A recent series of letters in the FT on the Local Government Pension Scheme (LGPS) brings to the fore an issue the pensions industry has repeatedly tried to ignore: the scaling up of pension funds. This is not in the industry’s interests, but is very much in the interests of scheme members.
There is mounting evidence that sub-scale schemes lead to sub-optimal consumer outcomes, yet of the UK’s 46,540 trust-based DC schemes, 44,000 have fewer than 12 members, and 38,300 have fewer than four. The average UK scheme size is 2,500 members; contrast this with Australian schemes that average 26,000 members.
One of the FT’s letters was from a senior actuary, who asserts that “ merging will do nothing to address deficits”. This is patent, self-serving nonsense, for a number of reasons:
● Larger schemes can utilise their buying power to secure more attractive transaction pricing, win big reductions in fund managers’ annual management charges, and also rebut initial charges;
● They are better placed to afford the in-house expertise needed to research the complex range of available investments;
● They can exploit co-investment opportunities (i.e. the ability to buy a share of portfolio companies without fees);
● They have greater reach across asset classes, geographies and (fixed income) asset maturities, resulting in more diversification (thereby reducing risk);
● They can better exercise annuity buying power on behalf of retiring members.
Furthermore, larger schemes are better placed to afford the best advice, and also harvest a “governance dividend”, estimated to add 0.5 per cent and 1 per cent to annual returns to defined benefit and defined contribution schemes, respectively.
In addition, only large schemes can accommodate effective risk pooling, (“collectivisation”), should members wish to participate. Finally, a scheme with more than 50,000 members costs £15-£30 per member to administer, compared with up to £200 for one with fewer than 1,000 members. To the extent that these benefits reduce fund costs, they help address deficits.
It is clear that small pension schemes are deficient, and need to merge (operationally) if they are to achieve transformational improvements in efficiency. Given that it is an expressed duty of trustees to act in the beneficiaries’ interests, they should be pursuing scheme consolidation, working in partnership with scheme sponsors and unions. But it is naïve to expect them to do so enthusiastically because, for professional trustees, fewer schemes means less business.
An external catalyst is required, ideally in the form of pressure from scheme members, but they often lack the data and collective organisation to act effectively. Therefore, all schemes should have to publish their operating and transaction costs per member, thereby enabling beneficiaries to hold trustees to account.
Meanwhile, local councils should take the lead and confront the staggeringly inefficient LGPS. Comprising 101 separate funds, these should be merged into five regional operations, to facilitate pooled administration and procurement; each would have some £30bn in assets. In time, they would become “expert clients” capable of extracting best value from the financial services industry, and enjoying the other benefits of scaling up.
But how to achieve this? Regional membership could be based on a voluntary process akin to treaty accession, led by a core of enlightened council leaders, employers and unions. This would attract stakeholders with a common sense of moral responsibility towards their pension fund members, boosting the prospects of successful implementation. By avoiding the “big-bang” approach of some grandstanding universal accord, no single fund or bloc could hold the process hostage.
A crucial prerequisite, however, is enhanced transparency, including an explanation as to why total commission payments by LGPS funds to brokers have more than doubled between 2003 and 2007, the result of portfolio turnover trebling over that period. That is scandalous, and indicates a serious failure of governance.
Michael Johnson is a research fellow at the Centre for Policy Studies
Get alerts on Pensions crisis when a new story is published