INVESTMENT Widening the pool
Pooling supported by flexible platforms will enable local authorities to benefit from scale in their future investment decisions, explains Sid Newby, BNP Paribas
- partnership and compromise will be key to the success of local authority investment pools
- pools will want quality data, fast
- pooling will create opportunities, with scale boosting efficiency and enabling great investment access.
The government’s timeframe for the pooling of funds by local authority schemes is very demanding. By April 2018, the pools will be expected to be “operational”. However, with pools still waiting on formal feedback from the submission in July 2016, it is not very clear what “operational” will look like. What is being decided now will shape how local authorities work for decades into the future.
Local authorities have accomplished a great deal in a short period of time. They have faced many challenges, while also allowing for opportunities to create a flexible platform that supports their long term investment objectives. Over the last 12 months, 89 independent schemes from across England and Wales have chosen their best matched pool of funds and have begun the process of establishing the pool’s structure.
In the meantime, pensioner benefits must still be paid and, with some schemes facing deficits, cost is top of the agenda.Indeed, cost will be a key driver when deciding the legal entity, fund structure and IT platforms used by the pools. Schemes which internally manage investments may argue that they already have a cost efficient model and that, in the short term, pooling could actually increase their costs.
Legal and consultancy fees will be another high upfront cost, but it is important that the right guidance is sought to ensure good foundations are laid.
One of the first major decisions the newly formed pools will be required to make is how they are structured. The main model – and the one likely to be chosen by the majority of the eight pools – is an authorised contractual scheme (ACS). The next key decision is whether to rent or build the management company – the entity regulated by the Financial Conduct Authority (FCA) that will run the pool on a daily basis.
There is a wide range of options available to pools – these include, but are not limited to, using an open ended investment company (OEIC), a unit trust or a limited partnership. However, the intended advantage of an ACS is its tax transparent nature. It will allow an investor to invest in securities directly via the market, rather than through a fund, while also retaining the tax efficiency that pooling provides. Therefore, withholding tax treaty rates that are applied would generally be those of the investors, rather than those of the fund. For pension schemes, in particular, due to their tax transparent nature and favourable tax treatment in many investment markets, this can save a significant amount of withholding tax. Meanwhile, using an opaque tax structure can create a tax drag which will impact overall investment returns.
For example, we compared the tax leakage of investing via an OEIC and an ACS. If we take an MSCI weighted portfolio and assume a dividend income yield of 2.41%, we quickly see a leakage of approximately 28 to 30 basis points from an OEIC, versus leakage of 1 to 2 basis points from an ACS for the same countries. This tax leakage can add up significantly over time.
There are a few considerations when establishing the ACS. One is concentration risk – given that there are a limited number of management companies, and in order to avoid a high concentration of pools using the same provider, it may be preferable to build one in house, allowing in-house experience to staff the management company.
While the ACS model is likely to be the most popular route, there are some pools that are considering a different path. Again, cost is a key driver – especially if we consider how much time and money some pools have already spent building the management company themselves. The regulations that cover the ACS structure require capital to be set aside and the use of a depositary. The long term cost of holding capital and paying for a depositary should not be underestimated.
A clear view
Regardless of which model pools choose, there will be multiple stakeholders, with different needs to satisfy – including individual local authorities’ trustee boards, the oversight board and the management company.
Local authorities will want a clear view of the performance of the assets held inside and outside of the pool. An oversight board will need information on the assets within the pool in order to engage with the management company over performance. Meanwhile, the management company will also need detailed performance data to support their manager selection responsibility.
Providing these stakeholders with the information they need is critical; therefore having a robust data management system across all assets, ready to be “sliced and diced”, is fundamental for decision making, regardless of whether you insource or outsource investment management.
Some private pension schemes have been through a similar journey and there are some useful lessons to be learned from their experience, particularly concerning data accessibility.
Howard Brindle, chief operating officer at the Universities Superannuation Scheme (USS), says the process begins with an accurate assessment of the assets you own. “You can’t manage what you can’t measure, so if you want to actively manage your assets, your asset allocation and make timely investment decisions, the starting point is a timely and accurate measure of the assets you own,” says Brindle. “At USS, we spent over a year building an internally developed investment book of record that provides a consolidated view of all our assets, both internally and externally managed, validated and approved each morning, on a T+1 basis.”
With all the complexity ahead, pools will be more reliant than ever on deeper and potentially more strategic partnerships to help them navigate this new system.
In a challenging economic environment, with low yields and interest rates, pressure on investment returns and funding ratios keeps building.
Many private pension schemes have assessed their models and costs and have decided to insource some of the investment functions. Pools will have the benefit of scale, which should help them find the most cost efficient solution for the future.
Another piece of advice comes from Chris Hitchen, chief executive officer of Railpen, who says: “We [Railpen] needed to be much more coherent about the way we allocated assets and careful with the amount we were paying away.”
Specialist skills are required to manage assets in house, and technology is a key piece of the puzzle. When schemes take the insourcing route, they need a coherent picture of risk and performance across multi-asset portfolios, which requires full scale integrated risk analytics.
All of this has data implications – particularly regarding the acquisition and standardisation of data and pricing assets. With decision making being insourced, a key requirement is the data infrastructure and analytics to support in-house strategies.
Those taking the ACS route will move towards daily valuation of their portfolios. This will ultimately help them to make faster investment decisions – reacting to market events, seizing opportunities and reducing risk. This shift was noted by Chetan Ghosh, chief investment officer of Centrica, who said: “Moving to a custodian that has the ability to give us daily valuation information was a key part of our initiative to improve the management information we receive.”
There are other examples, too, of how the new pools will be able to better meet the investment demands of the future. Take the growing interest in environmental, social and governance (ESG) investing, as an example. With clear investment objectives, oversight and data, pools will soon be able to apply ESG parameters to their investments in an informed way. This enhances the understanding of performance implications and how this will impact risk in their portfolios. Global custodians will be well placed to provide an independent and comprehensive ESG scoring of a pool’s portfolio to inform conversations with investment committees and managers.
Progress has been made in the past 12 months, with more challenges on the horizon – challenges that the schemes are more than capable of meeting. There is no one size that fits all in terms of the future platforms to support pooling. These new models will enable the flexibility to invest across asset classes efficiently and there is the opportunity to embrace new best practices, for example ESG, dynamic risk reporting and improved management information statistics.
With all the complexity ahead, pools will be more reliant than ever on deeper and potentially more strategic partnerships to help them navigate this new system and to meet the deadlines the government has set.