Leading council leaders such as Cllr Stephen Greenhalgh are lobbying George Osborne to support amalgamation of the 101 local council pension funds. This asset management reform proposal is correct. Combining this with a change in how councils invest could achieve even greater savings. Replacing active management of pension assets with investment in passive index tracking funds will lower costs. Councils don’t need to hire expensive financial investment firms to recommend equity investments. They can invest in an entire index and deliver better returns while incurring lower costs.
Investing in index funds reduces the need for expensive financial management advice. Customers purchase units and pay a small annual management charge usually 0.3 per cent or below. Fees are much lower than for actively managed funds. Annual Management fees charged on passive investment funds are also falling rapidly. Index funds track a market index such as the FTSE 100; they replicate the market in two main ways.
Physical replication involves index funds investing in all shares in a given index e.g. the FTSE 100. The percentage each company comprises of your investment correlates with that company’s proportion of the index. If the market capitalisation of BP is three per cent of the FTSE 100 then it is three per cent of each unit purchased. Investment risk is reduced as while any company in the index can go bankrupt the index itself is likely to survive and can recover losses in the long term.
Synthetic replication involves a company entering into agreements with other financial providers to guarantee the purchaser of an index fund unit a return equal to a given index. UCITS rules require that a minimum of 90 percent of the fund’s value is backed by assets in a separate custodial account, or that collateral is pledged. There is a counter party risk that the company backing the product provides poor quality collateral for the representative sample of assets backing the index fund but UCITS rules ensure that even synthetic funds are partly backed by hard assets.
By investing pension assets in index funds a council will not avoid criticism. Left of centre investors and activists will object to whole market index investing. The FTSE 100 and FTSE All Share Indexes include arms companies, oil companies and tobacco companies. Sunderland and Durham councils have faced opposition to such investments despite the above average returns they have historically achieved. Some will prefer their council to invest in so called ‘ethical’ indexes, these ethical funds have tended to deliver lower financial returns and are, in my opinion, less worthwhile than a whole market index fund.
Whatever index a council pension fund chooses to invest in they will save significant sums by reducing the charges they incur managing their pension fund assets. Investing in index funds achieves higher returns, on average, than active asset management. This is true for institutional investors such as councils as it is for individual investors.
Local authorities will still need targeted advice on asset allocation. Councils need to know how much to allocate to cash so they can cover payments to current retirees. They will want to know how much they should invest in fixed interest products, whether their pension fund reserves are sufficient to meet present and future obligations and if they should invest in a world index fund or allocate more to growth markets. Councils do not need to own shares in individual companies, they do not need advice on whether to invest in companies such as Imperial Tobacco or British Sky Broadcasting or to monitor their performance and be active owners. Councils can reduce the amount of costly financial advice and management they pay for.
The coalition government is increasing Local Government Pension Scheme employee pension contributions and raising the retirement age. This will reduce the demands of future pensioners on council pension funds. Reforming the structure and investment policies of council pensions funds will increase the size of future pension funds. Amalgamating council pension funds and directing pension fund resources to passive rather than actively managed schemes will reduce costs and leave more money in the funds to accumulate. These measures will ensure council pension funds can meet the promises made to the current generation of local government public pension savers.
The views expressed above are my personal views and not those of my employer or any other organisation with which I am associated. Investments are made at the investors own risk and the author recommends no type of index investment fund in particular.