How government can clarify its local and UK pension funds investment proposals

Defining local, and UK, investment

In its consultation on reforms to the local government pension scheme (LGPS) in England and Wales, the UK government outlined proposals for ‘local investments’ by the LGPS. For the purposes of this consultation, “local investment” was used by the government to include investments local to any of the administering authorities forming part of a LGPS pool, or investments in their region. However, it did not clarify how “local” or “regional” should be defined.

Views have been invited on this definition and it is likely that responses will focus on these investments making an impact which is targeted within a specific geographical area – i.e. improving physical spaces or economic prospects. Vital to understanding “local investment” would be a clear articulation of the UK government’s objectives. For example, whether there should be a link to other aims as well as financial aims, as well as where the regional boundaries will be drawn.

There have not yet been any specific recommendations on UK investment beyond consideration of local investment by the LGPS. However, a final report on the pensions investment review will be published at a later date and this will further consider investment within the UK by pension funds. The government requires to clarify more than geography when it is considering UK investment. For instance, it needs to indicate whether the focus be more on private markets or whether other UK assets will be encouraged, such as listed equity, bonds and gilts.

Continuing role of fiduciary duty

Any incentivisation of, or requirements placed upon, pension funds to invest in the UK needs to bear in mind the fiduciary responsibilities placed upon their trustees or committees to act in the best interests of their beneficiaries or members. Investment decisions therefore should be made based on risk and return considerations and with the objective of ensuring that future pension liabilities can be paid as they fall due.

However, any compulsion on the part of the government to make pension funds allocate to any specific geography or asset class would risk undermining the benefits of a portfolio construction based on risk and return considerations and could be contrary to the long-term interests of its beneficiaries or members. Pension funds exist primarily to pay pensions and should be incentivised to invest in UK-focussed investments in manner that allows them to meet this primary aim, which should also deliver an outcome that furthers a UK growth agenda, rather than being compelled to invest in a certain way by the UK government.

Fiduciary duty means that UK investments can only continue to be favoured by pension funds for reasons of risk-adjusted returns and not in order to meet any political agenda. Therefore, if there are attractive UK opportunities, a pension fund will invest in them. However, if there are more attractive opportunities overseas, fiduciary duty could drive investment outside of the UK. Any reforms proposed by the government which could be seen as either diluting fiduciary duty or mandating investment decisions at the expense of returns will likely be strongly resisted by pension funds.

Nevertheless, there is a case for the government to employ targeted incentives through growth programmes such as the National Wealth Fund and the British Growth Partnership whereby these programmes seek to adjust the risk-reward balance of UK investments and mobilise greater pension fund investment in such investable UK opportunities.

Measuring success

To maximise those investment opportunities available to them, it would be helpful if pension funds do not have to solely focus on reducing costs – i.e. paying lower fees – but could also take into consideration potential returns net of fees. Many UK investment opportunities are accessed through private markets, which typically have higher fees, including performance fees, but can also offer potentially higher returns as well.

Measuring success through improved returns net of fees can deliver value for money for pension funds since they will be able to access a wider variety of investment opportunities, including those with more complex and higher-cost strategies, such as private equity and infrastructure. Using a “value for money” benchmark allows pension funds to determine whether an investment has the right balance of risk and reward whilst still satisfying their fiduciary responsibilities.