Agenda 1 sdf - Emap.com...auto-enrolment regime. But the cost of the LGPS not winning the opt-out...

xx Month 2010 Local Government Chronicle xxlgcplus.com?? Local Government Chronicle 25 March 2010

Agenda sdf 1

LGC’s regular special report

Shareholders are making their opinions heard on excessive senior pay p12

Pension fund managers have to cope with a volatile world p14

The eurozone poses a particular risk factor p4

Infrastructure is an asset class to consider p6

xx Local Government Chronicle xx Month 2012 LGCplus.com?? Month 2011 LGC Finance 3

1 LGC’s regular special report ▼

NIC PATONSUPPLEMENT EDITOR

‘‘ The challenging environment may actually lead to the emergence of a better-skilled, better-rounded local government pension fund manager

2 LGC Finance 21 June 2012

Investment professionals know only too well the one thing markets hate is uncertainty. Unfortunately there is still rather a lot around and how funds are continuing to react and respond to the challenging climate is, arguably, the common theme of this LGC Investment supplement.

Yes, May’s agreement on the Local Government Pension Scheme may mean we are finally starting to see some much-needed clarity regarding its future shape but, as Warwickshire CC’s Phil Triggs has cogently argued on page 4, there are still risks galore out there – the eurozone, our ageing population, maturing funds and declining membership levels, inflation and market volatility – that are set to be focusing the minds of fund managers for the foreseeable future.

Yet what is also clear, as Torfaen CBC’s Graeme Russell has explained on page 6, is pension funds – and local authorities generally – are looking to innovative solutions rather than simply retreating into a risk-averse mentality.

Moreover, much as adversity is often said to be a catalyst for great art, there is a debate to be had about whether the challenging environment may actually lead to the emergence

of a better skilled, better-rounded local government pension fund manager.

This isn’t, of course, to imply fund managers lack the skills to do their jobs effectively – if anything, the successful and measured way we’ve seen funds being managed since 2007-08 shows how well most managers have navigated a very difficult course.

But the fact that, as Wolverhampton CC’s Geik Drever has highlighted on page 14, teams are becoming more multi-disciplinary so as to bring in a wider range of skills, outlooks and competencies to cope with the challenging climate is potentially a very optimistic signal for the future.

When things do (one day) improve, it will mean local authority pension funds will be being managed by a generation of fund managers who, battle-hardened from managing years of adversity, austerity and volatility, will be even more capable of providing the firm, nuanced leadership required.

Given that perhaps one of the biggest challenges – the ageing of our working (and pensionable) population – is one that will not be going away any time soon, that is, perhaps, at least something to be optimistic about.

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Contents

It’s a time of unprecedented change for public sector pension funds at the moment, says GRAEME RUSSELL, and this will inevitably be reflected in investment strategy p6

The financial climate might seem especially uncertain, but many risks are quantifiable and so, for the fund manager, it is a matter of awareness and action, writes PHIL TRIGGS p4

As the LGPS moves towards maturity, a change of investment emphasis will be needed to maintain the balance between contributions and benefit payments, writes GRAEME MUIR p6

The ‘shareholder spring’ brought excessive boardroom pay into the spotlight, and investment managers have a crucial role to play on the issue, as BRIAN BAILEY explains p12

Pension fund manager GEIK DREVER tells LGC about how the role has changed to meet evolving challenges and what she predicts will happen in the future p14

21 June 2012 LGC Finance 3LGCplus.com

xx Local Government Chronicle xx Month 2012 LGCplus.comLGCplus.com4 LGC Finance 21 June 2012

1

‘‘Risk is a part of God’s game, alike for men and nations.”

So said Warren Buffet, and the same applies to local authority pension funds. As we approach a triennial valuation in 2013, fund managers need to consider many risks and ensure relevant factors are reflected in contribution rates for the next three years.

Longevity riskImprovements in longevity show no sign of reversal, and pension funds need to be aware of these pressures.

The use of longevity swaps is one option, and can give a degree of certainty to the extent of future fund liabilities. The Hutton reforms will link the retirement age to the state pension age (SPA). The linking of the SPA to the Local Government Pension Fund will be a major factor in limiting costs with the new 2014 scheme. As the SPA rises, so will the LGPS retirement age and this will help to remove pressure from future liabilities and costs.

Moreover, costs will reduce as a result of the cost ceiling mechanism known as the ‘cap and collar’. As LGPS longevity runs ahead of the SPA then the cap and collar cost mechanism will switch the cost onus on to employee contributions, thus taking some of the cost pressures away from funds. It should

Taking control of the risk factorsCoping with uncertainty is part of any fund manager’s brief but, as PHIL TRIGGS explains, many risks can be predicted and action can be taken to mitigate their effect on funds

be noted this applies to future service only, with accrued rights earned to 2014 guaranteed within current LGPS rules.

Fund maturity risk With the LGPS announcement on 31 May, the picture has become clear as to the proposed regime and its future liabilities. Even with Hutton’s fairness, it is not unreasonable to assume an increased potential for member opt-outs from the LGPS and the resultant increasing maturity issues. Member opt-out could be countered by the pending auto-enrolment regime.

But the cost of the LGPS not winning the opt-out battle is scheme maturity, cash flow negative status and therefore significant changes to investment strategy. The fact these pressures are being felt in the midst of significant local cutbacks, lay-offs and early retirements (and involving significant numbers of highly paid senior staff) has not helped. The 2013 actuarial valuation will be a vital stepping stone in planning for the future.

As part of this, we need to assess our future cash income levels (contributions and dividend/interest receipts), the likely advance to future fund maturity, how long this will take and what the future investment strategy will be, with the assumption it will be a significant de-risking

further diversification by many LGPS funds into inflation-hedged assets has taken place, such as increased exposure to property. The buying of index-linked bonds also assists to mitigate this risk. However, index-linked bonds have become very expensive as a result of the low interest rate environment. The focus of the actuarial valuation process due to start from 1 April will be on the real returns on growth assets, net of price and pay increases. Some form of insurance for high inflation scenarios could be considered by funds in the future.

Taking control of the risk factors

strategy. Pitched against this is the need to invest in growth assets to reduce the fund’s deficit.

The most likely outcome is that, over the long term, the LGPS will move towards the characteristics of the private sector. There will be similarities of average member age and less risky assets within fund portfolios.

Inflation riskInflation is an issue and will remain so while low interest rates persist. Economic volatility will also be with us for the foreseeable future.

Inter-valuation monitoring gives early prior warning and

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Risky business: uncertainty in the eurozone is causing headaches for fund managers

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PA

21 June 2012 LGC Finance 5

Taking control of the risk factors

Investment riskThe risk here is that fund assets fail to deliver returns in line with the anticipated returns underpinning the valuation of liabilities over the long term. The LGPS is still able to anticipate a long-term return on a relatively prudent basis and the triennial valuations reset the road map when necessary.

However, the risk of an inappropriate long-term investment strategy and wrong decisions taken as to the overall risk budget would have a severe impact. Regular monitoring is required, along with a willingness to question accepted thinking.

Of course, a cataclysmic fall in equity markets, coupled with long-term low interest rates will have a significant impact on the LGPS, leading to significant deterioration in funding levels. Allocations of funds to bonds, property, hedge funds and absolute return strategies will alleviate such a fall in equities to some extent.

Conversely, there is the risk that switching too much away from equities will result in losing out from the eventual bounce in equity markets, whenever that may be.

Where funding levels are poor, growth assets are needed to recover but we must expect accompanying volatility. Once the funding level has improved, funds can take some of the risk away from the overall portfolio. This has become known as ‘the flight path strategy’, where risk is reduced as the funding level improves, or when market conditions are such that the potential upside no longer justifies the risk.

Employers ceasing to existThe risk of an employer ceasing to exist with insufficient funding or the adequacy of a bond is more prevalent now, especially with the advent of academies and the absence of any government guarantee in the event of any of them folding.

Moreover, the increase in number of admitted bodies such as charities closing

down, and employers who have closed their scheme membership, thus resulting in termination penalties, will require special attention.

LGPS managers need to plan for exits and engage in dialogue with bodies to understand their circumstances. If a body is regarded as likely to depart over the short or medium term, a gradual switching to gilts funding can take place, thereby reducing the shock of moving in one fell swoop from a uniform funding assumption to termination status. Seeking funding guarantees from employers could minimise default risk.

The one-size-fits-all investment strategy for all employer bodies may not be appropriate in the future.

For example, different strategies might be appropriate for more mature employers or well-funded employers who might prefer to de-risk, or short-term employers such as contractors who do not want volatility, or employers closer to cessation who do not want to risk a market fall before they cease to exist.

Gilt yield riskA fall in risk-free returns on gilts leads to an automatic rise in the value placed on liabilities. The UK’s current status as a safe haven has led to record recent gilt yield lows. Gilt allocation within the portfolio helps to mitigate this risk. But the bigger

concern – and therefore risk – is low gilt yields reflect a headlong rush from riskier assets.

The fund’s actuary could look at stabilising contributions for the most secure employers to counteract the effect of current market conditions. Early negotiation should be taking place in readiness for the 2013 valuation. Bond yields could remain low and discussions need to take place early in order to assess if contribution rates need to reflect the continuing low interest rate environment.

Effective governanceSpending time on the right things according to their impact, understanding the long-term nature of the risks and setting the investment strategy accordingly will all be crucial. The use of wider, more diversified portfolios by managers who can adapt to changing markets offers another opportunity.

Scheme management will certainly become harder for local authority officers and trustees; the Hutton reforms will place more demand on trustees, and decision making will become more involved: alike for men, nations and pension funds.l Phil Triggs is group manager of treasury and pensions at Warwickshire CC. From October he will become strategic manager for pensions and treasury at Surrey CC


‘‘ The agenda has never been fuller, with funds exploring a wide variety of new approaches and innovations in an attempt to manage their affairs more effectively

1

At the risk of stating the obvious, there is a lot happening in the world of public

sector pensions right now. Local Government Pension Scheme reform, auto-enrolment, the Treasury promoting the idea of using public sector funds to invest in infrastructure, continuing market turbulence, the potential for opt-outs and the level of public sector debt – all are providing a context for deeply uncertain and challenging times.

So you’d assume fund administrators would be focused on managing their investment risk profiles as effectively as possible and simply being responsive when it comes to changing investment strategy requirements. But is this what is actually happening?

The typical local authority fund will have a mix of equities, fixed interest and ‘other’ types of investment, the contents of which have steadily grown over time to include a variety of branded alternatives such as property, infrastructure and currency.

These asset allocations have been designed to meet the requirements of a defined benefit final salary scheme. The final shape and structure of the new LGPS based on career average is gradually emerging, as evidenced by the agreement reached in May between unions and the LGA, but it is also clear the changes

Living with uncertain timesIn a climate of economic instability and widespread changes, today’s fund manager is having to consider a number of innovative solutions, writes GRAEME RUSSELL

coming through will not be restricted to the benefit structure but will encompass governance-related issues.

This scheme will be introduced from April 2014 but, before that, auto-enrolment will make itself felt. It will have a ‘pull’ of potentially bringing more people into LGPS funds during 2013 but there may in turn be a counterbalance of increasing numbers of opt-outs as employees perceive their pension benefits are being eroded by the reforms.

The timetable of change is thus deliberate to allow the 2013 actuarial valuations to be calculated once the new scheme design is known, therefore enabling funds potentially to benefit from the more sustainable and affordable scheme design for the future.

The issue for funds, however, is what does this mean for investment strategy over the next 18 months, knowing the scheme design, member profile and liability profiles could materially change?

Some advisers will tell you activity is slowing down, with few funds undertaking a radical overhaul of their investment arrangements at this point in the cycle. Some even suggest there is a drift towards more passive investment as things continue to be almost too difficult to predict.

At the same time, however, schemes do appear to be

looking at a plethora of other aspects designed to improve investment return at the margins, reduce cost and improve effectiveness. On top of this there is a trend towards exploring ideas designed to provide stability or incremental improvement during what some may see as a hiatus period until there is more certainty surrounding the effects of so many changes on the LGPS.

For example, some funds have been looking at asset mechanisms designed to hedge interest and inflation risk. Some funds, too, are looking at how to improve their management of fixed

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COMMENT CHRISTOPHER NICHOLS Investment Director Standard Life Investments

For as long as there have been eggs and baskets, investors have sought to mitigate the impact of market and economic crises through diversification. The methods have evolved from balanced managed funds through to diversified growth and absolute return strategies. While the limitations of the first two were highlighted in the aftermath of the global financial crisis, absolute return strategies that invest globally on a multi-asset, multi-strategy basis have proved more successful.

An absolute return approach seeks to minimise the impact of market volatility through broad diversification, while delivering the positive returns needed to meet long-term objectives. To achieve this, absolute return investing releases portfolio managers from the requirement to invest in asset classes in which they hold a negative view.

As well as using traditional methods such as equities and bonds, absolute return investing can include cyclical and relative value opportunities in markets like inflation, volatility and foreign exchange. These can offer returns combined with strong risk and diversification over two to five-years, but would not be held passively for long periods of time.

Most importantly, absolute return investing

also offers the potential to provide positive returns in all market conditions. Investors face a highly uncertain future and must invest for multiple potential outcomes, including:1. A return to pre-2007 growth. While not the most likely outcome, it is still plausible.2. A return to deep recession. This outcome is perhaps rather less remote. With the ever-mounting cost of additional QE to re-stimulate recovery, this scenario would probably see risky assets seriously underperform.3. Muddling through. Perhaps a more plausible central view would be growth at near to stall-speed, but with continued intervention helping to rebuild confidence. Markets would continue to have periods of high volatility – and they will continue to produce a number of investment opportunities.

For everyone, the key question is how to invest for all these scenarios with a reasonable expectation of making an acceptable return. Earlier attempts at portfolio diversification have failed to provide an adequate solution.

Absolute return strategies that have weathered the storms of the past six years have proven more adept at stabilising investment portfolios and enhancing wealth in challenging market conditions.

Preparing for uncertainty

COLUMN SPONSORED AND SUPPLIED BY STANDARD LIFE WWW.STANDARDLIFE.COM

LGCplus.com 21 June 2012 LGC Finance 7

Living with uncertain times

interest portfolios in the more stagnant market conditions – and the increase of absolute return fixed interest products is certainly growing.

Beyond that, there are examples of more focus on liability-driven investing, emerging market debt, investment in property (where income flows are long term and stable) and related infrastructure investments, encouraged, as we have already mentioned, by central government looking to help stimulate the economy.

In administrative circles, there are examples of

sharing being explored or progressed, such as the LGSS partnership between Northamptonshire and Cambridgeshire CCs, which share a pensions team and finance director, who is also head of pensions. There are, too, examples of joint procurement arrangements and collaborations. Funds are looking at more inventive ways of working within procurement rules.

In a regulatory sense, there has also been work by accounting, actuarial and legal bodies that suggests simplification of the LGPS investment regulatory regime, thereby removing some of the grey areas that some funds regard as an impediment to managing in the best financial interest.

So, to conclude: are funds simply taking a more cautious view until all the volatile factors beyond their control stabilise?

The answer, as is so often the case, is not clear cut. On the one hand, while the fundamental investment strategy of many funds may be on hold for 12 months or more until a clearer picture emerges, on the other the agenda has never been fuller, with funds exploring a wide variety of new approaches and innovations in an attempt to manage their affairs more effectively.● Graeme Russell is head of pensions and employee services in the resources directorate of Torfaen CBC

Pension funds are being encouraged to invest more in infrastructure projects


1

The public sector pension reforms that are under way arguably stem from

the cashflow issues in the unfunded schemes the government uncovered when taking office in 2010.

While headlines such as “public sector pension costs to double in four years” certainly got some attention, in reality this was not, of course, strictly accurate. The element of cost that was expected to double in the next four years was the contribution from the Treasury that will be required to top up employer and employee contributions so that there is sufficient income to meet benefit payments (see Table 1).

The key problem, as has been well reported in LGC and elsewhere, is the effect of freezing pay and reducing public sector headcount, which means that contribution income from employers and employees is expected to remain static while pension payments continue to increase as more people retire, live longer and see their pensions increase with inflation (albeit perhaps less quickly than they once thought).

Thus, the unfunded schemes are in a position of benefit payments exceeding contribution income. This, in truth, should not come as too much of a surprise as all pension schemes arguably reach this state as they

Making the most of your assetsThe funded LGPS is in a good position, but a predicted change in the balance between contributions and benefits will need careful management, says GRAEME MUIR

mature. The more important question, however, is: will the funded Local Government Pension Scheme also reach such a position and, if so, what are the consequences?

The latest SF3 data for the whole of the LGPS in England and Wales from the Department for Communities & Local Government is set out in Table 2.

What this shows is a similar pattern developing to the unfunded schemes, with relatively static contribution income and benefit payments continuing to grow. The main difference is that contributions still exceed benefit payments, mainly as employer contributions include additional contributions to fund deficits – something that does not really apply in unfunded schemes.

However, with the size of the public sector expected to continue to decline, it is more than likely that we will come to a point when benefit payments overtake contribution income.

One key difference is that, in the funded LGPS, the assets are there to meet this eventuality and, in fact, arguably this is the raison d’être of the assets – to help employers meet their pension liabilities when contributions are no longer sufficient to meet benefit payments.

The assets are there to smooth or stabilise employer

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Chart 3 Projected cashflows (20% reduction in active membership, extra 1% income yield)

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Chart 2 Projected cashflows(20% reduction in active membership)



Making the most of your assets▼


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Making the most of your assets

Table 1 – Year Net cash spend (£bn)

Benefit payments (£bn)

Contributions received (£bn)

2008-09 3.1 22.5 19.42009-10 (estimate) 3.1 24.3 21.22010-11 (forecast) 4.0 25.4 21.32011-12 (forecast) 5.1 26.8 21.62012-13 (forecast) 5.8 28.3 21.52013-14 (forecast) 7.3 29.9 21.52014-15 (forecast) 8.9 31.3 21.42015-16 (forecast) 10.3 32.9 21.6

Table 2 2010-11 2009-10 % change

Benefit payments £6.7bn £6.3bn 7%

Employee contributions £2.0bn £2.0bn -

Employer contributions £5.9bn £5.8bn 2%

Total contributions £7.9bn £7.8bn 1%

New money £1.2bn £1.5bn (20%)

Investment income £2.7bn £2.6bn 4%

Cashflow £3.9bn £4.1bn (5%)

remains at current levels. As is clear to see, new money is only expected to remain positive until around 2015.

The good news is that investment income is anticipated to plug the gap for the foreseeable future. The bad news is that the prospect of a stable, active membership looks unlikely. Further reductions in headcount look inevitable and there is also the risk of an increasing level of opt-outs, particularly if there are increases in employee contribution rates.

Chart 2 shows the projections, assuming a 20% reduction in active membership between now and 2015. As this shows, this brings forward the time when new money turns negative to 2014 but, more critically, investment income may not be sufficient to plug the gap after 2023 or so.

Don’t forget, of course this is for the LGPS as a whole – the position of individual funds will vary, and there are funds that are already using investment income to help meet benefit payments. Perhaps ironically, some of the better-funded funds are ones with lower than average employer contributions.

Conventional wisdom suggests that as a fund reaches the point when assets may need to be sold to meet benefit payments, then the asset strategy should move to ‘less risky’ assets such as gilts and bonds to reduce the risk

of capitalising capital losses. At the moment the future returns from gilts and bonds are very low and so a switch into these assets will increase long-term costs (which, ironically, will then increase contributions and improve the cashflow position).

Ideally funds should adjust their strategy to try and retain the same total expected return but trade lower capital growth for higher income yield. Chart 3 shows how projections in Chart 2 change if we were to reduce the capital growth return by 1% in return for an extra 1% income yield. As we can see, this extends the time horizon to around 2030.

While the funded LGPS is clearly in a better place than the unfunded schemes, the same cashflow issues exist in all schemes. The assets in funded schemes are, of course, there to meet benefit payments and while the prospect of having to sell assets to meet benefit payments may excite many, with some careful management it is possible to adapt the investment strategy to cope.

The assets in funded schemes allow employers to manage their liabilities in an orderly manner and, with some help from their friendly actuary, they can avoid the sort of ‘surprises’ that apparently emerge in the unfunded schemes.l Graeme Muir is a partner at Barnett Waddingham LLP

costs, unlike in the unfunded schemes where they potentially are unlikely ever to stabilise.

Initially, investment income will be used to plug the gap (the equivalent of the Treasury contribution in the unfunded schemes). However, there may come a point when the investment income will be exhausted and assets may have to be sold to plug the gap. The question of course is: when is this likely to be?

Chart 1 shows our projections of the LGPS cashflows over the next 20 years, assuming the size of the active membership

‘‘ With the size of the public sector expected to continue to decline, it is more than likely that we will come to a point when benefit payments overtake contribution income

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10 LGC Finance 21 June 2012

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COMMENT BERNARD ABRAHAMSEN Head of Sales and Distribution M&G Investments

At M&G, we are in the privileged position of managing 61 fixed income, equity and property mandates for 40 UK local authority pension funds.

Within fixed income, our mandates stretch across a variety of mainstream and non-mainstream asset classes, such as corporate and government bonds, leveraged loans, infrastructure and long-lease property.

We manage almost £110bn on behalf of our parent company, Prudential plc, the UK’s largest insurer, and the long-term nature of their liabilities means that their investment requirements are very similar to those of our pension fund clients. There is a need to source assets that can deliver long-term growth, stable income and, if possible, affordable inflation protection. Such investments are sometimes hard to find or somewhat unconventional and we often prefer to test them for suitability with the capital we manage on behalf of Prudential before providing opportunities for our other clients to co-invest.

Credit analysis has always been our forte. We made the decision more than 30 years

ago that the extra returns available from taking credit risk were the most appropriate for our long-term objectives.

Therefore, we established what we believe is one of the largest and most experienced teams in Europe, capable of delivering class-leading performance across a wide variety of public and private fixed income instruments. In fact, no less than 100% of our active institutional fixed income funds have delivered returns ahead of their benchmarks over the three years to March 2012.

While we cannot claim to offer as wide a range of products as some of our peers, over the years we have expanded our offering as new compelling opportunities have arisen. For example, a number of Local Authorities have invested in our ground-breaking UK Companies Financing Fund, set up at the height of the banking crisis to provide medium-to-long-term finance for solid UK companies struggling to find new loans.

Today, most of the opportunities we are working on are connected to the banking crisis, either by providing sources of

alternative direct lending or buying assets off banks’ balance sheets. For example, we are able to provide our clients with access to:• the UK’s social housing sector, with returns of around 2.5% pa above inflation, compared to less than 0.5-0.6% above government bonds before the crisis (source: M&G, Bloomberg).• European commercial mortgages, which return 3.3% pa above cash rates on the safest loans, compared to 0.6% above cash on equivalent loans before the financial crisis (source: M&G).• asset-backed securities, with returns on the safest assets providing returns of 1.5-2% above cash rates compared to 0.15% above

cash rates before the crisis (source: Bloomberg).

We believe that the financial crisis is creating some once-in-a-generation opportunities and while news on the macroeconomic and geopolitical front is far from uplifting, we remain relatively confident, given our exceptionally well-resourced team, that we will not only continue to navigate successfully through the storm, but also take advantage of the many attractive opportunities that the crisis presents. At a time when bank lending has greatly reduced, we can best represent our pension fund clients by buying existing loans from the banks or providing fresh loans to those who need them, while demanding premium returns for doing so.

We plan to bring many more opportunities to local authorities when we are sure that they are the right strategies. We are proud that so many of you have chosen to invest alongside us and we hope we can work even more closely with UK public sector pension funds in future.● For more information, please contact us at [email protected]

Managing in diffi cult circumstances

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This article reflects M&G’s present opinions reflecting current market conditions; are subject to change without notice; and involve a number of assumptions which may

not prove valid. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not

accept liability for the accuracy of the contents. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the

Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill,

London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Services Authority

‘‘ No less than 100% of our active institutional fi xed income funds have delivered returns ahead of their benchmarks over the three years to March 2012

40 Local Authority

To find out more about our Fixed Income capabilities, please visit www.mandg.co.uk/institutions or contact the Fixed Income team at [email protected]

Thank you to all of our

clients for trusting us with 61 mandates

We look forward to continuing ourpartnership with you

M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under No. 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Services Authority. JUN 12 / 38505


1

Headlines over unacceptable levels of pay for company

directors have been appearing for years yet have failed to make a difference. However, driven by a combination of public and political pressure, there are indications that lasting changes may finally be happening.

The High Pay Commission, established by Compass with support from the Joseph Rowntree Charitable Trust and which ran for a year from November 2010, reported that publicly quoted companies’ excessive high pay is damaging for business and the economy. Where excessive pay has little connection with success or failure, it has a negative impact on society.

Accountability and transparency, it also argued, is undermined by the complex nature of many remuneration schemes; remuneration committees appear to lack robust independent challenges and the argument often used about the need to retain talent is not substantiated.

The commission made 12 recommendations:● executives should be paid a mainly basic salary; ● companies should publish the top 10 executive pay packages outside the boardroom;● remuneration reports

Speaking up on our behalfPublic anger over excessive boardroom pay is finally being addressed, writes BRIAN BAILEY, and the asset manager will be critical in realigning remuneration with results

should be presented in a standardised format;● shareholders should fully disclose how they vote on remuneration;● there should be employee representation on remuneration committees;● all publicly listed companies should publish an income distribution statement over three years showing: total staff costs, company reinvestment, shareholder dividends, executive team total package, and tax paid;● shareholders should vote on remuneration arrangements for three future years;● companies should implement a structured programme to develop future directors;● the recruitment of non-executives should be openly advertised to improve diversity;● companies should detail their use of remuneration consultants;● companies should produce fair pay reports; and● a permanent body should be established to monitor top pay.

A number of these same recommendations have been put forward by others, and a general consensus has now begun to build.

The government has also recently announced it will act to restrain some of the worst behaviour of excessive pay awards and strengthen the hand of shareholders to

A recent study by independent research consultancy PIRC highlighted the analysis of 17 asset managers in the 2010 annual general meeting voting season for FTSE-100 companies and found:● an average of 11.6% of remuneration reports were opposed;● the median level of opposition was 8.4%; and● four asset managers opposed less than 5% of remuneration reports.

Raising the threshold for a pay deal to pass, if investor voting remains broadly the same, will mean more

hold companies to account. On shareholder powers the government has said it will consult further, but options are a binding vote on future pay policy and on notice periods greater than one year, and an increase in the level of support required to pass a policy.

A critical issue is whether shareholders will exercise their powers or, more importantly, will their agents, the investment managers, restrain some of the worst behaviour and strengthen the hand of shareholders to hold companies to account?

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COMMENT KEVIN CULLEN Client Relationship Manager – Local Authorities, SSgA

Traditionally, passive investment strategies have tracked indices that allocate weight to equities and bonds in accordance with their market capitalisation –so companies with the largest market capitalisation automatically have the largest weighting.

While this type of indexing still dominates the world of passive investing, a growing range of strategies seeking to capture ‘alternative’ or ‘advanced betas’ have also become popular. Broadly speaking, beta is any transparent, consistent, rules-based process aimed at capturing a particular return or diversification benefit.

A number of index providers have created indices that target different types of advanced beta. In addition, investment managers can use passive investment techniques to create customised solutions that remove the need to track a traditional published market index – meaning that you can focus on investments that have characteristics you prefer.

Why would you wish to consider such an investment? Well, there are a number of potential benefits. First, these are true passive approaches – with all the clarity and cost effectiveness that implies – that can enable you to gain broad, diversified exposure to global markets. They also avoid the potential pitfalls

of making the wrong ‘active’ decision, while capturing many of the benefits of active investments. And because they trade a diversified basket of securities, they usually provide liquid exposure.

Although advanced beta strategies can span a variety of asset classes and investment styles, one particularly interesting type enables you to depart from the market’s allocation of capital. So-called ‘fundamental strategies’ use tracking indices that weight equities and bonds according to certain key fundamental factors, such as financial ratios. Using such factors, the strategies attempt to favour better performing companies and so have the potential to provide greater returns.

These types of strategies are significant because there is substantial long-term empirical evidence suggesting that incorporating such ‘tilts’ into portfolios can generate worthwhile additional returns.

As a complement to traditional index investments – or as an alternative to active – advanced beta strategies can combine the transparency, consistency and low costs of traditional passive investing with the potential for better returns, as well as gaining the possible risk mitigation and liquidity benefits of broad diversification.

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Speaking up on our behalf

companies fail to pass controversial policies.

The recent voting behaviour of many investment managers does not suggest they will act effectively in containing excessive pay awards. An obvious measure would be to make the disclosure of shareholder voting records mandatory. This would ensure those managers who support excessive remuneration packages would come under greater scrutiny. Some observers are sceptical about shareholder action. However, greater transparency for the public

and those reporting public views can force restraint if the outrage is sufficient, as has been seen recently.

Some of the High Pay Commission’s recommendations are more challenging and raise a divergence of views, for example employee representation on remuneration committees. It is not surprising the government has declined to embrace this. This is regrettable because, as shown through representatives on pension committees, employee representatives can play a constructive role and make a useful contribution to decision making.

The interests of shareholders and companies need to be aligned over the medium and long term, so ensuring stability for the company, steady growth and fair division of earnings between all interested parties (shareholders, directors, staff and taxpayers). A share of high rewards for all is acceptable, but a very high share for a few and poor relative returns for others is not.

Ultimately, shareholders collectively need to give a clear message and think about exercising their powers before the public identifies that they may also be part of the problem.● Brian Bailey is former director of the West Midlands Pension Fund at Wolverhampton City Council

Shareholders have been making their opinions about excessive pay heard


1

How did you arrive at your current job?I originally trained as a chartered accountant, working for a number of years within a local authority before becoming the chief accountant for the-then Lothian Regional Council and then for the City of Edinburgh Council.

In 2002 I took on an investment function role with Lothian Pension Fund and then in 2005 brought together the pension fund, administration and benefits side before the move this year to West Midlands Pension Fund, a position I am really excited about.

Can you describe a typical week?It’s very varied and diverse. One day I might be having, as happened just this week, a trustee meeting for another pension fund where we will be dealing with various issues around the investment strategy of the fund. Another day it can be giving a talk around communication issues.

A lot of it does revolve around trustee and staff meetings, business planning and strategy planning. I also oversee an investment team that runs our in-house funds, so there is never a dull moment.

How has pension fund management changed from when you started? Are different skills or

Two days are never the same

competencies required nowadays as a result?Things have changed tremendously since I first took over the Lothian role in 2002. It’s been a very challenging environment for the past few years with all the market volatility and falling markets that we have seen.

And, of course, in many of the intervening years we were dealing with markets that were predominantly going up, which created a different set of challenges and required different decisions.

The markets have been extremely stressed since 2007 so pension funds – and their managers – have had to focus on resilience and thinking for the long term.I feel things will continue to change rapidly and be volatile for at least the next three years.

The volatility has also put our role much more in the spotlight. Pensions and fund management used to be a bit of a backwater when I first started but now it is something people – from the most senior levels downwards – are aware of and interested in. There is much more coverage of pension fund investment matters in the newspapers too, almost every day it sometimes feels.

To that extent, one of the key skills a fund manager needs to have – and will continue to need to have – is

Ongoing market volatility and the prospect of a new LGPS means there’s never a dull moment, new West Midlands Pension Fund manager GEIK DREVER tells LGC

under pressure to deliver returns while at the same time coping with the challenge of rising longevity.

What would you say are the key challenges facing pension fund managers today, both internally in terms of their function and role within local government and externally, in terms of the pressures, constraints and challenges they face?

simply an interest in the world and what is going on. You have to be aware of the geo-political environment.

A decade ago, for example, decisions were probably a lot more straightforward towards building a balanced mandate. Nowadays there is a lot more focus on sub-asset classes and alternative investments, with private equity and infrastructure investment also now much more in the mix. Everyone is

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‘‘ Try out things and try to find out what you would like to do. Develop an ability to research, and just as importantly, reflect effectively

Two days are never the same

Local authorities are going through severe cuts which, in turn, are feeding into reduced headcounts, reduced payroll and contributions and therefore impact on the pension funds. So we are seeing funds maturing earlier and more funds likely to be becoming cash negative in the future – that is going to be a major, long-term challenge.

Auto-enrolment from this autumn may help to stem some of those flows out but I

do think compulsory enrolment would have been a better option for the government to consider. It would have helped in terms of people’s future retirement provision and simply in getting this country saving properly for retirement.

The new Local Government Pension Scheme is, of course, another central challenge as will be, more widely, how we manage outflows and ensure funds stay sustainable. The LGPS needs to be sustainable for at least the next 30 years, so how are we going to ensure that? I think there does need to be some debate around that.

Will we in time see a different sort of fund manager emerging, perhaps with a different focus, qualifications, background and/or skill-set?Professional qualifications are always going to help when it comes to career progression but, having said that, I am seeing teams becoming more and more multi-disciplinary.

You need, obviously, to have financial skills and qualifications and that sort of financial or pension fund background but, increasingly, you also must have good interpersonal skills because of the imperative of needing to be able to communicate effectively with customers and other fund managers.

Customer service is very important nowadays.

At senior levels there is going to be a continuing need for local government fund management to have strong, effective leaders who are able to be decisive and can see the bigger picture.

If you were able to travel back in time and meet yourself at the start of your career, what advice would you give your younger self?Be inquisitive and take the chances that present themselves to you. If you have the right skills and training it is always possible to switch discipline.

But don’t forget about soft skills: they are important too. Try out things and try to find out what you like to do. Develop, too, an ability to research and, just as importantly, reflect effectively; that is very important nowadays.

What do you predict is going to be the most exciting/challenging element of your role over the next five to 10 years?I think the main challenge is going to be, very simply, ensuring pension funds continue to get the returns they need. The financial markets, I am sure, are going to continue to be volatile, especially the eurozone, which will I suspect remain a big issue for a number of years to come, and is not just going to be about Greece.

The investment environment is likely to remain very, very stressed so we are going to have to continue to get returns in a difficult market environment. To that extent it is going to be a challenging but also an exciting time for fund management. There will be a lot of pressures on funds and I suspect we may see sharing of services or perhaps mergers as had been mooted by colleagues of the pension funds in the London area.

Another exciting challenge I think will be the evolving role of technology and how that is going to affect how funds are managed and the speed of decision making. The next few years are definitely going to be an exciting time!l Geik Drever was appointed as director of the £8.3bn West Midlands Pension Fund at Wolverhampton City Council, taking over from Brian Bailey following his retirement

The one certainty in today’s markets is uncertainty

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