UK Public Funds Target Pooling Savings | Chief Investment Officer

Public pension pooling in the UK could save up to £300 million ($428 million) a year, analysis shows—but the government has been warned that its desired savings will not materialize quickly.

An analysis of local government pension schemes (LGPS)—claimed by its participants to be the biggest ever of the UK system—said government plans to create six pools of £25 billion to £30 billion each were achievable.

But the report warned that “in the short term, establishment and transition costs could exceed savings.”

In addition, the report reiterated investor concerns that a push to use more passive funds could hurt the pensions’ ability to generate returns and address funding shortfalls.

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“Although greater use of passive could save more on manager fees in the short term, this has to be set against the loss of potential for well governed pools to deliver active manager outperformance which could be much more valuable,” the report said.

The analysis gathered information from 37 LGPS funds and 40 asset managers, with support from consultancy firm Hymans Robertson, which has played a central role in pooling discussions.

The work “compared different pooling models as well as the most efficient ways of accessing the range of assets used by LGPS funds,” said a joint statement from the participating funds.

UK Chancellor George Osborne wants the 89 LGPS fund in England and Wales to club together to form six larger pools, achieving economies of scale and increasing the ability of the funds to invest in domestic infrastructure.

“The government’s objective of setting up six pools can be met if these are established on a multi-asset basis, including actively managed listed equities and bonds which form the larger portion of scheme assets,” the analysis said.

The analysis estimated that annual savings would reach between £190 million and £300 million, assuming that assets grow by 3% to 5% a year.

“Actual cost savings could be greater due to a combination of downward pressure on fees once fund managers begin competing for pool assets, additional savings on the less visible layers of fees on alternative investments, and greater use of in-house management,” the report added.

However, the government was warned that cost savings would not be immediate due to the considerable work required for the transition.

“The risks of a transition of assets on the scale required should not be underestimated as this has never been done previously,” the report said.

The Department for Communities and Local Government published a consultation regarding the pooling proposals in November. Responses are to be submitted by February 19.

Passive investments may not be quite as cheap as they appear.

According to a report by Research Affiliates, the gross returns of index investments are “materially depressed” by hidden trading costs.

“You don’t see these costs in performance attributions, unbundled management fees, or even standard trading costs analyses,” wrote Research Affiliates Director Michael Aked. “The fact that they are unobserved doesn’t mean that they don’t exist, can’t be measured, or shouldn’t be taken into account when selecting an index strategy.”

These hidden costs are implicit trading costs, or the “loss of performance due to transactions occurring at prices that would not have prevailed if investors didn’t need to enter trades.” When a stock becomes a member of an index, investors pay a “substantial” premium.

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“An index is just a model portfolio, and it cannot be implemented above and apart from the laws of managing money,” Aked wrote. “To attract sellers for stocks you wish to buy, you have to pay more. To attract buyers of stocks you wish to sell, you need to ask for less.”

These price differentials add up so that the cost of implementing capitalization-based indexes is “meaningfully higher” than that of well-designed smart-beta offerings, he continued.

Furthermore, Aked argued that this costly construction of indexes can mean they are essentially active management.

“Index designs run the full gamut, from highly systematic, rules-based procedures to largely discretionary, committee-based processes,” he wrote. “In every case, the explicit selection criteria, weighting rules, and committee decisions directly affect indexes’ active shares.”

While trading costs can be expensive, cap-weighted indexes are self-adjusted, meaning they minimize that particular type of cost, Aked noted. However, he continued, that does not mean they should be viewed as costless.

“It’s lunacy to believe that the implementation of popular capitalization-based indexes is costless, that their negative selection and weighting bias is zero, or that their implicit trading cost as a percentage of aggregate assets is currently below that of well-designed smart-beta offerings,” he concluded.