The case for pool products to be based on objectives, not asset classes

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Anonymous author!

In this issue’s Devil’s Den, our anonymous author argues LGPS pools should shift from asset-class silos to objective-based funds, streamlining choices for committees whose future role will be oversight, not implementation

The dating game between the 21 ACCESS and Brunel orphan funds and the surviving pools is over. Seven have gone to Borders To Coast, six to LGPS Central, six to LPPI, and one to the London CIV. One has failed formally to approve any move and remains in limbo.

It has been clear that some committees found making the decision difficult, because the pools today, whatever they may say publicly, offer different models.

Over the next ten years it is my view that they will coalesce round a structure closer to LPPI’s. In fact, I believe they should go further and base their sub-funds round objectives, not asset classes. Let me try and explain.

My first exhibit is RailPen, which manages the investments and liabilities of over 150 organisations. RailPen operates with only four sub-funds.

The core is a diversified and largely liquid multi-asset portfolio designed to deliver sufficient returns to pay pensions in full and on time. Round that are three other sub-funds, one investing in liquid markets, one in illiquid assets and one designed to match client liabilities.

These three satellite funds allow individual clients a degree of flexibility. They invest in the core sub-fund to deliver returns. But they can also vary their investment, duration, and inflation risk respectively to match their chosen appetites by allocating to the three other sub-funds.

For example, if they want to reduce exposure to inflation risk, they put more into the matching portfolio. If they want to dial up investment risk, they put more into the liquid assets sub-fund.

I do not say this is necessarily the exact model for the LGPS pools, but it demonstrates there’s no need for large numbers of sub-funds such as (most) pools offer today to give partner funds flexibility.

My second exhibit is the process investment consultants currently use to advise LGPS funds on their asset allocation. Universally they divide the assets into a small number of objective-based categories such as growth, income, or inflation matching and allocate assets (or asset classes) to each. Equities, for example, go into growth.

It is not a perfect process, because some assets do not fit neatly into one category. But in a similar way to RailPen, it creates a framework which allows funds to prioritise where they want to take or mitigate risk.

For example, if a committee views inflation as the major risk, they can (after taking proper advice) increase their allocation to that bucket.

Most of the pools today are in the process of reviewing their product offering, some because new partner funds are joining, others for different reasons. This is an opportunity to design their sub-funds round objectives rather than asset classes.

For example, a growth vehicle could comprise both listed and private equity. An Income sub-fund could invest in a wide range of assets depending on what is attractive at any given time.

An Inflation sub-fund could include assets ranging from those which provide a precise hedge (index-linked Gilts) to those which are less precise but offer higher returns (infrastructure and real estate). A matching sub-fund would more precisely target inflation and duration matching.

Using objective-based vehicles has several advantages. Above all, the process of asset allocation and implementation becomes simpler and clearer: partner funds choose their overall return target and which risks they wish to take or mitigate.

They then allocate to those pool vehicles which target their chosen risk and return objectives. This is exactly in line with the government’s intentions, though I do not make my case just because of that.

In the new world, the amount of investment expertise at committees will inevitably decline. The government has provided an asset allocation template, but committees’ skillset to allocate between, say, listed and private equity will be limited.

In due course they will find themselves largely relying on the pool’s advice. So why not cut out this part of the process and simply align the choice of vehicles with the return and risk decisions which they will continue to make?

The pool would then have responsibility for the implementation within each objective-based vehicle. In the case of growth, to use an example, they would allocate between private and listed equities – and any other asset which might help deliver their return objective.

The boundary between strategic asset allocation and implementation would no longer be muddied, as it is with the current template. Clarity on who makes which decision and who is responsible for what has another important advantage: it will help partner funds hold their pool properly to account.

What’s not to like? I know my view will be unpopular with many, but partner funds need to face the reality of the Pension Schemes Bill. Their investment role in the future is going to be one of oversight, not one of implementation. Let’s have the structures in place so that they can do that effectively.

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