Transition managers prepare for LGPS pool influx

Transition managers prepare for LGPS pool influx

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The consolidation of 89 UK Local Government Pension Scheme (LGPS) funds into eight larger pools to boost economies of scale and purchasing power is a development that few would oppose, but the government has issued an aggressive timetable for its reform. Currently at the planning stage, the structure, governance and administration arrangements will continue to develop over 2016-17, with transitions required to commence by April 2018.

Each pool made a submission to the government in July 2016 and awaits its response expected in October, a few months later than originally planned. With each pool predicted to be approximately £25bn, the project, which is expected to last up to four years, will entail a huge volume of transitions.

The first task has been to set up an Authorised Contractual Scheme (ACS) run by an operator, regulated by the Financial Conduct Authority, which will manage the fund and be responsible for appointing service providers. An ACS is a pooled asset vehicle with tax efficiencies, particularly regarding withholding taxes, stamp duty and VAT exemptions. Not all pools have yet decided a firm framework however.

“April 2018 is by no means an impossible timeframe, but there is still a lot to do to transfer employees into new entities, apply for their licenses and at every phase manage the process to avoid any potential bottlenecks, especially as multiple pools are aiming to achieve these goals at the same time,” says James Mitchell, executive director, co-head transition management group, Goldman Sachs.

“Having established a quorum and reviewed their current investments, the pools are now reviewing the impact of their asset transition out of their current structure and into a collective target vehicle or, since an ACS can’t hold certain investment vehicles, in some cases into multiple structures. While some pools are intending to establish fully-regulated FCA internal investment management functions within the pool, others will outsource to asset managers through unitised vehicles. Savings will initially be derived through both in-sourcing efficiencies and, as we have already seen with a number of passive equity investments, collective bargaining power.”

First steps

A majority of pools have already started the passive asset consolidation process. The next phase will be the consolidation of actively-managed assets and thirdly, in some cases, alternative assets.

“While the easier-to-transition assets might be scheduled first to achieve timeframe goals and to assist phasing, achieving maximum cost reduction will also be important,” adds Mitchell. “If fees for more challenging asset classes can be reduced by a greater amount, this might also be a factor in a scheme’s consolidation schedule. Additionally, there are substantial operational preparations to be made, including consideration of any taxes associated with the transition of assets.”

London CIV started its own pooling process more than two years ago and has recently established multiple funds for the London boroughs. This groundwork is providing invaluable insight for those following in its wake. In broad terms, the switch of responsibility for manager selection and monitoring away from council chiefs to specialists at the pool is expected to result in more stable long-term strategic asset allocations and medium-term, rather than short-term, horizons. Transition managers can also help hugely in relationship management where difficult decisions, and sacrifices, must be made.

Equal treatment

Each scheme must be treated fairly and the strategy agreed before the process begins. For example, the sequencing of transactions may have unintended consequences in the share of transition costs between schemes, and a successful transition will meet both the collective goal and individual schemes’ priorities.

“Transition managers have a responsibility to each fund individually, not simply a duty to reduce total cost and risk at the aggregate level and this requires sensitive handling,” explains Mark Dwyer, head of portfolio solutions EMEA, Macquarie. “Take, for example, the design of the derivative risk strategy. You need not only a simple risk strategy that reduces risk at aggregate level, but one that also provides cost/benefit risk reduction at each individual pension fund. The transition manager’s role is to minimise risk and to ensure such risk reduction is proportionate for each fund.”

There are lessons to be learned from the pension fund consolidation in the Netherlands and the MySuper reforms in Australia, adds Mr Dwyer. “LGPS are looking at co-operation in asset management pooling, rather than mergers. The liabilities remain with the particular local authority. A whole spectrum of different approaches are being adopted, from the creation of an ACS, to arrangements to invest collectively in a smaller universe of funds, with the objective of each structure to secure lower costs and asset manager fees. However, all are different and provide numerous opportunities for the transition manager to minimise cost and risk.”

In fact, the transition event can be seen as one of the first opportunities to realise material cost and risk savings by cooperation and coordination. “Take, for example, the transition to the consolidated fund pool. When pooling assets, whether an ACS or simply agreeing on a concentrated fund group, a critical question will be whether to execute each pension fund transition separately or simultaneously. If executed in the optimal way, this can be a driver for very substantial savings.”

By executing a multiple pension fund transition simultaneously, there will be a high probability of reduced costs due to a change in beneficial owner (CBO) crosses between the pension funds in transition. “The larger the number of funds transitioning together, the higher the probability of crossing opportunities. Taking out the market impact, spread and commission on these equities can significantly impact the total costs of the transition.”

While there has been industry concern about the market impact of such an enormous simultaneous transition, Dwyer says the CBO cross savings should be significantly larger than the market impact, which should be only marginally elevated.

Of course, some assets are easier to cross than others. “Assuming no asset allocation changes, the main costs of passive consolidation are frictional and cash costs,” says Catherine Darlington, senior transition manager at LGIM. “One of the challenges here is the emerging market piece, as 60% of a typical emerging market benchmark is non-transferable when a pooled structure is involved on either side. The value allocated to these markets typically moves via cash redemptions and subscriptions. A transition manager must work to coordinate pricing points or use futures to minimise out-of-market risk.”

Trading turnover

“Consolidating the active assets will likely generate higher trading turnover and therefore attract higher costs, driven by the lower level of asset commonality between active portfolios. In addition, there is simply a greater proliferation of active managers per pool, particularly in equities. In some pools there are over 50, a number of whom manage assets for just one pool.”

Whether transitions will be phased or simultaneous will depend on each pool’s preferences. While a big bang approach would confer crossing opportunities, the FCA is said to be quietly warning pools against trying to do too much at one time.

“As the various transitions are not necessarily a series of discrete events, there are likely to be a number of potential unforeseen risks relating to markets and interdependencies between schemes/pools,” cautions Katrina McMillan, head of transition project management at LGIM. “The pools already have a cross-pool working group taking a holistic view on the entire exercise.”

Most pools have yet to decide how they will use transition managers, but Ms McMillan suggests they consider putting in place a flexible transition management framework before the implementation of the active consolidation phase, to facilitate timely implementation of investment decisions and help protect the confidentiality of flow.

“We are very much at the beginning of a long journey and there are many steps the schemes will have to go through until any asset restructuring will be taking place,” warns Andy Gilbert, Managing Director at BlackRock. “At the moment the schemes are still looking at the structure of each pool. They then need to agree an investment line-up they all like, how to generate savings in future, and work with the new regulations and even perhaps with the Regulator, and that’s before they even begin to move assets around.

“Essentially, all we can do at this point is offer our services to help them make informed decisions by taking into account key considerations such as transaction costs or operational challenges associated with different scenarios, the schemes appreciate receiving input on these questions as well as ideas for best practice around transition management governance. Of course, we hope that this will help the adoption of the transition management service if and when they arrive at the asset restructuring stage.”


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