”

Mr Mackay said LGPS funds investing in infrastructure to achieve societal aims was only “going one further” than funds taking environmental, social and governance issues into account when making investment decisions such as voting against unethical practices within the companies in which they invest.

Although he insisted that any action on infrastructure investment would stem from a “partnership” between the government and the funds, Mr Mackay said that a “team Scotland” approach was necessary.

“We have to do this; it is the right thing to do,” he said.

“We’ve got to focus, otherwise we’ll be in a cycle of decline. We must give Scotland the edge as we head for Brexit.”

A poll of delegates at the conference found that 82% believed pooling similar to that between English and Welsh funds would be enforced in Scotland as well.

When asked by a delegate whether pooling would be replicated in Scotland, Mr Mackay said there had been “no decision” on the matter.

He said there was “a school of thought that [Scottish funds] could all go in one fund” but added: “Can you not just make things work better, not necessarily by changing the structure?”

“There is a drive towards efficiency in local authorities generally,” said Mr Mackay.

“If there is no efficiency then I will have no choice but to put in place a plan but there is no secret plan for one big pot.”

Barry White, chief executive of the Scottish Futures Trust, an arm’s-length company set up by the Scottish government to encourage infrastructure investment, also spoke at the conference.

Mr White said: “Investing in the fabric of the nation is incredibly important. The LGPS could do much more [investment] locally and directly.”

He added: “Restructures aren’t the only way to get the scale you need to do direct infrastructure investment.”

Richard McIndoe, head of pensions at Glasgow City Council, outlined the £17bn Strathclyde fund’s approach to responsible and impact investment at the conference.

“You can’t run a big fund without having an impact on the environment and society; it’s about how you manage that impact,” said Mr McIndoe.

He explained Strathclyde’s activity in this vein included voting at shareholder meetings, engagement with the companies with which it invested through Global Engagement Services, shareholder litigation and “impact investing”.

Strathcylde set up its “new opportunities portfolio” specifically for impact investing in 2009 as a reaction to the banking crisis. Mr McIndoe explained that when choosing impact investments, Strathclyde had a preference for “opportunities that have positive elements and for local opportunities”.

This included investment in renewable energy, loans for small businesses through the Scottish Loan Fund, and infrastructure via the pensions infrastructure platform, a vehicle set up by a group of large UK pension funds.

Local Government Pension Scheme funds have often prided themselves on outstanding governance. In a 2013 report, The Pensions Regulator found that the LGPS was among the better-governed public sector schemes.

However, the individual funds are now forming investment pools and some elements of decision-making will move to a partnership level. Pension committees will move away from selecting managers and towards strategic asset allocation. How can local committees and officer teams continue to ensure they achieve the best performance for their scheme members?

Elected members and officers discussed this topic at an LGC roundtable sponsored by Grant Thornton at the LGC Investment Summit in September. The group tackled the difficulties of scrutinising the costs of investing via a pool, whether pension committees and local pension boards have the skills required to hold pools to account, and how to manage conflicts of interest between administering authorities and their pools.

Grant Patterson, director, public sector assurance, Grant Thornton, said: “Good governance is a key building block in any successful organisation. That is why it has always been important to us as a firm. We’re interested to learn about the practical challenges LGPS funds are facing and the support you might need. How will all these new arrangements begin to pan out, and how do you maintain and demonstrate appropriate governance, structures and accountability to pension fund members and also taxpayers?”

Power balance

A number of funds have been concerned about the potential threat to local sovereignty that pooling may pose.

Duncan Whitfield, strategic director of governance and finance, Southwark LBC, asked how funds could “maintain the sovereignty of local pension funds in the context of the development of the pools”.

John Beesley, chairman of the Dorset pension committee, said elected members on committees are answerable to the staff and pensioners benefiting from their funds and for that reason local sovereignty was essential.

“My first and only responsibility, both legally and morally, is to the members of the scheme, regardless of what the government says, regardless of what the government thinks it can force us to do,” he said.

Chris Bilsland, non-executive director of the London Collective Investment Vehicle and chair of the discussion, said the development of pools challenged council fund committees’ traditional notions of sovereignty.

“In a council, there is a structure in place, which will ensure that the voice of the council prevails,” said Mr Bilsland. “But once you’re joining a pool, you can get outvoted. How can we get to a position where funds don’t feel that they’re going to be outvoted and that the decisions that were very important to them they’re consistently going to lose?”

“We all make our investment decisions, which may or may not be with our pool; certainly there are some areas within our strategy which may, at least temporarily, be outside the pool that’s been created,” said Mr Whitfield.

However, asset allocation decisions aside, Mr Whitfield said there may be some areas where pools may make decisions that are not strictly consistent with the position of the funds that they represent.

“The dynamic that concerns me is where pools are creating offers which may be considered in conflict with some of our sovereign funds. Scheme member or union representation [at the pool level] is a possible example of that. Socially responsible investment would be another. This is likely to be an issue of the sovereign funds having different thinking to their pool as much as the pool working beyond their remit.”

Cllr Beesley said the Brunel pool had actively worked to prevent any invasion of funds’ sovereignty by the pool.

“We have been very conscious of the danger of that happening. One of the things that I have been trying to promote is to ensure that while we’re setting all of this up, it’s imperative it is done transparently, with as much information as possible, because in each case it’s going to have to go back to respective councils and there are going to be people waiting to undermine the entire process. So we’ve got to be mindful of that and take people with us,” Mr Whitfield said.

Scrutiny

LGPS fund officers and councillors have raised concerns about their ability to scrutinise both the process of creating pools and the pools’ performance once they are operational.

Cllr Beesley said that while setting up the Brunel pool, allowing councillors on individual funds’ committees to scrutinise plans in detail has been crucial. “Doing this in stages, but in quite a lot of detail, has meant there’s been a high degree of scepticism around the table by officers and members from each of the ten sovereign funds,” said Cllr Beesley.

“We’ve allowed that to flow, not because we wanted to end up with a really negative feel, because it isn’t; it’s about looking at how we can get this to work to the best advantage for the members of our schemes. It has flushed out a lot of issues that might otherwise have ended up with conflict.”

James Hakewill, vice-chair, Northamptonshire Pension Fund Committee, said communication between the funds and the pools was “crucial” to allay fears of pools undermining fund sovereignty.

“There is nothing worse in local democracy than [when someone] perceives that something was done behind closed doors,” said Cllr Hakewill.

Mr Bilsland said that beyond good communication, there was “a whole reporting framework which needs to be created” via which funds can scrutinise pool performance.

Mr Whitfield said that scrutiny of costs and fees will continue to be essential.

“We’re stripping down the fees from our fund managers and we will start to replace some of these with new fees from our pools. We must ensure that the new cost doesn’t exceed the old one, as we create what may become a new layer of fund management; we must avoid duplication,” said Mr Whitfield.

Phil Triggs, strategic manager for pension fund investment and treasury, Surrey CC asked what options would be open to a fund that was dissatisfied with its pool’s performance.

“These pools are answerable in the same way that any city fund manager is. There are going to be times of outperformance and times of under-benchmark performance,” said Mr Triggs.

“If [an administering authority’s] faith in a fund manager capitulates, they can terminate and move on to somebody else. That situation with a pool is a bit more difficult. Say for example, three years down the line, a pool is not performing and there is distinct cause for concern amongst the administering authorities. What is the situation?”

Mr Bilsland said funds have various tools at their disposal for holding pools to account.

“If the [pool’s] staff aren’t performing, that’s where you bring in to play your shareholder responsibility. It’s a matter for the shareholders at the annual general meeting to vote out the directors if you don’t think they’re delivering,” said Mr Bilsland.

“As customers, you’ve always got the right to take your money out of the sub-funds within the pool if you think they’re not doing well.”

Mr Whitfield added that it was important for funds to have clear contracts with their pools about what they can expect. Mr Bilsland added these should in particular set out how pools will scrutinise the performance of the asset managers that it holds.

You’ve got to be open about conflicts because if you’re not they can drag you down… You have to establish a climate of mutual confidence among everybody involved

Mr Bilsland added: “At the moment [funds] receive a quarterly report. A regulated company has to go behind the figures. It’s got to find out if the figures that are being presented are actually correct. Nobody’s going to beat up a council pension fund if they assume they’re correct, but if the regulator finds a pool isn’t doing the extra due diligence it’s a breach and a fine.”

Cllr Ellard added: “It’s reporting that leads to confidence. Regular reporting and scrutiny, and early alarm bells, mean you can intervene and sort things before they get too bad. It’s what we have to do because these are such big funds.”

Cllr Hakewill said funds could continue to use their independent advisers to help keep track of pool performance. “I am assuming that we will still be retaining the independent advisers we have. Those advisers are key, along with our professional officers to say ‘are we performing?’”

Conflict of interest

Mr Triggs said a major issue within his pool, Border to Coast, was how to manage conflicts of interest between the pool and its funds.

Mr Whitfield said: “Certainly from a London perspective, there is something about ensuring there are some very clear distinctions between the management of the administrative arrangements of the sovereign funds and of the pools themselves.”

He added that the problem of how to arrange those distinctions differed between pools because of the size, geography and political relationships between the administering authorities within the pools.

James Hakewill, vice-chair, Northamptonshire Pension Fund Committee, said councillors could help to solve conflicts of interest.

“Councillors have, for many years, had to resolve conflicts,” Cllr Hakewill said.

“I chaired the board of what became the South East Midlands LEP. [My authority] was one of the smaller partners with Labour Luton, with Conservative Central Bedfordshire. Everybody had their interest but actually after a while, you effect a mentality change which says, ‘we’ve all got to get on with this’.

“Local government, councillors and local professionals have the ability to get together and resolve those conflicts of interest because we are by our nature democratic.”

Doug McMurdo, chairman of Bedfordshire Pension Fund Committee, said there is a wider conflict at play between the government, with its desire to maximise some of the LGPS’ assets for national infrastructure funding, and the funds themselves, which are legally required to put their members’ best interests first.

Cllr Ellard said the method for dealing with conflicts would depend on the make-up of the pools themselves. His own pool, which consists of Lancashire, the London Pension Fund Authority and Berkshire, benefits from its size, he said.

“When you’ve got a small number of partners in a room, you put a towel around your head and sort it out,” he said.

“You’ve got to be open about conflicts because if you’re not, they can drag you down, and take a lot of energy and resource to sort out. Put it on the table at the beginning. You have to establish a climate of mutual confidence among everybody involved,” he added.

Mr Triggs said officers are under pressure as they are forced to divide their time between their daily work for their fund and the work necessary to set up a pool. He added that the Border to Coast pool may try to make this division of work clearer through secondments.

However, Mr Triggs added that the structure of a pool – in most cases, designed around a company regulated by the Financial Conduct Authority and owned jointly by the councils as shareholders – places councillors in a potentially difficult position.

“With Border to Coast there are 12 chairs who form the member steering group. They ultimately would be accountable for the operation of the pool; they will appoint the executive function of that operator, and will have some form of jurisdiction and scrutiny over how the pool works,” said Mr Triggs.

“But as chairs of their administering authorities, they are accountable to the electorate for the running of their own administering authorities. In effect the operator would have a similar role as any external fund manager. That operator will be answerable to the joint committee in terms of its overall performance. So it’s down to the joint committee to say, ‘are things running satisfactorily here?’ There’s that responsibility from the operator to the pool, and for that joint committee to assess as to whether it’s working well, and that’s a conflict of interest for us to manage.”

However, Mr Bilsland said: “There’s a kind of duality of interest: the funds are shareholders with an interest in the company with all of the shareholder powers that go with it, but obviously they are customers with all of the customer controls. How can there ever be a situation where the pool can be operating against the best interest of its member authorities?”

Cllr McMurdo said the sheer practicalities of achieving a consensus among funds within a pool could also present problems. “I don’t think it’s a position of not being able to resolve [conflicts]; it’s whether you can get 12 people around the table,” said Cllr McMurdo.

Knowledge and skills

Councillors and officers will be unable to decipher whether pools are working in their members’ best interests without the requisite knowledge and skills. The group discussed to what extent committees and officers are ready for the challenge.

Cllr Hakewill said: “I got on to the county council and missed the first meeting but found myself on the pension board, and on the second meeting, I found myself as vice-chairman. It’s a massive learning curve.”

He added that councillors’ training was important, but that their role to “ask the naïve question” on behalf of tax-payers and pensioners was essential.

Cllr Ellard said that elected member training was “one of my 10 commandments” of good pension governance. “It really is incumbent upon our officers. They’ve got make sure that we’re kept up to date. Training has got to be compulsory,” he added.

Mr Whitfield said skills among officers are also important. The move to running FCA-regulated pooling vehicles would “take a very different skill-set and a very different remuneration package”, he said.

Summing up the discussion, Mr Bilsland said: “How can we ensure that pools are successful? By ensuring that the pools are facing the same way as the funds, and with conflicts of interest, ensuring there is a way to work through the conflict.”

STAFFING INVESTMENT POOLS

Much of the debate around pooling has centred on the evolving role of elected members in decision-making processes. Elected members on some committees are used to being closely involved in manager selection, and must now adjust to a more strategic role in which they focus on asset allocation. Some elected members will also sit on the joint committees governing their pools, while others will not.

However, it is not just the politicians who will face different roles in future. As pools gear up to go live in April 2018, officers involved with the running of LGPS funds will see their duties change.

In the run-up to April 2018, the bulk of the preparatory work is being done by LGPS officers. This has involved some sharing of officer time between authorities.

Colin Pratt, investment manager at Leicestershire CC, says: “The Central pool has not yet been set up as a legal entity, and officers from the individual funds are carrying out most of the work required to ensure that the pool is set up. Some staff are working on the pooling project on a full-time basis but remain employed by their own fund with the other funds contributing towards the costs.”

Some staff are working on the pooling project on a full-time basis but remain employed by their own funds contributing towards the costs. This does not mean those members of staff will necessarily work for the pool once it is operational

Mr Pratt adds: “This does not mean those members of staff will necessarily work for the pool once it is operational.”

Mark Lyon, head of investments at East Riding Pension Fund, confirms a similar process is taking place in the Border to Coast group.

Once the pools are operational, however, legal entities will exist and staff can be appointed to them; in the case of Border to Coast the initial, senior appointments will most likely be made by the joint committee representing each of the partner funds and then all other recruitment will be carried out by the new corporate entity.

Mr Lyon explains: “The intention is for the senior staff, eg chief executive, chief investment officer, chief operating office and compliance officer, to be appointed initially to take on the implementation phase.”

After that, the staff employed by the pool itself will grow significantly. Mr Lyon adds: “Expectations are for an initial staff of around 35-40 from April 2018, increasing to around 55-60 over the next three to five years.”

Funds with internal management teams are likely to have more staff than those that do not, and both Border to Coast and Central, which contain funds that have internal management teams, plan to make these staff employees of the pool.

Mr Pratt explains: “Once the pool is operational, those staff working in a direct investment management capacity at Derbyshire, West Midlands and Nottinghamshire will be transferred via TUPE to work for the pool as long as investment management is a sufficiently large part of their current job.

He adds: “Central will initially be launched with internally and externally managed sub-funds, with the internally managed ones being broadly a replication of the internal investment management currently carried out at individual funds.

“It is not initially expected that all of the funds in the pool will use those internal capacities; they will continue to use an external manager for those assets that are currently externally managed, but do this within the pool.”

The transfer of in-house management teams at East Yorkshire, South Yorkshire and Teesside to the pool will be similar at Border to Coast, Mr Lyon says.

However, it is not just the in-house management capacity of individual funds that will be needed at pool level, both officers say.

Mr Pratt says: “Other staff working at the individual funds, but not managing money directly, will also be transferred across to the pool under TUPE if their current responsibilities are transferred to the pool.

“While some of this resource will be transferred from the funds to the pool, there is an expectation that further appointments will be required. Most funds will have staff where the majority of their work will remain at individual fund level but certain aspects of it (manager monitoring and manager selection, for example) will transfer to the pool.

“It will also employ people similar to the traditional role of those working in local authority funds, who will monitor the performance of external managers serving the pool’s members.

“It will still be necessary for funds to maintain these roles at individual fund level, to assess the performance of the pool, and to assist members in asset allocation,” says Mr Pratt.

Dawn Turner, chief pensions officer at the Environment Agency Pension Fund, says the Brunel pool’s staff will comprise a similar mixture.

“It is reasonable to assume that resourcing will be a combination of both new staff, existing staff, term contract staff and consultants. However, the balance between these resources is still to be finalised.”

Ms Turner adds that due process during the appointments will be crucial.

“We hope to make an early appointment to the role of chairman of the new company,” she says.

“They would then be involved in the appointment of the senior executive officers of the new company. There is a clear potential conflict of interest and therefore existing officers of the pension funds will not be responsible for the appointments.”

Ms Turner adds there will be some roles at the pools that would be outside of the remit of an LGPS officer.

“There are clear functions that are unlikely to be within the existing qualifications or experience of the existing officers to the satisfaction of FCA; an obvious one is compliance and risk.”

The structures of pools and the ownership of those structures will dictate staffing requirements and responsibility, to an extent. The Welsh LGPS funds are looking to appoint a third party to run the operator company that will manage its pool and in that situation staffing would be the third party’s responsibility. However, the Welsh pool has yet to confirm its plans.

Some pools are not yet ready to discuss concrete staffing plans. The Access pool is currently considering a number of options. The northern pool, comprising Greater Manchester, Merseyside and West Yorkshire, is awaiting final approval from the government of its pool plan before it begins its staffing strategy in detail.

There are clear functions that are unlikely to be within the existing qualifications or experience of the existing officers to the satisfaction of the FCA; an obvious one is compliance and risk

Peter Wallach, director of pensions at Merseyside, says: “The pool’s assets will be managed collectively but the investment teams will not be co-located and will remain based locally. It is likely that centres of excellence will develop over time. The in-house expertise across the three funds will play a large part in any staffing arrangements but we will need to recruit to some specialist roles.”

Pools that are already operational are naturally further ahead in their staffing plans. The London Collective Investment Vehicle, which already has live sub-funds, has appointed a board, a chief executive and operating officer, and a six-strong investment team. Most of the appointments to the latter were from the investment management industry, with the exception of assistant client director Jill Davys, who was head of financial services at Hackney LBC for 12 years.

The Local Pensions Partnership, comprising the London Pension Fund Authority, the Lancashire Pension Fund and, soon, the Berkshire fund is also live. It offers a slightly different service to participating funds and this is reflected in its staffing plans as it will need staff to deliver the additional services such as third-party administration that it will provide.

LPP chief executive Susan Martin explains: “It’s a pension services organisation. Both the LPFA and Lancashire were already providing some services to other pension funds; we already had in-house capability in investment management, risk and liability management and administration.”

Ms Martin says the way in which the partnership was created has affected the skills its staff now have.

“We had legal, compliance, and financial advice help, but did the rest of it ourselves. That has really helped in understanding all the FCA requirements,” she says.

Recruitment for the partnership is not yet complete. Ms Martin adds: “We need more people, but it’s not just having the investment team; it’s about having the legal, finance and risk assessment team. We had that at both organisations, but we needed more of that.”

TRANSITIONING TO POOLS

By April 2018, Local Government Pension Scheme funds will have completed the transfer of the majority of their individual assets into pools.

The complexity of this task should not be underestimated: merging 89 funds in six pools in an efficient and cost effective manner takes considerable skill.

A badly managed transition can be very costly. Not only do the funds have to ensure that the asset transition is a smooth process but they also need to ensure they not caught out by unforeseen expenses.

There are fund managers that specialise in these processes, known as transition managers. In the past, however, these managers have been criticised for failing to provide fee transparency. State Street was fined £22.9m by the Financial Conduct Authority in 2014 for charging its clients substantial mark-ups.

Both the individual schemes and the finan pool need to plan their stategy in advance… That will, to a large degree, dictate the costs that the scheme and the pools will incur

But these misdemeanours served a useful purpose. Sam Gervaise-Jones, head of client consulting for UK and Ireland at bfinance, says: “This has helped sharpen schemes’ awareness of the risks associated with this process.”

The best way to address these risks is for each and every scheme to examine which transition manager suits their requirements.

Mr Gervaise-Jones says: “Some managers are better at accessing and transitioning particular asset classes.”

Planning is the key to minimising the nasty surprises. Andy Gilbert, managing director at BlackRock’s transition management group, says: “Both the individual schemes and the final pool need to plan their strategy in advance.” That requires determining the final asset allocation and the managers they will select for the pool.

Once this plan has been put in place, the schemes and pool can then look at how much the existing assets overlap with the target structure. Mr Gilbert says: “That will, to a large degree, dictate the costs that the schemes and the pools will incur.”

When the final destination has been determined, the LGPS’ familiarity with public procurement will help with the next stage.

Chris Adolph, head of transition management for Russell Investments, says: “This process focuses almost exclusively on cost.”

But unlike more straightforward procurement processes, it is only possible for managers to estimate rather than quote the cost of transitioning assets, within a certain range, as the actual cost will depend on the prices available and the liquidity and volatility in financial markets at the time of implementation, according to Mr Adolph.

Mr Adolph says: “To achieve the greatest cost transparency, the funds will need to understand what is included to give a cost estimate and understand the factors which will affect that cost estimation.”

Important variables include whether assets can be crossed internally or externally.

The funds need to become familiar with these key variables in order to be able to compare different quotes and find the best transition manager

In internal transitions, the manager finds the buyer for the assets that the LGPS fund is selling among their own clients. By matching these two trade together, the manager can avoid going out to the markets to transact, saving on some costs.

External crossing involves sourcing the other side to the LGPS trade from elsewhere.

The cost of the transition process will vary across different asset classes.

Mr Gervaise-Jones says: “In less liquid assets, such as property, any changes in allocation can be both challenging and expensive. Early planning is vital for these less liquid asset classes.”

That will enable the transition managers to gradually shift these assets across to ensure there no forced sales.

It is likely that the complexity and illiquidity of these holdings will make a systematic transition very difficult. A preferable option could be for oversight of existing assets to pass to the pool, which may then take advantage of market opportunities to rationalise portfolios. New investments could then be pooled together as much as is appropriate for market advantage, he adds.

All of these factors can have a material impact on the cost of the transition. Mr Adolph says: “The funds need to become familiar with these key variables in order to be able to compare different quotes and find the best transition manager.”

Track record is also an important consideration. The LGPS will need to select a transition manager who can demonstrate that they can deliver in line with their cost estimates, he adds.

In less liquid assets, such as property, any changes in allocation can be both challenging and expensive

Once a manager has been appointed, it is vital the scheme can communicate clearly with them to explore all possible options. Mr Gilbert says: “A transition manager can model different scenarios to help them to understand the impact on the cost of the project.”

This would give the scheme a much better sense of how the transfer of assets can be made, how long it will take and what transaction costs are involved, he adds.

John Minderides, head of portfolio solutions at State Street Global Markets, adds: “This will help the LGPS fund, the pool and the transition manager to agree some metrics for success.” That will ensure greater transparency and ensure the process is successful.

For example, an important consideration might be the allocation between active and passive equities in the final pool. The transition manager can look at whether current asset allocations are segregated or pooled and then determine if it is worth having a centrally managed transition account.

There will be a lot of moving parts to these deals including fund managers, accounts and custodians. That may well overburden the resources of transition managers

Mr Gilbert says: “This helps to avoid the legacy managers simply selling the existing positions and instead transferring these assets across to the new manager.” It’s about finding the most efficient route that will minimise cost and risk, he adds.

That could include the use of derivatives. Mr Gilbert says: “Futures and foreign exchange forwards can play an important role to manage that risk.”

Funds might need more than just a transition manager to ensure a smooth process. Mr Adolph says: “While the LGPS will be familiar with transitioning some assets to different managers when mandates are changed, transferring an entire fund is a much complex undertaking.”

Pools could play a key role in overseeing the transition process. Mr Adolph says: “It would make sense for the pools to focus on transition management expertise, as a larger fund will likely make manager changes more frequently than smaller funds.”

Funds should consider staggering their pooling. If all the transfers are made at the same time, it could overburden the transition managers.

Mr Minderides says: “It’s unlikely that liquidity will be the most important factor, as many of the assets will be passive, but there could be significant operational constraints. There will be a lot of moving parts to these deals including fund managers, accounts and custodians. That may well overburden the resources of some transition managers,” he adds.

The LGPS will need avoid the mistakes made by other pension schemes. Mr Minderides says: “Too often trustees and plan sponsors leave the transition management process too late in the day.”

“The key to making such a significant undertaking a success will be early planning and early engagement with every stakeholder,” says Mr Minderides. This will be best way to avoid any risks or unnecessary costs associated with a transition, he adds.

MIFID: A THREAT TO COMPLEX INVESTMENTS

Local Government Pension Scheme fund officers have been warned to prepare for the impact of updated European regulations in order to continue accessing services from investment managers.

The Markets in Financial Instruments Directives are EU rules that regulate companies providing investment management services. An update to the directives, known as MiFID II, is due to take effect from 3 January 2018.

Part of the directives dictate the categories to which the different investors belong. As a result of the revision, the Financial Conduct Authority is proposing to reclassify different types of investors within its own Conduct of Business Sourcebook (COBS).

MiFID categorises investors in recognition of the different levels of experience and knowledge they have, and requires investment management firms to treat them according to these categories. Those categorised as ‘retail clients’ are considered to be less sophisticated than those in the ‘professional clients’ category, and therefore investment managers are prohibited from selling them certain complex investment products.

As a result of the latest revision of MiFID categories, the Financial Conduct Authority is proposing to reclassify local authorities and their pension funds as retail clients by default.

This could limit the investment freedoms that LGPS funds currently have, because a wide range of investment products that LGPS funds already use are judged to be complex. These include derivative overlays used for currency or inflation hedging, or unlisted securities, such as private equity or direct infrastructure.

Categories

Currently, pension funds are categorised as ‘eligible counterparties’ or professional clients, which means investment managers’ dealings with them are subject to less regulation. Professional clients are judged to be capable of making investment decisions and understanding complex financial instruments at a higher level than retail investors.

However, the MiFID rules seek to increase the regulatory protections for public bodies and restrict the types of public body that can be listed as professional clients.

Under the FCA’s proposed rules, LGPS funds will be reclassified as retail clients, with the ability to ‘opt up’ to become professional clients by asking their investment managers to treat them as such.

It is investment managers’ responsibility to demonstrate that their clients are sophisticated enough to be sold complex investments. Under these proposals, investment managers will have to apply a new, rigorous test to determine whether clients are professional or retail.

The new tests

LGPS funds must ask each manager they want to continue investing in complex products to treat them as professional clients. Managers will need to assess each client’s status, which could prove time-consuming, while different managers may interpret the assessment criteria differently.

The FCA is proposing a new qualitative and quantitative test to demonstrate professional client status.

Managers must undertake an assessment of their client’s expertise, experience and knowledge to ensure the client can understand the risks involved and make its own decisions.

LGPS funds must now also have financial instrument portfolios exceeding £15m, and must either have carried out significant transactions within the relevant market at a certain frequency over the previous year, or employ someone who has worked in a professional position in the financial sector for at least a year.

Impact

The LGPS Advisory Board has issued guidance to LGPS funds urging them to assess their status against the new opt-up criteria, and to ask their current investment managers if they would continue dealing with them as retail clients, and what instruments and services would be available to them on that basis.

It has warned some funds may struggle to demonstrate their track records of transactions in the relevant markets unless they have an in-house investment team.

There are also implications for LGPS pooling. Pools will technically be fund management companies themselves, selling investment products to their member funds, and so they must also carry out assessments on their member funds.