The Hidden Cost of Poor Advice: A Review of Investment Decision-Making and Governance in Local Government Pension Schemes ( LGPS ) Part 1

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1 The Hidden Cost of Poor Advice: A Review of Investment Decision-Making and Governance in Local Government Pension Schemes ( LGPS ) Part 1 Universe and Data 99 Local Government Pension Schemes in England, Scotland and Wales 208 billion in LGPS assets as at 31 st March 2013 Data sources: public data (annual reports, council committee minutes, etc.) going back 10 years Performance data: 10 years (58 funds / 70% of Assets) and 5 years (71 funds / 81% of Assets) Introduction The focus of the Local Government Pension Scheme debate has so far predominantly related to large versus small funds, the cost of internal versus external or active versus passive management. However CLERUS believe that the reality is that performance differences are largely attributable to the quality of governance and investment decision-making that takes place in the institutional investment industry. In this report, we examine the performance impact of the failure to implement key elements of the Myners Principles. These principles were originally developed in 2001 following a report commissioned by HM Treasury with a view to improve governance across the pension fund sector; the principles were later revised in However as we shall see, very few LGPS, are truly compliant with the spirit and objectives of Myners Principles, which has led to a significant cost to the tax payer. Net Performance Impact of Investment Decision-Making in LGPS Table 1 summarises the monetary impact from investment decision-making in LGPS over the past 10 years. Investment decisions are categorised into (i) those that relate to changes in a scheme s benchmark (such as a shift from equities into absolute return funds) and (ii) those that relate to the implementation, i.e. typically manager selection exercises. Changes in asset allocation typically take place during the triennial valuation process, following recommendations made by the investment advisors or actuaries. The performance impact of these activities is not being reported by any of the 99 schemes we reviewed. The performance relative to benchmark is typically provided by WM Company but is reported gross of fees. Table 1: Net performance contribution from LGPS cumulative investment decisions over 10 years Investment Decisions Strategic Asset Following Initial Setup: Allocation Changes 1 Tactical Total Cost to Implementation2 Performance 1+2 Decision Category Benchmark Changes Benchmark Relative All Investment Decisions Performance Target Not Stated Benchmark + 1.3% Benchmark + 1.3% Period 5 Years 10 Years 5 Years 10 Years 5 years 10 years Net Impact vs. Benchmark and Target() in % p.a.* -0.8% (-0.8%) -0.3% (-0.3%) -1.1% (-2.4%) -0.7% (-2.0%) -1.9% (-3.2%) -1.0% (-2.3%) Annual Shortfall versus Benchmark and Target()** 1.7bn ( 1.7bn) 0.6bn ( 0.6bn) 2.3bn ( 4.9bn) 1.5bn ( 4.1bn) 3.9bn ( 6.6bn) 2.1bn ( 4.7bn) Net Present Value Lost vs Benchmark and Target()*** 7.3bn ( 7.3bn) 5.3bn ( 5.3bn) 10.0bn ( 21.9bn) 12.3bn ( 35.1bn) 17.4bn ( 29.2bn) 17.5bn ( 40.3bn) 1 The difference between average actual WM Local Authority performance and the hypothetical performance of a portfolio which had left the asset allocation weights unchanged from the average local authority asset allocation since 31 st March Tactical implementation consists of the choice of management style (active/passive) and the selection of managers to implement the chosen investment style against the chosen benchmark.

2 * Figures show CLERUS estimate of the contribution to Schemes total performance per annum, after reported and/or estimated fees ** Based on 208 billion in LGPS assets as at 31 st March 2013 ***NPV has been calculated by applying the average annual net impact to reported historic WM Local Authority assets, adjusted by the Retail Price Index. Performance targets or objectives for the changes to strategic asset allocation are typically not stated, other than that it is based on advice from the investment advisor. It is hard to imagine that changes would have been made and costs incurred without an expected benefit such risk and/or return. However we have compared the riskiness of the average asset allocation at 31 st March 2003 with that of the average asset allocation at 31 st March 2013 and conclude that the historic volatility is almost identical, suggesting that, if risk-reduction was the objective, then it has not been achieved. Performance targets from manager selection activities are typically described in the Statement of Investment Principles by the Scheme itself. Net Impact: The total monetary impact of the investment decision-making process across all of the Local Government Pension Schemes over the past 10 (5) years can be estimated to have produced a net negative impact to investment performance of roughly -1.0% (-1.9%) per annum. This corresponds to a shortfall against the Schemes benchmark returns which has resulted in a cost to the tax payer of 2.1 billion ( 3.9 billion) per annum or 17.5 billion ( 17.4 billion) in net present value over 10 (5) years. Attribution: Approximately 70% (60%) of the shortfall over 10 (5) years can be attributed to the tactical implementation of benchmark decisions, with the remainder from changes to asset allocation. Over the past 10 years, the main change to asset allocation has been to shift from equities and bonds into alternative investments (from 1% to 9.5%) which have underperformed the equity/bond mix that it replaced, and mostly so over the past 5 years. Shortfall versus target: If we measure the actual performance impact versus the average out-performance target of 1.3% above benchmark from manager selection activities plus an unspecified benefit from asset allocation decisions, we are looking at decision-making deficits that are substantially higher. Closing the performance gap by 0.5% per annum would add 10% to Schemes asset values over 20 years. Governance Performance measurement and assessment is the cornerstone of any decision-making process. Without this, effective decision-making cannot exist because learning or improvement cannot take place. In the absence of continuous learning and improvement comes the risk of a vicious cycle where the solution to past underperformance is to do more of the same, in particular where the likely future cost cannot be accounted for upfront. A collective governance process that consistently targets a 1.3% additional return above benchmark, but delivers a negative 1.0% return per annum over 10 years and which does not trigger a change in decision-making behaviour, is clearly not an example of a set-up that applies and demonstrates the highest standards of investment governance. The difficulty of performance measurement is that it is almost impossible to self-assess objectively, even for those with the highest level of integrity. This is because most people will have a positive bias on their own achievements which can sometimes get in the way of full objectivity and transparency. It is why students are not allowed to mark their own homework, or why employees do not undertake their own performance review. Across the LGPS universe, while a minority of strong Schemes provide high levels of information and transparency for this kind of data analysis, there are persistent examples where, following periods of significant underperformance, Schemes have stopped reporting on basic performance metrics, while 2 P a g e

3 continuing to follow the advice of their investment consultants as if nothing had happened 3. Often these Schemes will also apply public secrecy clauses to council meetings where pension fund performance is being reviewed and discussed (and still claiming full compliance with the Myners principle on transparency!). Performance measurement of investment advisors recommendations and trustees own effectiveness is a requirement of Myners Principle 4 (and previously Principle 8). A significant part of the original 4 and subsequent 5 Myners Reports is spent discussing why this is so extremely important for investment decision-making. A subsequent review of progress by NAPF in highlighted the low implementation of this principle at that time. It is therefore of interest to see how many Local Government Pensions Schemes apply this principle twelve years later. Figure 1: LGPS stated and applied compliance with Myners Principle 4 on performance measurement As we can see from Figure 1, 94% of Local Government Pension Funds do not substantially comply with the key requirements of Myners Principle 4: To arrange for the formal measurement of performance of the investment advisors, and to periodically make a formal assessment of their own effectiveness as a decision-making body and report on this to scheme members. A significant number (50%) of funds state full compliance with this key governance principle but in fact do not comply. It is therefore important that we qualify this assessment. For example some will say trustee effectiveness can only be established once the fund has been wound down or trustee effectiveness is being measured because we log and report on meeting attendance ; all these are deemed to be noncompliant with making a formal performance assessment of their own effectiveness as a decision-making body. Similarly, funds who say that they carry out a formal assessment of their investment advisor because they market test investment consultants on price or we believe that they give appropriate advice but do not 3 In one of many examples identified during our review, one LGPS, of which the cumulative benchmark relative performance was behind by 5.4% over 3 years to 31 st March 2009, subsequently stopped reporting benchmark performance, stating that this kind of benchmarking had become less important to the fund 4 HM Treasury: Institutional Investment in the United Kingdom: A Review March HM Treasury: Myners principles for institutional investment decision-making: review of progress December Institutional Investment in the UK Six Years On January P a g e

4 objectively measure (or require evidence of) the performance of past recommendations are deemed to be non-compliant. LGPS which do not measure performance of investment consultants typically do not measure their own performance either. Where a Scheme has been assessed as substantially compliant, it is because specific examples have been given on compliance in either one or both areas. Substantial compliance will often, but not always, be in place with those Schemes that manage some money internally and therefore have to approach performance measurement more like a professional investor would have to do. However, in no cases does this assessment appear to have been carried out independently or the results been reported in public, hence the use of the word substantial. Figure 2: LGPS Average Performance net of fees as a function of Principle 4 compliance: Attributing benchmark relative performance targets to this important governance principle is interesting. First, we see that those who do not provide a statement exhibit the worst benchmark relative performance, closely followed by those who say they comply but in reality do not. Those who acknowledge that they are not complying fare slightly better, but they also seem to suffer from having the highest outperformance targets from the active management selection process. From a governance point of view the most interesting observation is it that those who substantially comply also have the least under-performance and the lowest average targets, although a gap of 0.9% between target and realised performance is still huge. As suggested above, it may be that, because these funds possess some applied portfolio management experience, or board level expertise, and so are better able to challenge advice and also have become slightly more realistic in terms of the performance targets they apply. It therefore appears that some significant performance improvements can be gained from the proper implementation of Myners Principle 4 with respect to measuring the performance of investment advisors recommendations and the subsequent impact this has on trustees own effectiveness as a decision-making body. To the extent that some of the same governance and decision-making issues play out in the semigovernmental or corporate pension fund space improving investment governance via performance measurement of investment decisions and advice has the potential to yield significant results. 4 P a g e

5 Impact of Investment Advisors on Performance With a low headline cost of a few basis points of assets, investment consultants have stayed below the radar and have avoided much scrutiny, despite the significant amount of assets that they advise on. However with investment consultants being unwilling to provide independently verified performance data to their clients, it continues to be difficult for trustees to assess if they should continue to be acting on their recommendations to the extent that they currently do. Prioritising performance assessment based on headline cost is probably misleading because the investment decision-making that follows investment advisors recommendations is the single biggest factor determining investment outcomes (both in absolute terms and in benchmark relative terms) for a pension fund. In addition, these decisions have an indirect influence on the investment management fees and transactions costs paid across the portfolio to external parties. Figure 3: The hidden cost of poor investment advice In Figure 3 we compare the net performance of those LGPS that use investment consultants with those that do not. As we can see, the data shows that Local Government Pensions Schemes that use Investment consultants have on average performed 0.44% worse than funds that do not use them over the past 10 years. These additional hidden costs are equivalent to the total investment management fees that are being paid every year. In sterling terms, it looks like the cost to the tax payer for the 168bn of assets on which they advise is 740 million per annum or 6.2 billion net present value over the past 10 years. It is therefore no surprise that consultants have declined to come forward with an independently verified performance track-record of their own recommendations, but it is a surprise that local government investment panels and staff have not pursued this critical governance principle with more rigour thus far. To the extent that investment consultants have similar influence on investment decision-making across other defined benefit pension funds (which a recent Spence Johnson report 7 suggests they do), carrying out a review of the performance contribution of past investment decisions could be a very useful governance exercise for trustees. 7 Spence Johnson: The Russell Pensions Governance Index 2013 October 2013 p22 5 P a g e

6 Conclusion CLERUS review has highlighted the need to implement fully the good governance recommendations made by the Myners Report, in particular with regards to the formal performance measurement of investment decision-making by trustees and of the recommendations made by their investment consultants on which they typically act. The reluctant take-up by LGPS to these key governance principles suggests that the current policy of letting local pension schemes and investment consultants marking their own homework has not been effective in promoting the highest standards of good governance. Given that we are dealing with significant amounts of public money, if local pension fund boards or committees will not submit their decisions-making process and their investment advisors to independent performance assessment, the government should instigate this process on their behalf, or if necessary make it a regulatory requirement. After all, the performance measurement and attribution techniques required in order to provide the transparency, which can unlock significant performance improvements, are well established within the financial services industry. The recent proposal to force LGPS into passive management for a significant part of their assets will certainly address part of the governance gap identified in this report, but not all. This is because, in CLERUS opinion, it deals with the symptoms rather than the root of the problem namely poor governance driven by the lack of appropriate performance assessment required to create a virtuous cycle of learning and improvement. The risk of dealing only with the symptoms is that LGPS advisors will simply focus their manager selection activities in the alternatives space where the value proposition is much less transparent, and proper performance assessment significantly harder than in established markets. As illustrated by Figure 2 in this report, it is the quality of governance and decision-making that drives performance differences and the Schemes with good governance have on average performed better than Schemes with poor governance. This is a conclusion not dissimilar to the one reached by Hermes Fund Managers with regards to corporate governance and equity market outperformance over the past 5 years. 8 Improving outcomes for tax payers may not be that complicated after all. 8 Good governance is good for the wallet feabdc0.html?siteedition=uk#axzz31W0785VW 6 P a g e

7 Important Information: Clerus LLP is registered in England and Wales, partnership number OC390368, at 4 th Floor, Rex House, 4-12 Regent Street, London SW1Y 4PE, United Kingdom. Clerus LLP is an Appointed Representative of Stoneware Capital LLP, which is authorised and regulated by the Financial Conduct Authority, and appears on the FCA register under number th Floor, Rex House, 4-12 Regent Street, London SW1Y 4PE, United Kingdom E: henrik.pedersen@clerus.co.uk T: M: E: richard.rothwell@clerus.co.uk T: M: W: 7 P a g e