The long and widening LGPS road
14 November 2017
Between the LGPS pooling project, Brexit and changes in technology, fund managers in the UK, and their service providers, have a lot to think about
Image: Shutterstock
UK public sector funds are facing challenges from all angles—from the possibility of limited resources to the constant question of balancing risk and reward against asset safety. Throw that in with the 3 January 2018 deadline for compliance with the second Markets in Financial Instruments Directive (MiFiD II), and working with Local Government Pension Scheme (LGPS) funds is proving to be a challenge for all involved in the industry.
Since May 2017, asset managers working with LGPS funds have been able to sign up to a transparency code between investment managers and administering authorities. As a way of boosting managers’ attractiveness for mandates, the code was designed to create greater clarity on investment fees, and applies to all listed asset classes.
Just a few months prior, a State Street-sponsored report into the pension scheme’s asset allocation revealed a 61 percent spike in alternatives exposure by the 89 public funds participating in the LGPS, representing £16.6 billion in assets.
A further £34.7 billion in assets were given over to fixed income, leading to a 31 percent increase in that business line.
At that time, Andy Todd, head of UK pensions and banks for asset owner solutions at State Street, said: “Mounting cost pressures and persisting lower-for-longer yields have led pension fund investment committees to seek ‘higher yielding’ assets to assist them in meeting their strategic investment targets. Alternatives have historically been seen to provide this solution.”
However, the asset allocation of the 89 member funds could still see considerable changes to their current portfolio construction over the coming years, with unprecedented changes in technology in the pipeline, in the UK alone.
When the State Street report was released, JR Lowry, head of State Street global exchange for Europe, the Middle East and Africa, noted: “LGPS [funds] are in a period of extreme change and technology will be the next stage of their evolution. As they reshape to adapt to their new size and structure, they have a significant opportunity to overhaul outdated legacy systems and benefit from new economies of scale.”
“If embraced and properly harnessed, technology has the potential to help them confront these challenges.”
Sid Newby, head of business development for the UK at BNP Paribas, which has secured five custody mandates under the LGPS framework, to date, says the custody provider is indeed embracing new technology.
He says: “In the last 18 months, the technology we can deploy and leverage is more powerful and provides more opportunities for providers and clients.”
But, that’s not to say everything is plain sailing in all areas of the industry.
Todd suggests that one of the most important challenges facing pension funds is the limitation of resources.
He says: “There are few trustee boards, management and investment committees or HR and pensions departments that would claim to have surplus resources beyond that required to meet the day-to-day challenges of running a pension fund. It is commendable how staff within the LGPS member funds have adopted the initiative, taken ownership and driven the project forward despite the resource challenge.”
Asset managers also have to contend with the issue of balancing risk and reward strategies against asset safety, added to this is mounting cost pressures and persisting lower-for-longer yields. It is lower-for-longer yields in particular that have led pension fund investment committees to seek ‘higher yielding’ (often illiquid) assets.
This limitation of resources and juggling risk and reward against asset safety have been challenges that pension funds may have to deal with year-on-year. But, with the implementation of MiFiD II, among other regulations, the industry is playing a whole different ball game, particularly between now and April 2018.
You say you want some regulations
Todd suggests that a key thing to consider is MiFID II’s re-classification of LGPS funds as retail investors, explaining that such funds are now working together with their advisors and asset managers to transition back up to professional investor status.
“Any that do not opt up are likely to part company with many of their assets managers—specifically, those managers that do not have the regulatory permissions and investment operational infrastructure to support retail clients,” he says.
“The indirect consequences, which may be more far-reaching for the industry, are the provisions around transparency. We’re seeing a demand for greater transparency, for example, in dealing especially, and in costs more generally.”
Pension funds have also had to achieve a balance between some form of liability-driven investments—matching their investments with their liabilities—which they can do through a specific liability-driven investment manager or through direct fixed income investments.
Back to the EMIR
Newby also highlights the European Markets Infrastructure Regulation (EMIR) as one of the most difficult regulations to navigate, particularly because of the collateral requirements it will bring in. However, new requirements could also bring new opportunities.
He says: “While looking to derivatives for diversification or hedging, EMIR is requiring greater collateralisation. That’s a pain if funds don’t have the cash required for margin.”
“One of the consequences, alongside the reporting that clients require, is the ability to optimise their collateral and optimise their cash positions. It’s becoming a very keen topic for them to understand how they can do it efficiently, particularly with EMIR regulation.”
Let it be Brexit
Closer to home, LGPS funds are also facing extra uncertainty on the road to the UK’s exit from the EU, with negotiations due to come to a close in March 2019.
An audience poll at this year’s Sibos conference in Toronto saw 46 percent of audience members suggesting that Frankfurt will take over from London as the world’s financial centre, post-Brexit. It cannot be denied that the upheaval and uncertainty around the Brexit process brings some uncertainty to LGPS funds. But, ultimately there are still questions around how much of an impact it will really have.
In recent years, UK pension funds have diverted away from the London stock market in favour of foreign stock and bond markets, even before last year’s referendum result. As Prime Minister Theresa May grapples with EU negotiations, organisations with pension funds are understandably concerned about the type of volatility on financial markets and the overall impact on asset managers.
Todd says: “The only element you can be sure of is that it’s coming.”
Although he warns that there is volatility in financial markets that has adversely affected asset prices, he reassures that LGPS funds will likely remain strong come March 2019.
He says: “Pension funds, including the LGPS, should not feel panicked or pressured into making sudden changes to their business models and asset allocations.”
We can work it out
Amid the smoke and mirrors surrounding Brexit and the other market pressures, asset managers and pension funds alike are looking intently to the future, whether this means the reevaluating of funds, looking to outsourcing opportunities or considering the effect financial technology will have on the industry in the coming years.
Ultimately, funds are looking for the most efficient and cost-effective methods to generate returns.
Newby says: “In general, we are seeing the large pension funds re-evaluating how they’re set up and looking more proactively to outsource certain functions, whether that is support with their private equity investments, in terms of managing the middle-office cash management of those assets, or whether it is reporting.”
He adds: “Our clients’ main question, and their business demand, is always: How can I operate most efficiently?”
On this point, Newby says, data is going to “change the game”. Particularly he points to ‘data-as-a-service’ as something likely to become a big topic in asset management over the next few years.
He says: “We’re talking to some sophisticated schemes about how, as a provider, we can help them manage their data and make use of the new tools available, in a way that they’ve never been able to do before.”
LGPS securities lending update
For agent lenders, the LGPS presents an administration exercise along with an opportunity to re-open the book on historic securities lending agreements with beneficial owners and amend certain conditions.
According to Michael Huertas, counsel at Baker McKenzie, the creation of a new legal entity as part of the consolidation process, along with reclassification of terms and conditions of various agreements and order and/or best execution policies all require re-papering. Although this may initially appear to be an unnecessary resource drain during a critical implementation period for other incoming regulatory frameworks, it also presents an opportunity to update terms.
In a research note on the possibilities the scheme presents for securities lending published last year, Hywel Robinson, a partner at Clifford Chance, explains: “The government’s current drive on LGPS asset pooling may, however, prove helpful here [for securities lending].”
“Certain types of pooled vehicle are treated as standalone entities for capacity purposes, meaning that, as long as the operator of the pooled vehicle is permitted to enter into the particular contract/investment, there is no need to look behind this and confirm the capacity of the vehicle’s participants to enter into those underlying contracts.”
“Investment via a pooled vehicle could therefore prove useful where there are concerns over LGPS funds’ capacity to invest in particular arrangements directly as capacity to invest in the pooled vehicle itself may well be sufficient.”
Opt up or opt out
One cause for concern for LGPS members and asset managers alike is that, as of 3 January 2018, certain public authority pension funds will likely have to be re-classified as ‘retail clients’ under MiFID II. The thought process behind this is that public authority pension funds should be afforded additional protections as investors to ensure their risk management process are secure.
However, in doing so, LGPS funds could be cut off from utilising certain strategies, such as derivatives, which are gaining popularity among investors as a way of diversifying their portfolio.
Huertas explains that public consensus on the issue indicates that most in-scope funds will choose to forgo the additional retail-level protections and opt-up in order access a wider arsenal of investment strategies, asset classes and transaction types in a search for yield.
The LGPS advisory board states: “Such a reclassification [retail] would severely limit both the financial instruments and providers available to authorities for pensions purposes, which could be both costly and reduce the potential for returns. Authorities should consider electing for a return to professional status in order to ensure they can access the full range of vehicles and managers to meet the needs of their investment strategy.”
“The board, along with other stakeholders, has successfully lobbied for the opt-up tests proposed in the 2016 FCA consultation to better reflect the constitutions and decision-making processes of authorities and has worked with industry bodies to develop the standard opt-up process below.”
“LGPS-administering authorities are strongly advised to make use of this standard process and documentation in order to provide for a smoother opt up.”
Opting up within MiFID II involves a multi-stage process of providing proof of effective understanding of certain investment strategies and maintaining specific levels of liquidity and assets under management. Affected funds were recently warned by the LGPS Advisory Board that failure to begin the application process well ahead of MiFID II’s January deadline may result in the application not being completed in time, or being rejected outright.
Speaking on the recent trend of LGPS funds discovering a taste for alternatives, Todd says: “Traditional asset classes such as equities and fixed income will remain core holdings. However, mounting cost pressures and persisting lower-for-longer yields have led pension fund investment committees to seek ‘higher yielding’ (often illiquid) alternative assets to assist them in meeting their strategic investment targets.”
“Pension funds are becoming increasingly adept in the use of alternatives within their strategic asset mix and this is a trend that, as a consequence of the LGPS Pooling initiative, is set to continue.”
“However, it’s important to highlight that alongside this trend, one key consequence of MiFID II is the effective re-classification of LGPS member funds as retail investors, significantly limiting their ability to gain exposure to illiquid assets, such as alternatives.”
“Such funds are now working together with their advisors and asset managers to opt back up to professional investor status.”
Who’s who in LGPS
Major players in the securities lending marketplace are taking full advantage of the opportunities presented by the pooling scheme to secure a plethora of securities servicing mandates.
Northern Trust has secured 13 mandates to provide asset services, including securities lending, to pension funds under the LGPS across the UK. Most recently, the bank was appointed to manage £6.7 billion in pension fund assets belonging to the Northern Ireland Local Government Officers’ Superannuation Committee in April.
As well as securities lending, Northern Trust will provide global custody, accounting, performance management and foreign exchange services for the pension fund assets.
In March, Northern Trust was appointed to provide global custody services for £550 million in assets for the Scottish Borders Council. Meanwhile, UBS Asset Management secured one of the UK’s biggest passive management mandates, worth £11 billion, from 11 UK local pension funds. The deal was signed with Access, a collaboration of funds from the Central, Eastern and Southern Shires, which boasts £33 billion in assets overall.
BNP Paribas holds five mandates, including providing global custody for £3 billion in pension fund assets for the West Sussex Pension Fund.
Key facts
Since May 2017, asset managers working with LGPS funds have been able to sign up to a transparency code between investment managers and administering authorities. As a way of boosting managers’ attractiveness for mandates, the code was designed to create greater clarity on investment fees, and applies to all listed asset classes.
Just a few months prior, a State Street-sponsored report into the pension scheme’s asset allocation revealed a 61 percent spike in alternatives exposure by the 89 public funds participating in the LGPS, representing £16.6 billion in assets.
A further £34.7 billion in assets were given over to fixed income, leading to a 31 percent increase in that business line.
At that time, Andy Todd, head of UK pensions and banks for asset owner solutions at State Street, said: “Mounting cost pressures and persisting lower-for-longer yields have led pension fund investment committees to seek ‘higher yielding’ assets to assist them in meeting their strategic investment targets. Alternatives have historically been seen to provide this solution.”
However, the asset allocation of the 89 member funds could still see considerable changes to their current portfolio construction over the coming years, with unprecedented changes in technology in the pipeline, in the UK alone.
When the State Street report was released, JR Lowry, head of State Street global exchange for Europe, the Middle East and Africa, noted: “LGPS [funds] are in a period of extreme change and technology will be the next stage of their evolution. As they reshape to adapt to their new size and structure, they have a significant opportunity to overhaul outdated legacy systems and benefit from new economies of scale.”
“If embraced and properly harnessed, technology has the potential to help them confront these challenges.”
Sid Newby, head of business development for the UK at BNP Paribas, which has secured five custody mandates under the LGPS framework, to date, says the custody provider is indeed embracing new technology.
He says: “In the last 18 months, the technology we can deploy and leverage is more powerful and provides more opportunities for providers and clients.”
But, that’s not to say everything is plain sailing in all areas of the industry.
Todd suggests that one of the most important challenges facing pension funds is the limitation of resources.
He says: “There are few trustee boards, management and investment committees or HR and pensions departments that would claim to have surplus resources beyond that required to meet the day-to-day challenges of running a pension fund. It is commendable how staff within the LGPS member funds have adopted the initiative, taken ownership and driven the project forward despite the resource challenge.”
Asset managers also have to contend with the issue of balancing risk and reward strategies against asset safety, added to this is mounting cost pressures and persisting lower-for-longer yields. It is lower-for-longer yields in particular that have led pension fund investment committees to seek ‘higher yielding’ (often illiquid) assets.
This limitation of resources and juggling risk and reward against asset safety have been challenges that pension funds may have to deal with year-on-year. But, with the implementation of MiFiD II, among other regulations, the industry is playing a whole different ball game, particularly between now and April 2018.
You say you want some regulations
Todd suggests that a key thing to consider is MiFID II’s re-classification of LGPS funds as retail investors, explaining that such funds are now working together with their advisors and asset managers to transition back up to professional investor status.
“Any that do not opt up are likely to part company with many of their assets managers—specifically, those managers that do not have the regulatory permissions and investment operational infrastructure to support retail clients,” he says.
“The indirect consequences, which may be more far-reaching for the industry, are the provisions around transparency. We’re seeing a demand for greater transparency, for example, in dealing especially, and in costs more generally.”
Pension funds have also had to achieve a balance between some form of liability-driven investments—matching their investments with their liabilities—which they can do through a specific liability-driven investment manager or through direct fixed income investments.
Back to the EMIR
Newby also highlights the European Markets Infrastructure Regulation (EMIR) as one of the most difficult regulations to navigate, particularly because of the collateral requirements it will bring in. However, new requirements could also bring new opportunities.
He says: “While looking to derivatives for diversification or hedging, EMIR is requiring greater collateralisation. That’s a pain if funds don’t have the cash required for margin.”
“One of the consequences, alongside the reporting that clients require, is the ability to optimise their collateral and optimise their cash positions. It’s becoming a very keen topic for them to understand how they can do it efficiently, particularly with EMIR regulation.”
Let it be Brexit
Closer to home, LGPS funds are also facing extra uncertainty on the road to the UK’s exit from the EU, with negotiations due to come to a close in March 2019.
An audience poll at this year’s Sibos conference in Toronto saw 46 percent of audience members suggesting that Frankfurt will take over from London as the world’s financial centre, post-Brexit. It cannot be denied that the upheaval and uncertainty around the Brexit process brings some uncertainty to LGPS funds. But, ultimately there are still questions around how much of an impact it will really have.
In recent years, UK pension funds have diverted away from the London stock market in favour of foreign stock and bond markets, even before last year’s referendum result. As Prime Minister Theresa May grapples with EU negotiations, organisations with pension funds are understandably concerned about the type of volatility on financial markets and the overall impact on asset managers.
Todd says: “The only element you can be sure of is that it’s coming.”
Although he warns that there is volatility in financial markets that has adversely affected asset prices, he reassures that LGPS funds will likely remain strong come March 2019.
He says: “Pension funds, including the LGPS, should not feel panicked or pressured into making sudden changes to their business models and asset allocations.”
We can work it out
Amid the smoke and mirrors surrounding Brexit and the other market pressures, asset managers and pension funds alike are looking intently to the future, whether this means the reevaluating of funds, looking to outsourcing opportunities or considering the effect financial technology will have on the industry in the coming years.
Ultimately, funds are looking for the most efficient and cost-effective methods to generate returns.
Newby says: “In general, we are seeing the large pension funds re-evaluating how they’re set up and looking more proactively to outsource certain functions, whether that is support with their private equity investments, in terms of managing the middle-office cash management of those assets, or whether it is reporting.”
He adds: “Our clients’ main question, and their business demand, is always: How can I operate most efficiently?”
On this point, Newby says, data is going to “change the game”. Particularly he points to ‘data-as-a-service’ as something likely to become a big topic in asset management over the next few years.
He says: “We’re talking to some sophisticated schemes about how, as a provider, we can help them manage their data and make use of the new tools available, in a way that they’ve never been able to do before.”
LGPS securities lending update
For agent lenders, the LGPS presents an administration exercise along with an opportunity to re-open the book on historic securities lending agreements with beneficial owners and amend certain conditions.
According to Michael Huertas, counsel at Baker McKenzie, the creation of a new legal entity as part of the consolidation process, along with reclassification of terms and conditions of various agreements and order and/or best execution policies all require re-papering. Although this may initially appear to be an unnecessary resource drain during a critical implementation period for other incoming regulatory frameworks, it also presents an opportunity to update terms.
In a research note on the possibilities the scheme presents for securities lending published last year, Hywel Robinson, a partner at Clifford Chance, explains: “The government’s current drive on LGPS asset pooling may, however, prove helpful here [for securities lending].”
“Certain types of pooled vehicle are treated as standalone entities for capacity purposes, meaning that, as long as the operator of the pooled vehicle is permitted to enter into the particular contract/investment, there is no need to look behind this and confirm the capacity of the vehicle’s participants to enter into those underlying contracts.”
“Investment via a pooled vehicle could therefore prove useful where there are concerns over LGPS funds’ capacity to invest in particular arrangements directly as capacity to invest in the pooled vehicle itself may well be sufficient.”
Opt up or opt out
One cause for concern for LGPS members and asset managers alike is that, as of 3 January 2018, certain public authority pension funds will likely have to be re-classified as ‘retail clients’ under MiFID II. The thought process behind this is that public authority pension funds should be afforded additional protections as investors to ensure their risk management process are secure.
However, in doing so, LGPS funds could be cut off from utilising certain strategies, such as derivatives, which are gaining popularity among investors as a way of diversifying their portfolio.
Huertas explains that public consensus on the issue indicates that most in-scope funds will choose to forgo the additional retail-level protections and opt-up in order access a wider arsenal of investment strategies, asset classes and transaction types in a search for yield.
The LGPS advisory board states: “Such a reclassification [retail] would severely limit both the financial instruments and providers available to authorities for pensions purposes, which could be both costly and reduce the potential for returns. Authorities should consider electing for a return to professional status in order to ensure they can access the full range of vehicles and managers to meet the needs of their investment strategy.”
“The board, along with other stakeholders, has successfully lobbied for the opt-up tests proposed in the 2016 FCA consultation to better reflect the constitutions and decision-making processes of authorities and has worked with industry bodies to develop the standard opt-up process below.”
“LGPS-administering authorities are strongly advised to make use of this standard process and documentation in order to provide for a smoother opt up.”
Opting up within MiFID II involves a multi-stage process of providing proof of effective understanding of certain investment strategies and maintaining specific levels of liquidity and assets under management. Affected funds were recently warned by the LGPS Advisory Board that failure to begin the application process well ahead of MiFID II’s January deadline may result in the application not being completed in time, or being rejected outright.
Speaking on the recent trend of LGPS funds discovering a taste for alternatives, Todd says: “Traditional asset classes such as equities and fixed income will remain core holdings. However, mounting cost pressures and persisting lower-for-longer yields have led pension fund investment committees to seek ‘higher yielding’ (often illiquid) alternative assets to assist them in meeting their strategic investment targets.”
“Pension funds are becoming increasingly adept in the use of alternatives within their strategic asset mix and this is a trend that, as a consequence of the LGPS Pooling initiative, is set to continue.”
“However, it’s important to highlight that alongside this trend, one key consequence of MiFID II is the effective re-classification of LGPS member funds as retail investors, significantly limiting their ability to gain exposure to illiquid assets, such as alternatives.”
“Such funds are now working together with their advisors and asset managers to opt back up to professional investor status.”
Who’s who in LGPS
Major players in the securities lending marketplace are taking full advantage of the opportunities presented by the pooling scheme to secure a plethora of securities servicing mandates.
Northern Trust has secured 13 mandates to provide asset services, including securities lending, to pension funds under the LGPS across the UK. Most recently, the bank was appointed to manage £6.7 billion in pension fund assets belonging to the Northern Ireland Local Government Officers’ Superannuation Committee in April.
As well as securities lending, Northern Trust will provide global custody, accounting, performance management and foreign exchange services for the pension fund assets.
In March, Northern Trust was appointed to provide global custody services for £550 million in assets for the Scottish Borders Council. Meanwhile, UBS Asset Management secured one of the UK’s biggest passive management mandates, worth £11 billion, from 11 UK local pension funds. The deal was signed with Access, a collaboration of funds from the Central, Eastern and Southern Shires, which boasts £33 billion in assets overall.
BNP Paribas holds five mandates, including providing global custody for £3 billion in pension fund assets for the West Sussex Pension Fund.
Key facts
- The LGPS scheme includes 101 funds across the UK managing £217 billion worth of assets, as of 2016
- The pooling project is set to launch in April 2018
- From 3 January 2018, public pension funds will no longer be categorised as professional investors under MiFID II, unless prior approval has been granted
- Public pension funds must reclaim professional status if they wish to engage in more complex investment strategies
- The LGPS scheme was first introduced in 2015 by then-chancellor turned newspaper editor George Osborne
NO FEE, NO RISK
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
