Reform UK has a simple plan to fix local pension performance. But are things really that bad?

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Reform UK made waves earlier this week with some punchy claims about the dismal investment record of the UK Local Government Pension Scheme — the country’s largest funded pension scheme which manages £392bn of assets across 86 administering authorities.

And they have a solution, as Mary McDougall wrote in MainFT:

Reform UK has called for the sprawling Local Government Pension Scheme to reduce the “egregious” fees it pays fund managers by moving assets into low-cost global equity index and bond trackers.

Really-long-time strategy

Strategic asset allocation is pretty much the most important investment decision any institutional investor can make. It explains around 100 per cent of fund returns.

To choose an SAA and set a fund benchmark, pension funds (and their consultants) go through a long-term capital market assumption process that involves them guessing what market returns might be for the next ten or twenty years and what sort of market volatility they will be able to endure. For example, they might use BlackRock’s expectations that US stocks and UK gilts to provide respective annualised returns of 4.3 per cent and 4.7 per cent per annum in sterling terms (with volatility of returns of 17.5 per cent and 5.4 per cent) over the next ten years, to inform their benchmark design.

They also have to look at an actuarial assessment of their projected cash flows (modelling when their current and former employees will retire and then die, along with how inflation may develop). So, for example, a fund paying out vast quantities of cash to pensioners each year might have a different tolerance to risk versus a fund that isn’t expecting to have distributions exceed contributions for years to come.

Despite all being local government pension funds, the answers that LGPS funds arrive at as to what the ‘right’ benchmark might be varies enormously. We’ve illustrated this below with a marimekko chart that splits the year-end allocations of all LGPS funds between equities, bonds, etc. The dotted lines represent averages:

At one end of the asset allocation spectrum sits Kensington & Chelsea’s fund with 75 per cent global equities, 13 per cent property, 7 per cent private equity and 4 per cent bonds. At the other is Clwyd’s, which had a measly 14 per cent net allocation to equities and 37 per cent in bonds among other allocations.

And this is what we understand Reform UK think it should look like:

Over the last ten years public equity markets have been on a tear, buoyed by US stocks. This proposed new benchmark might produce stronger returns over the next ten years. Or it might produce weaker returns. We’re not sure. These are things about which reasonable people can disagree.

It seems incongruous though to measure pension funds’ historic investment returns against those of a public equity-heavy strategic asset allocation that may or may not be appropriate for the future. But this is what Reform have done. MainFT, again:

The party said the 13 council pension funds — which include Lancashire, Kent and Staffordshire and altogether manage £66bn of assets — had underperformed [the index they reckon might work for the next ten years] by an average of 1.9 per cent a year since 2019.

If we’re going to play this game of making LGPS fund performance look rubbish surely we can bung in a bit of crypto, or at least some gold (Reform leader Nigel Farage would surely have approved)?

Performance: it’s all relative

While strategic asset allocation will determine the overall shape of returns and fund volatility, institutional investors can try their luck boosting returns further by hiring active fund managers and charging them with beating the benchmark you set them.

As Robin is at pains to tell us all again and again and again, active fund managers (at least in mutual fund form) tend to do a bad job in aggregate matching — let alone outperforming — their fees.

How do actual investment returns from LGPS administering authority funds measure up to the actual benchmarks chosen by LGPS administering authorities at the end of their strategic asset allocation processes?

We sifted through the annual reports of the 51 funds that have so far released them (in either draft or final form) on the LGPS Board website. All funds report the performance of total portfolio and their policy benchmark over the past year, but anything can happen in twelve months and we wanted longer-term data. We found total fund benchmark returns for longer periods in the annual reports of 35 funds. These capture around half of the total assets managed in the LGPS system. We may have missed some, but grabbed the longest period for each and show these all in the chart below:

The results are mixed, but — to be honest — they’re better than we’d anticipated.

Clearly, the £5.8bn Avon fund has had a shocker in their manager selection and/or strategic tilts, reporting as it does an annualised underperformance of 2.4 per cent over the last ten years. But the £10.9bn Essex fund has blown the doors off, beating their SAA by 1.6 per cent per annum over the same period.

Fund management isn’t free. It’s actually pretty expensive. And when paying hefty fees leaves you with investment returns that are lower that a market index you might’ve accessed more cheaply through passive management, it’s natural to feel embittered. But it looks like LGPS funds that report longer-term relative-to-benchmark returns have, on an asset-weighted basis, outperformed their strategic asset allocations.

Whether these strategic asset allocations are more or less appropriate than the 75 per cent FTSE Global Equity Index, 25 per cent Vanguard Global Bond Index Fund* benchmark is something we’ll leave you to discuss in the comments.

*As an aside, Reform UK recommend a 25 per cent fund weighting to the Vanguard Global Bond Index Fund. The Vanguard website tells us that this fund has underperformed its index — the Bloomberg Barclays Global Aggregate Float Adjusted and Scaled Index in GBP — by 0.6 per cent per annum over the past five years and 1.5 per cent per annum over the past ten years. This looks surprisingly bad.