Cynics in the legal profession are always keen to embrace legal uncertainty – they argue it keeps them in business. In the end of course, no one wins from uncertain, or still less, bad law. The Local Government Pension Scheme (Investment and Management of Funds) Regulations 1988 (the “LGPS Regulations”) are, unfortunately for the LGPS sector, a case in point as they suffer not only from uncertainty as to the scope of the drafting or the intention behind the law, but also a widely held view that the LGPS Regulations are simply out of date because they take an arbitrary approach to asset allocation.
The case for change: an unlevel playing field?
Why these problems matter is not just that investment decision-making can be made more difficult for local authority funds, but also because the market place for institutional investors ends up being distorted by creating prudential barriers to investment of local authority funds where none are prescribed for private sector schemes. Hence the cost of investing can go up because of the need to find ways round the legislation by creating alternative structures.
So what are the differences between the public and private sector?
Until the Occupational Pension Schemes (Investment) 2005 Regulations (the “OPS Regulations”) came into force, there were no statutory restrictions for defined benefit occupational schemes in the private sector at all (although there were, oddly enough, restrictions for defined contribution schemes until 1997). The OPS Regulations imported prudential rules into English law which derive from the Pensions Directive1. They prescribe a “prudent person” approach to the setting of investment strategies, so that trustees of private sector schemes are required to use their powers of investment in a manner calculated to ensure the security, quality, liquidity and profitability of their portfolios as a whole and to have regard to their schemes’ expected future liabilities2 when determining the schemes’ investments. Otherwise, the only asset-specific restrictions in the OPS Regulations concern derivatives and borrowing, but even then the constraints are expressed by way of purpose tests, not quantitative limits. Hence, derivatives may only be used if they reduce risk or facilitate efficient portfolio management and where the scheme is not excessively exposed to either a single counterparty or other derivatives. Borrowing is prohibited for private sector schemes, unless it is to provide liquidity for the scheme and where it is entered into on a temporary basis.
By contrast, and despite the reality that LGPS funds have the same basic obligation to provide retirement benefits, the LGPS Regulations impose fairly rigid quantitative limits by asset class. Admittedly, some flexibility was introduced in 2003 when the limits were increased if a local authority took both “proper advice” and account of the principles of diversification and suitability, but the arbitrary nature of some of the limits is still preserved. Hence, no local authority may invest more than 35% in unit trusts or open-ended investment companies which are managed by the same person, nor may an authority invest more than 35% in a single insurance contract, even if it might otherwise be prudent to do so.
This is not to say that quantitative limits are wrong in themselves, and certainly arguments can be made that, for instance, a limit of 25% on stock lending3 could well be regarded as prudent by any pension fund, but the imposition of such limits is more akin to the way that authorised investment funds and insurance companies are supervised than other pension scheme vehicles.
The dangers of uncertainty
The different prudential approaches adopted in the private and public sectors are, ultimately, a matter for debate and it would be wrong to say that there is clearly a “right answer” for all local authority funds, whatever one might think of the professionalism with which LGPS funds are run. However, by contrast if the law is uncertain or badly drafted, then the case for change is much more compelling.
Readers will no doubt recall the way in which the Government (via civil servants in the Department of Communities and Local Government) resolved legal fears over the enforceability of forward currency contracts at the end of 2006 by way of a letter from the Department confirming its interpretation of Regulation 3(3). In that instance, the concern was that active currency mandates which were in place to generate income or capital gains (as opposed to those which were purely used to hedge out currency risks) might not fall within the meaning of “investment” under Regulation 3. Although the issue has now, we hope, been resolved, the fact that it arose in the first place is an indication of the extent of the problem with the drafting of the LGPS Regulations. One could make similar points about numerous definitions in the LGPS Regulations where, because the drafting approach which was taken in 1998 was prescriptive as to particular asset classes which were then in vogue, doubts about the scope of what those classes now include and exclude have been raised. For example, do “financial futures” include commodity futures?
It is a separate matter that the LGPS Regulations contain a number of statutory references which are out-of-date: clearly a purposive approach to interpretation needs to be taken until parliamentary time can be found to update the text.
Resolving the problems
By the time that you read this article, LGPS administering authorities should have received from the Chartered Institute of Public Finance Accounting (“CIPFA”) a survey which asks local authorities for details of their own experience in interpreting and coping with the LGPS Regulations. CIPFA will be supplementing this survey of views from LGPS practitioners with input from interested trade bodies such as the Association of Pension Lawyers (“APL”), the Society of Pension Consultants, the NAPF and the IMA. Hammonds involvement in this process is via not only our own experience of working with local authority clients on specific investment assignments but also via our leading rôles in the APL and SPC Investment Committees. We are naturally keen to work with CIPFA to assist in this process in the interests of promoting clarity and a sensible prudential framework for local authority investments for the future.
If you are a recipient of the survey request but are not normally given to responding to market research surveys, please help CIPFA in this valuable work. Only if local authorities themselves can demonstrate the need for change will the Government be persuaded of the case!