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APPENDIX A

REVIEW OF INVESTMENT MANAGEMENT ARRANGEMENTS 2015

1. Project Plan

2. Terms of Reference

3. Baseline Position

4. Challenge

5. Costs

6. Alternatives

7. Performance

8. Findings and Recommendations

Review conducted by:

Independent Investment Advisors

Peter Moon Fred Green

Chief Finance Officer

Paul Slocombe

Head of Investments & Treasury Management

Paul Campbell

Teesside Pension FundReview of Investment Management Arrangements 2015

1. PROJECT PLAN

1. The Investment Panel appoints the Head of Investments & Treasury Management, in collaboration with the Fund’s Investment Advisors, to carry out the review. Terms of reference are drawn up.

2. Draw up a Baseline Position Statement.

3. Challenge what the Fund is trying to achieve.

4. Consider the costs of current service provision.

5. Consider alternative methods of service provision.

6. Evaluate the relative performance of the current management arrangements.

7. Draft Action Plan.

8. Agree final Action Plan.

9. Report Action Plan to Investment Panel and seek approval for recommendations.

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2. TERMS OF REFERENCE

1. To review all the existing investment management arrangements and to report back to the

Investment Panel with recommendations.

2. To consider, in each case, whether the existing arrangements:

Contribute beneficially to the overall performance of the Fund

Are cost-effective

Can be supported by existing resources of the Section.

3. To consider whether alternative arrangements could be introduced which would be beneficial

to the Fund and to make recommendations where appropriate.

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3. BASELINE POSITION STATEMENT

The Teesside Pension Fund and Investment Panel (the Investment Panel) has responsibility for

the investment of surplus monies not required to meet immediate payments to Fund

beneficiaries. Over the years a fund has been created, the income and future capital growth from

which is available to meet the liabilities of the Fund.

The Investment Panel is a Committee of the Council with plenary powers. Members of the

Investment Panel, although not Trustees, act as quasi-Trustees. The investment of pension funds

is a statutory function and must be undertaken in accordance with the Local Government

Superannuation Regulations 1986, as amended with the Local Government Pension Scheme

(Management & Investment of Funds) Regulations 2009. In discharging the investment function

the Regulations require that administering authorities have regard to:

The need for diversification of investment fund monies

The suitability of any investments proposed

Appropriate advice obtained at reasonable intervals.

The Teesside Fund operates under a Management Agreement, which sets out the extent of

powers delegated to Officers and the responsibilities of those Officers. The Agreement also

includes a Statement of Investment Principles (SIP) which sets out the investment responsibilities

of the Investment Panel, the Chief Finance Officer, the Head of Investments, the Fund’s Custodian

and the Investment Advisors. The SIP is attached (Appendix A1).

A. The Investment Panel

The Investment Panel is structured in such a way that Members take advice from advisors

and officers. Responsibility for day-to-day management of the Fund, including the

implementation of Advisor’s recommendations, is delegated to the Head of Investments &

Treasury Management. The Investment Panel meets four times a year.

The Investment Panel has two external investment advisors:

Peter Moon

Fred Green

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The Investment Panel will also take advice from other specialist advisors at appropriate

times:

Aon Hewitt, Fund Actuary

The Fund Solicitor, the Head of Legal Services

B. The Investment Management Arrangements

The Investment Panel is responsible for determining the investment management

arrangements. The current position has evolved over the years as changes have been

agreed on the advice of the Investment Advisors and Officers. The management

arrangements can then be described, in outline, as follows:

The Head of Investments & Treasury Management is responsible for:

The investment of Fund assets in compliance with prevailing legislation and the

requirements of the Management Agreement.

Implementing the Investment Advisor’s recommendations on asset allocation within the

parameters laid down

Security selection within asset classes

Preparation of quarterly reports to the Investment Panel and an annual report on

investment performance

Reviewing investment management, custodial and other external relationships and

advising the Investment Panel as to future policy with a view to delivering continuing

improvements within a Best Value regime

Implementing the Investment Panel’s policies on corporate governance and ethical,

social and environmental investment

Assisting the Chief Finance Officer and the Investment Panel in the preparation of the SIP

and other Statements and ensuring compliance with their terms.

The internally managed investment team, under the management of the Fund Manager, are

responsible for:

The day-to-day management of all directly held bond and equity investments, within the

limits set out in the Management Agreement

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The internal fund management arrangements, including country and sectoral

management responsibilities assigned to managers.

Equities

The portfolio of equity investments are managed internally on an active basis. The vast

majority of investments are directly into company shares across the following global

markets:

UK Equities

US Equities

European Equities

Far East Equities

Japan Equities

A number of managed funds are used to manage a small amount of the overall equity

portfolio. These managed funds provide exposure to specialist areas (e.g. smaller

companies) or certain geographical areas where direct share holdings are not possible or

practicable (e.g. India or Latin America).

Management of the equity portfolio is split on a geographical and, in the case of UK Equities,

a sectoral basis. The portfolio is split between the Investment Managers, at the discretion of

the Fund Manager.

Property

Property is managed externally by CBRE on a non-discretionary basis. In practice the Head of

Investments & Treasury Management makes decisions based on advice from CBRE. The

Fund also invests in Property Unit Trusts and Property Partnerships under the management

of the Head of Investments & Treasury Management, as a means of obtaining exposure to

types of property where direct exposure is not practicable.

Alternatives/Other Investments

The alternative portfolio is designed to contain investments which are uncorrelated to equity

and bond markets and have a more regular and steady return profile. The Fund has a small

number of investments in specific “project funds” funds (e.g. a caravan park managed fund),

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private equity and infrastructure funds, under the control of the Head of Investments &

Treasury Management.

In addition, the Fund invests in passive exchange tradable funds which track specific

commodity prices (e.g. the oil or gold price). These investments are managed by the

Treasury Manager, at the discretion of the Fund Manager.

Fixed Interest/Bonds

The fixed interest portfolio is managed internally on an active basis. The portfolio comprises

investment in UK and Overseas Bonds and Index Linked stocks. The Fund’s Bond portfolio is

managed by the Treasury Manager, at the discretion of the Fund Manager.

Cash

The Fund’s cash balances are deposited with a select few counterparties (Banks & Building

Societies) or in “call accounts” with Banks. The only exception is that a small amount is

retained by the Fund’s Custodian as working capital.

Related, non-investment management functions

The Head of Investments is responsible for implementing the Investment Panel’s policy on

corporate governance and socially responsible investment. Although these may be

considered separate from investment management, the philosophy of the Teesside Fund is

very much that encouraging companies to follow best practice will improve company

performance and, therefore, investment returns to the Fund.

C. The Loans & Investment Section

The Section provides two main Services:

Pension Fund Investment Management

Treasury Management for Middlesbrough Council

Some officers work exclusively in the delivery of one of the Services while some divide their

time over both. Because of the nature of their work, which is driven by demand, and because

of the “Team” ethos it is difficult to determine a precise split. An analysis of timesheets for

the Section as a whole shows the following split of time:

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Pension Fund 93.5%

Treasury Management 6.5%

The long running trend is towards more resources being devoted to the Pension Fund,

reflecting the growth of the Fund, the increasing complexity of the Investment Management

function & providing the administration and accounting support required for this function,

and the demands of the Investment Panel in areas such as Corporate Governance.

The structure of the section is shown below:

The Chief Finance Officer is the lead responsible officer for the Administrating Authority’s

management and administration of pension provision. The Head of Investments & Treasury

Management has overall responsibility for Service Delivery. The Section is not split strictly

along Service lines, but has two distinct functions:

Investment Management which comprises those officers with investment

management authorisation:

Head of Investments

Fund Manager

Investment Managers (x3 WTEs)

Treasury Manager

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Chief Finance Officer

Head of Investments

Fund Manager

Investment Managers (x3

WTEs)

Investment Support Officer

Treasury Manager

Administration Manager

Senior Administration

Assistant

Admin Assistants (x4 WTEs)



Treasury Management which comprises those officers with money market dealing

authorisation and also deals with leasing:

Head of Investments

Treasury Manager



Senior Administration Assistant

Administration Assistants

Both these functions are supported by:

Administration which deals with all administrative functions for the Section and

comprises:

Head of Investments


Senior Administration Assistant

Administration Assistants (x4 WTEs)

The Management Agreement requires that those officers with investment management

authorisation acquire the Investment Management Certificate unless they have achieved

equivalent qualifications. The Agreement also requires that those officers carry out relevant

professional training per year. Costs relating to investment management training and

required qualifications are a management expense of the Fund.

Officers will also have skills and qualifications outside the investment management arena,

but which will be relevant to their ability to perform. These form the “Skills Base” of the

Section, which can be set out as follows:

Officer & Fund Management Experience

Investment Management Qualifications

Other Professional Qualifications

Paul Campbell

16 years

IMC CIMA

AAT

Investment Management Team

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Officer & Fund Management Experience

Investment Management Qualifications

Other Professional Qualifications

Andy Hill (Equities & Bonds)

26 years

IMC BSc

AAT

Wendy Brown (Equities)

7 years

IMC AAT

Kelly Rose (Equities)

2 years

IMC CIPFA

AAT

Sue Smithyman (Equities)

New starter

AAT

Graham Jones (Bonds & Cash)

19 years

IMC AAT

Administration Team

Rachel Walker

23 years

IAQ MBA

Diploma in Mgmt. Studies

Clare Gettings

19 years

Amy O’Donnell

7 years

Certificate in Mgmt. Studies

Helen Jefferson

13 years

Jade Hooker

1 year

Amanda Trattles-Johnson

New starter

Gemma Wilson

New starter

The majority of the Fund (over £2 billion) is currently managed by three equity managers

with combined experience of 35 years, almost 12 years each, and who manage an average of

approximately £700 million of assets each. Whilst the average amount of assets managed

looks too large, the new starter will eventually gain the required qualification and

experience, alleviating this issue. However, the Fund is still vulnerable whenever key officers

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depart. Currently, just less than 95% of the combined experience in equity management

rests with 2 officers (Andy Hill & Wendy Brown) and 74% with 1 officer (Andy Hill).

A recent reduction of experience came about after two experienced officers left the team of

equity managers in the past three years; one to promotion and the other left the Authority.

These departures came at the same time as the equity markets experienced high volatility.

There is a similar issue in the Administration team after an officer with over 20 years of

experience, who was responsible for a number of key tasks, recently left. This left a big gap

in a small team with the remaining staff members completing the duties of the officer who

left whilst training the replacement officer.

In both the Investment Management and Administration team, there are no ready-made

replacements.

The investment management function is supported by information systems currently

supplied by Bloomberg. System costs are identified in the Management Expenses Budget

(Appendix A2).

Costs relating to the management of the Fund are charged to the Fund as Management

Expenses. These comprise staff costs and other costs. The Management Expenses Budget

for 2015/16 is attached (Appendix A2). The Budget covers both the investment

management function and the supporting administration required for this function. The

Budget will vary depending upon how the Service was delivered (e.g. internally or externally

managed).

Over the last ten years the Fund has more than trebled in terms of assets under

management, the number of transactions has increased significantly, and the Fund invests in

more equity markets than ever before. Overall, the size, scope and nature of the Fund has

changed greatly.

Since the previous review of management arrangements (2007), and after agreement from

the Investment Panel, the resources increased as follows:

1 Investment Manager

1 Administration Assistant

1 Senior Administration Assistant

1 Investment Support Officer

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Each year, a Business Plan is presented to Members of the Investment Panel for

consideration and approval. Within this Plan, the Fund’s Performance Targets are set out

(Section 11). The Performance Targets are:

Annual audit report showing compliance with the terms of the Management

Agreement and no other significant issues.

Performance better than the return for the Customised Benchmark, as set out in the

Asset/Liability Study, for:

The latest financial year

The last three financial years (rolling)

The last ten financial years (rolling)

Above median performance as measured against the WM All Funds & WM Local

Authority universes for the past one, three & ten years (rolling).

Investment management costs, as measured on a £ per scheme member basis, 25%

lower than the average local authority fund.

D. Partners

The Fund has a number of “partners”, internal and external, involved in the delivery of the

Service:

The Investment Advisors are responsible to the Investment Panel for:

Advising the Panel on the most appropriate short term asset allocation for

the Fund, given the up-to-date economic and financial market conditions at

each meeting

To recommend to the panel the appropriate investment management

structure for the Fund

Advising the Panel on the most appropriate long term asset allocation for the

Fund as part of the Asset/Liability Study

Advising the Panel in the preparation and review of the Statement of

Investment Principles

Advising the Panel in their regular monitoring of the performance of the

Investment Managers

Advising the Chief Finance Officer on matters relating to the strategic

direction of the Fund

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The Fund’s Custodian, who is responsible to the Investment Panel for:

Ensuring that the Fund’s assets are secure and that the Fund is able in a

timely fashion to meet its contractual obligations

Providing the Investment Panel with quarterly valuations of the Fund’s Assets

Collecting all income due to the Fund

Carrying out instructions received from the Head of Investments & Treasury

Management in respect of voting actions.

The Fund’s Actuary, who is responsible for:

Advising the Investment Panel on the most appropriate long-term asset

allocation for the Fund as part of the Asset/Liability Study

Determining the Employer’s contribution rate as part of the triennial

valuation

The Local Authority Pension Fund Forum (LAPFF) which is a group of Local Authority

Pension Funds who share a common belief that active engagement with companies

in which they invest will improve standards of Corporate Responsibility and

performance.

Mouchel, the Council’s Strategic Partner, and in particular the Pensions

Administration Section which works with the Loans and Investments Section on

issues of common interest.

The Loans & Investments Section is part of the Finance and Investments Service Area.

Because of the specialist nature of the investment management function, interaction and

interface on investment matters with the rest of the Finance & Investments Service and,

indeed, the rest of the Council is limited.

The Section uses the accounting system (currently SAP, but changing to Agresso)

The Section uses the services of the VAT Accountant for VAT-related issues,

particularly with property purchases and sales

The Section uses the services of the Fund Accountant employed within the Central &

Pensions Team of Council’s Finance & Investments Service Area

There is interface with Mouchel’s Pensions Administration Section on a number of

issues which are “corporate” to the Pension Fund:

Dealing with the Fund Actuary on matters pertaining to the Fund Triennial

Valuation

Servicing the Investment Panel

Preparation and publication of material informing scheme members.

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E. Customers

There are a number of users, or Customers of the Service:

The Investment Panel, the Members of which act as Trustees of the Fund, is a

principle customer. The Members are fulfilling a legal obligation in managing the

assets of the Fund and chose to do so via existing arrangements. The Management

Agreement and the Rules of Conduct, which the Agreement contains, is effectively a

contract between the Investment Panel and officers. All business conducted in the

name of the Fund and other matters, relating to the Fund are reported to the

Investment Panel for decision or information. The Investment Panel includes

representatives from the other Employers belonging to the Fund.

The Fund’s Employers make contributions at a rate determined as part of the

Actuary’s Triennial Valuation. The investment returns are a key part in the Funding

Level and determining the contribution rate set

Members of the Scheme, such as active members and pensioners, are also

customers. Although the levels of contributions and benefits are currently not

affected by the actions of the investment managers, members should be made aware

of the activities undertaken on the Fund’s behalf. Trade Union representatives are

invited to attend the Investment Panel as observers.

Local taxpayers are also customers, as the level of Council Tax varies over time as the

employer’s contribution rate is adjusted by the Fund’s Actuary.

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4. CHALLENGE

“Challenge what the Fund is trying to achieve and consider the possible routes for Service

provision”

Rationale for the Service

Why do we provide the Service?

There is a statutory obligation on Middlesbrough Council to invest monies not immediately

required to pay benefits. Middlesbrough Council is the Administering Authority appointed by the

Secretary of State to run the Fund.

What visions might there be for the future of this Service?

The Local Government Pension Scheme (LGPS) is currently under scrutiny on a number of matters.

LGPS 2014 was introduced on 1 April 2014 with changes to scheme members’ contribution rates

and benefits. Changes are imminent on the governance arrangements, as a result of the Public

Pension Services Act 2013 for both the Scheme as a whole, and individual Funds with the

introduction of the national Scheme Advisory Board and local Pension Boards.

The management arrangements for all LGPS Funds, and particularly the investment management

fees paid, is currently subject to a national consultation, with no outcome at the time of writing

this report. Fund management fees have increased across the Scheme as a whole recently,

without improvements in both investment returns and funding levels. Possible solutions, which

would all have direct consequences for the Fund, that have been put forward over the past few

years to resolve this are:

The creation of large “Super-pools” to manage the investments of individual Funds in five

large geographical areas

The creation of a national Administering Authority to administer all Schemes

The creation of compulsory Collective Investment Vehicles (CIVs), managed on a passive

basis, with all Funds investing in the CIVs.

It is also possible that the Statutory nature of the LGPS could be either abolished or discretion

given to Administering Authorities to opt out in part or in total. This could lead to the

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establishment of “Money Purchase” schemes although a Fund would still need to be maintained

for existing members and beneficiaries.

Does the Service meet or exceed minimum mandatory requirements?

There are no minimum mandatory requirements relating specifically to investment management.

The Audit Commission carry out annual audits and any failure to meet appropriate standards

would be reported.

What is the rationale for continuing to provide the Service at the current level of activity?

The Fund is managed in such a way as to maximise returns commensurate with the level of risk

deemed appropriate by the Investment Panel. On that basis there is no “level of activity” which is

appropriate.

Provision of the Service

Could/should the service be delivered differently?

The current method of Service delivery is the subject of this review. The management of the Fund

could be delivered in a number of different ways. The alternatives are set out under

ALTERNATIVES and the recommendations are contained in FINDINGS & RECOMMENDATIONS.

What examples are there from other Local Authorities, the private sector and other

organisations of different ways of delivering and organising the Service?

Information relating to the way in which other funds, both private and public sector deliver the

Service is readily available. The WM Company provide information for most LGPS and private

sector funds. Recently, with a “spotlight” on LGPS investment management, there have been a

number of report published, including Hymans Robertson’s LGPS Structure Analysis (2013),

requested by the Department for Communities and Local Government to consider different

options for LGPS structural reform.

Can we integrate with other agencies / services to provide the best service to the public and

other identified customers?

The responsibility for Service Provision must rest with the Administering Authority. How it delivers

that Service is the purpose of this Review.

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Performance

How do we measure the benefit of the Service?

The measurement of performance is covered in PERFORMANCE. Middlesbrough Council benefits

from delivering the Service in the current way in a number of ways:

The performance record of the Fund, coupled with the low cost of Service delivery, reduces

the impact on the Revenue Budget and releases resources to frontline Services.

The status of Middlesbrough Council and Middlesbrough as a financial centre is enhanced

as one of only 89 Administering Authorities in England; many of the others are much

larger Authorities.

The Loans & Investment Section and the professional staff managing the Fund provide a

skills base which is unusual in a Local Authority Finance Department and which has

contributed to the effective delivery of the more general Finance function in many ways.

How could costs be reduced most effectively?

As will be covered in COSTS, costs associated with the current method of Service delivery are very

low compared with other Local Authorities. Cost reduction possibilities are always being sought.

Where is performance currently weakest and strongest?

These will be considered in PERFORMANCE.

How can performance be improved?

This will be considered in FINDINGS & RECOMMENDATIONS.

External Change

Are there likely to be changes to the population of users or potential users of the Service over

the next five years and how would this affect Service provision?

Recently there has been considerable change in the profile of Scheme members in the Fund. The

trend in mortality is for Scheme members living longer, and therefore drawing pensions for longer.

There have also been significant changes to active member numbers with reductions in the

workforce numbers for the four local authority employers in the Fund.

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There have also been changes to the employee contributions rates and benefits for Scheme

members. On the horizon in 2017, the new “Cap and Share” scheme is proposed, where if the

collective employer rate calculated for the LGPS as a whole is over 14.6% consideration will be

given by the Department of Communities & Local Government to changing employee contribution

rate and/or scheme member’s benefits.

In what ways could new technology be used to improve the delivery or organisation of the

Service?

Changes in technology have seen significant changes in both the investment management

function and the administration support for this function. Market and stock analysis and research

improved significantly over ten years ago with the introduction of the Bloomberg systems. The

functionality of this system continues to improve, particularly with portfolio analysis and a trading

facility allowing the Investment Managers greater trading flexibility.

The administration team has used technology to improve efficiency, introduce more automated

calculations to improve accuracy and improved the checking and reconciliation systems required

to ensure accurate accounting records. A feasibility study is planned to investigate whether

further technological developments can facilitate efficiencies and improvements with settlements,

e.g. straight through processing.

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5. COSTS

“Consider the costs of current service provisions in comparison with alternatives”

Costs associated with the Investment Management function are, directly or indirectly, charged to

the Fund and not to Middlesbrough Council. Any evaluation of the way in which the Investment

Management function is carried out must consider the cost effectiveness of the current

arrangements.

An analysis of those costs must take into account the following types of cost and how each are

charged:

CENTRAL COSTS RECHARGED. These are costs associated with staff, accommodation and

sundry other business-related expenses which are met by Middlesbrough Council and then

recharged, in full, to the Fund.

MANAGEMENT EXPENSES. These are costs associated with the management of the Fund;

Custodian and other professional fees, Investment Panel expenses, training costs. Such

costs are charged directly to the Fund. The Management Expenses Budget which includes

Central Recharges is attached (Appendix A2).

The budgeted totals relating to these costs for 2014/15 are:

£

Central Costs Recharged 542,000

Management Expenses 646,000

Total 1,188,000

Central Recharges and Management Expenses which are charged to the Fund are identified as

Investment Management Expenses in the information supplied in the SF3 (Superannuation Fund –

Form 3 Return) submission to the Department of Communities and Local Government. The SF3

submission is used to compare investment costs with other LGPS Funds.

These are two ways in which Management Expenses can be expressed, in order for meaningful

comparisons to be possible:

£ per scheme member (PSM)

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This is simply the total Investment Management Expenses divided by the number of Scheme

Members, defined as active members, deferred members and pensioners. This is the

comparator used as a performance target as it allows straightforward comparisons to be

made with other LGPS funds.

A PSM approach benefits from being easy to understand but flatters those funds which are

attracting new members. An influx of new members makes no difference to the investment

management of the Fund, other than increasing cash flow which, in another context, could

be seen as beneficial, but does reduce the PSM number.

Assets Under Management (AUM)

This is simply the total Investment Management Expenses expressed as a percentage of fund

value. A basis point (bp) is one hundredth of 1%. So a fund valued at £500 million which had

management expenses of £600,000 would express its costs as 12bps. Again this concept is

easy to understand and has the benefit that, when fund values change, some expenses, such

as custodian fees also change on a pro rata basis. The concept is flawed if comparisons are

made between funds of considerably different sizes, as many of the core expenses are

broadly similar.

TEESSIDE FUND COSTS

On a PSM basis the costs for 2013/14 for the Fund were £16.81. This compares with the average for

all LGPS funds for England and Wales of £99.92. If the Teesside Fund’s costs were at the national

average level, this would cost an additional £5.5 million per annum.

Although, as previously stated, there are flaws in this methodology the numbers do paint a picture

which is broadly accurate. Since the previous review of investment management arrangements, the

average PSM has more than doubled, whereas the Teesside Fund’s cost has increased by £3 PSM

(22.5%). The reasons for the rise in the Fund’s cost PSM are:

An increase in staff numbers

Property management costs were deducted against rent income received at the time of the

previous review but, from 2011 with a change of Property Manager, are charged directly to

management expenses, providing greater transparency.

On an AUM basis, and based on the 2013/14 Report and Accounts, investment management

expenses were £1,118,000 and Fund value was £3.05 billion, equating to AUM of 3.7bps. For

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comparison purposes, a recent report by East Riding Pension Fund, assisted by the WM Company, “A

Critical Analysis of Investment Performance, Costs and Management Arrangements” calculated the

national average for all LGPS Funds to be 23bps. If the Teesside Fund’s costs were at this national

average, this would cost an additional £5.8 million per annum.

To provide a further comparison the table below shows the Teesside Fund’s 2013/14 costs against

the other LGPS funds that are internally managed, as defined in the East Riding report:

Pension Fund Assets Under Management

No. of Scheme Members

Inv. Mgmt. Expenses £’000

Cost of AUM

Cost PSM

Derbyshire Pension Fund

£3.32 bn 86,880 £5,381 16.2 bps £61.94

East Riding Pension Fund

£3.32 bn 98,501 £2,968 8.9 bps £30.13

South Yorkshire Pension Authority

£5.55 bn 138,441 £2,102 3.8 bps £15.18

Teesside Pension Fund

£3.05 bn 66,526 £1,118 3.7 bps £16.81

West Yorkshire Pension Fund

£10.37 bn 255,313 £2,297 2.2 bps £9.00

Data taken from each Fund’s 2013/14 Annual Report & Accounts

On both measures of costs, the Teesside Fund compare well with the other internally managed

funds of similar size (Derbyshire & East Riding), is on a par with the much larger South Yorkshire

Pension Authority but costs more than the West Yorkshire Pension Fund, however West Yorkshire

benefits from its greater size. On a measure of pure costs, the Teesside Fund is about half the cost

of West & South Yorkshire, both of whom are internally managed. Both Derbyshire and East Riding

have part of their portfolios, less than 25%, invested with external managers, hence the higher cost.

An additional cost of investment management related to the transaction costs (i.e. broker

commission, stamp duty, etc.). The costs of each purchase and sale are capitalised and not charged

to management expenses. The common expression for measuring transaction activity is fund

turnover. This describes the amount by value of purchases and sales expressed as a percentage of

the fund’s total value.

The 2013 WM Company Report “Lessons from Internally Managed Funds” states that the average

internally managed fund turns over a quarter of its UK equity portfolio each year, i.e. it sells an

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eighth of its portfolio by value every year and buys back a different eighth. The All Fund Universe

average turnover is 46% while for the financial year 2013/14, the Teesside Fund turned over 13.8%

of its UK equity portfolio. At a whole fund level, the Teesside Fund turned over 21.6% for 2013/14

with a total cost of transactions of £1.7 million, as reported in the Report & Accounts. The WM

Company claimed in their report that the substantially lower turnover reflects internally managed

funds’ longer term approach to investments.

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6. ALTERNATIVES

“To consider alternative methods of service provision”

The Teesside Pension Fund uses a series of managers, both internal and external, to manage the

Fund. It is irrelevant whether those managers are employees of Middlesbrough Council or of an

external service provider. This allows the freedom of choosing the most appropriate management

arrangements without changing the basic ethos of the Fund.

THE ALTERNATIVES:

Internal v. External

Although thought of as an internally managed fund, the Teesside Fund in practice utilises both

internal and external management. The use of pooled investment vehicles, of varying type, to cover

specialist areas from Japanese smaller companies and European property to AIM stocks is well

established. According to the latest Annual Report & Accounts for 2013/14, pooled investment

vehicles made up 11.6% of the Fund by value.

The choice therefore is between the current arrangements and an extension of external

management to cover more, or the entire Fund. Any significant external appointment would have to

go through the due process including formal tendering.

When assessing the rationale for external management appointments the following main areas are

considered:

1. Performance – The 2013 WM Company Report “Lessons from Internally Managed Funds”

shows performance up to end 2011 and before fees are deducted. The results show

internally managed funds in the LGPS have outperformed at the whole fund level, and in

four asset class groups:

5 Yrs. 10 Yrs. 20 Yrs. 25 Yrs.

Whole Fund:

Internal 3.7% 6.2% 8.6% 8.9%

All Funds 3.5% 5.9% 8.3% 8.6%

Relative 0.2% 0.3% 0.3% 0.3%

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5 Yrs. 10 Yrs. 20 Yrs. 25 Yrs.

UK Equities:

Internal 1.4% 4.9% 8.4% 9.1%

All Funds 1.1% 4.8% 8.1% 8.9%

Relative 0.3% 0.1% 0.3% 0.2%

Overseas Equities:

Internal 2.4% 5.3% 7.8% 7.4%

All Funds 2.4% 5.0% 7.6% 7.0%

Relative 0.0% 0.3% 0.2% 0.4%

Property:

Internal (1.6%) 6.7% 8.1% 8.5%

All Funds (2.1%) 6.4% 8.1% 8.5%

Relative 0.5% 0.2% 0.0% 0.0%

Alternatives:

Internal 6.3% 7.0% N/A N/A

All Funds 4.6% 6.1% N/A N/A

Relative 1.6% 0.8% N/A N/A

2. Costs – As can be seen in COSTS there is evidence to support the view that internal

management costs are lower, both explicitly as measured by fees and charges and implicitly

by way of transaction costs and activity levels. Full external management of the Teesside

Fund would increase the cost of managing the Fund significantly. By applying the average

LGPS cost, the cost of AUM would increase by 20bps or £5.8 million p.a.

3. Staff (Key Man Risk & Succession Planning) – Internally managed funds are relatively small

in terms of the number of employees. The key man risk when a member of staff departs is a

recent issue at the Teesside Fund. Large parts of the whole fund are managed by few

Investment Managers. When an Investment Manager departs, this creates a large gap which

needs to be covered by the remaining team of Managers, obviously stretching the team.

The key man risks that occur in the Investment Management team also occur in the

Administration team with key knowledge held by a few members of the team.

4. Staff (Recruitment & Retention) – Investment management is a specialised area requiring

suitably qualified and experienced staff. It is difficult to recruit and retain appropriate staff,

particularly in this region which does not benefit from an existing comparable private sector.

Previous practice for investment management has been to recruit trainees. It would be

24


difficult at current pay levels to attract and recruit fully qualified, experienced Investment

Managers.

5. Increasing complexity – In recent years both asset allocation and governance arrangements

have become wider ranging and more complex requiring internally managed funds to be

better resourced to cope with this increased complexity. The impact of more complex asset

allocation and governance is seen across the whole Section, both the Investment

Management and Administration teams. Two areas that are impacting the Fund are

compliance with stock market regulations and increasingly complicated tax laws.

The current trend by pension funds is to “insource” more investment management. As reported in

the Financial Times (15 February 2015), a State Street survey (Pension Funds: DIY) revealed

insourcing has become a strategy for pension funds to reduce costs and retain tighter control of risk

and performance across their portfolios. The survey also revealed that the pension funds surveyed

spend, on average, 46 basis points on external management fees compared to 8 basis points for

internal management.

Active v. Passive

Active management is the use of a human element, such as a single manager, co-managers or a

team of managers, to actively manage a fund's portfolio. Active managers rely on analytical

research, forecasts, and their own judgment and experience in making investment decisions on what

securities to buy, hold and sell. Investors who believe in active management do not follow the

efficient market hypothesis. They believe it is possible to profit from the stock market through any

number of strategies that aim to identify mispriced securities.

Passive management is the opposite of active management. Followers of passive management

believe in the efficient market hypothesis. It states that at all times markets incorporate and reflect

all information, rendering individual stock picking futile. As a result, the best investment strategy is

to invest in an index based on a weighting of the market size of the companies in that index.

One alternative to passive index-based passive investing is to follow a “smart beta” investment

strategy. Smart beta strategies are a lower-cost, rules-based form of active management that seek

better risk-adjusted returns than a market capitalisation-based index, and are seen as a halfway

house between active and passive management.

The Teesside Fund is mostly managed on an active basis, with very little exposure to passive, index-

tracking managed funds. Across the fund management industry, there is a growing trend towards

25


passive management, with active manager risk being targeted in areas where there is greatest

conviction that it will add value. Where such conviction is absent, the risk of deviation from the

benchmark is being eliminated by the use of index managers.

The argument of active versus passive is currently high profile and subject to a DCLG consultation,

which at the time of writing this report has not concluded. This consultation came about after the

investment management costs across the LGPS as a whole have increased significantly, without any

improvement in the Scheme’s overall funding level. Hymans Robertson was commissioned to

produce a report on the potential savings from wider use of passive funds, and this report (LGPS

Structure Analysis) was published in March 2014. Hymans Robertson’s findings were based on

potential savings for the LGPS as a whole.

Passive management generally reduces costs and takes away the risk of underperformance against

the benchmark index. However, for the Teesside Fund, the fees for passive management are still

above the Teesside Fund’s current costs, and there would be a cost to transitioning the Fund’s assets

to the new arrangement. Also, the opportunity for outperformance is taken away and it may be

necessary to invest in companies “one would not wish to invest in” simply for tracking purposes.

26


7. PERFORMANCE

“To evaluate the performance of the Fund”

The Fund subscribes to the comparative performance service provided by the WM Company. This

allows performance of the Fund to be measured against its Customised Benchmark and against

other funds, as follows:

The Customised Benchmark is an asset mix designed to meet the long-term liabilities of the

Fund and is agreed every three years by the Investment Panel as part of the Asset/Liability

Study carried out after the Actuary’s Triennial Valuation. In practice, this measures

performance against each benchmark index and measures the short-term asset allocation

decisions against the long-term asset allocations in the Customised Benchmark.

The “All Funds” Universe which compares Fund performance on a calendar year basis with

over 1,000 other funds, both private and public sector. It also provides a percentile ranking

for the Fund as a whole compared to other funds and for each asset class.

The “Local Authority” Universe which compares Fund performance on a financial year basis

with the other Local Authority funds totalling around £180 billion in value. It also provides a

percentile ranking for the Fund as a whole compared to other Local Authority funds and for

each asset class.

The Investment Panel receives an annual report on performance against the Customised Benchmark

and the All Funds Universe. The Fund’s Annual Report & Accounts reports performance measured

against the Local Authority Universe.

When considering the performance there are two principal questions to ask:

At the Total Fund level, are the Trustees able to satisfy themselves that the investment

management arrangements in place have delivered performance sufficient to enable them

to consider their fiduciary duties fulfilled?

Do results at the Sector level demonstrate that acceptable management arrangements are

in place?

27


EVALUATION OF PERFROMANCE 2004 – 2013

Total Fund Level

For the purpose of this report, performance against the WM All Funds Universe to the end of 2013

will be reported. This is consistent with the last report to the Investment Panel in June 2014.

The most important measure of performance of the Fund is over the long term. The Fund’s

investments are managed with a long-term view. On this basis, the Fund’s performance over 10

years compares well against both the Customised Benchmark and other Funds. The Fund also

compares well over 20 years too, with an annualised return of 7.6% and a percentile ranking of 24.

More recently, performance has not met the required benchmarks for two out the last three years.

This coincides with a period of high volatility in the equity, bond and currency markets following

central banks’ policies of quantitative easing, i.e. a monetary policy in which a central bank

purchases government securities or other securities from the market in order to lower interest rates

and increase the money supply in order to provide financial institutions with capital in an effort to

promote increased lending and liquidity. The Fund’s performance year-on-year against the

Customised Benchmark and the All Funds Universe are stated below:

Relative Performance v. Customised Benchmark:

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 3yrs 10yrsFund 11.1 20.3 11.8 10.3 -17.3 21.8 14.7 -4.2 10.2 12.5 5.9 8.5B’mark 10.6 19.5 10.2 6.2 -16.7 16.9 14.0 -.03 9.6 16.4 8.1 8.1Rel Pfmce 0.4 0.6 1.5 3.9 -0.7 4.1 0.6 -3.9 0.6 -3.3 -2.0 0.4

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 3 yr 10 yr

-5

-4

-3

-2

-1

0

1

2

3

4

5

Relative Performance v Benchmark

28


WM Company – Teesside Pension Fund Annual Performance Review 2013

Relative Performance v. WM All Funds:2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 3yrs 10yrs

Fund 11.1 20.3 11.8 10.3 -17.3 21.8 14.7 -4.2 10.2 12.5 5.9 8.5WM 11.2 20.1 10.5 7.0 -17.2 15.1 12.7 3.6 8.4 11.0 7.6 7.8Rel Pfmce -0.1 0.1 1.2 3.0 -0.1 5.8 1.8 -7.6 1.7 1.4 -1.6 0.7% Rnkg (40) (42) (21) (4) (46) (12) (15) (95) (38) (53) (93) (18)


The measure of performance, the rate of return, can be broken down into its two components; stock

selection and asset allocation. Stock selection refers to the investment manager’s ability to select

investments which will outperform other investments. Asset allocation refers to decisions on the

asset mix of the Fund. These are driven by Investment Advisors’ recommendations on which asset

class to overweight or underweight. The impact on overall performance of both stock selection and

asset allocation can be quantified as either a positive or negative figure, building up a picture

explaining performance against other funds and the benchmark.

It is difficult to explain the asset allocation in terms of responsibility since the investment

management team plays a significant role in market timing; an important aspect of asset allocation.

However, stock selection is the responsibility of the investment management team, and the WM

Company does report the annualised impact from stock selection. Over the past 10 years, the

investment team has impacted performance positively by adding 0.8% per annum to the 10 year

performance returns when measured against the Customised Benchmark. The performance split

between asset allocation and stock selection is shown below:

29


2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 3yrs 10yrsFund 11.1 20.3 11.8 10.3 -17.3 21.8 14.7 -4.2 10.2 12.5 5.9 8.5B’mark 10.6 19.5 10.2 6.2 -16.7 16.9 14.0 -.03 9.6 16.4 8.1 8.1Rel Pfmce 0.4 0.6 1.5 3.9 -0.7 4.1 0.6 -3.9 0.6 -3.3 -2.0 0.4Asset All. -0.5 -0.5 0.2 -0.4 1.3 -0.1 0.0 -3.2 -0.1 -1.1 -1.5 -0.4Stock Sel. 0.9 1.2 1.3 4.1 -1.9 4.0 0.7 -0.1 0.7 -2.2 -0.5 0.8

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 3 yr 10 yr

-4

-3

-2

-1

0

1

2

Asset Allocation

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 3 yr 10 yr

-3

-2

-1

0

1

2

3

4

5

Stock Selection


At the time of writing this report the full performance picture for 2014 is not known, but will be

reported to the Investment Panel in June 2015. However, for the first three quarters of 2014,

performance has followed the recent trend of underperformance for both asset allocation and stock

selection.

Asset Class Level

The Fund is split into two distinct parts, growth and protection assets. Growth assets are equities,

property and alternatives, while protection assets are bonds and cash. The Fund is currently

managed as follows:

30


1. Equities (10 yr. performance 9.7%/percentile ranking 17)

Most equities are managed by the internal investment management team with a very small

part invested in managed funds. This is the area of the Fund which has seen most expansion

since the previous review of investment management arrangements, particularly into far

eastern markets. Total equity investments now represent over 80% of the whole Fund.

2. Property (10 yr. performance 4.5%/percentile ranking 45)

Property assets are split between 78% invested in direct properties and 22% invested in

managed funds. Management of the direct properties is outsourced on a non-discretionary

basis to CBRE. There is also a small portfolio of managed funds (Property Unit Trusts &

Property Partnerships). Property is another asset class that has seen significant expansion

since the previous review, particularly in direct property.

3. Alternatives (10 yr. performance 2.3%/percentile ranking 70)

The asset class was a catch-all for assets which did not fit the other asset classes. In March

2010, a report was presented to the Investment Panel setting out the logic of alternative

investments; namely to provide investments which were uncorrelated to other markets

(equities & bonds) and provided a steady absolute return which matched closely to the

required actuarial return.

At the Teesside Fund, investments are made in infrastructure funds, commodity exchange-

tradable funds (i.e. funds which match the rise and fall of the underlying commodity price)

and other funds which offer absolute return strategies. The commodity ETFs are managed

internally, whereas the infrastructure and other funds are managed funds.

4. Bonds (10 yr. performance 4.4%/percentile ranking 96)

Bonds are managed internally, and are split into 3 component parts; UK Bonds, UK Indexed-

Linked Bonds and Overseas Bonds. Bonds form the foundation of the protection assets for

the Fund and, as such, a risk-averse investment strategy is taken with Bonds, particularly

when compared to other funds who invest in riskier assets (e.g. emerging market debt,

structured credit, etc.). It should also be noted that this asset class has shrunk as a

31


proportion of the whole Fund since the previous review, and now only represents approx.

6% of the Fund.

5. Cash (10 yr. performance 3.0%/percentile ranking 36)

Cash is managed internally with investments in a select few counterparties which are

disclosed at each Investment Panel meeting in the Treasury Management report. Cash is

classed as a protection asset, but over the past few years has been allowed to grow and then

deployed into the equity markets, in particular, when opportunities arose.

32


8. FINDINGS & RECOMMENDATIONS

“To consider the strengths and weaknesses of the existing investment arrangements and to

recommend, where appropriate, changes designed to improve service delivery in terms of cost-

effectiveness and performance”

Over the past 10 years the size of the Fund has tripled and this expansion is replicated in the global

reach of the Fund’s investments, and the types of assets the Fund now invests in. In addition the

administration and compliance requirements for LGPS Funds have increased, and further changes in

governance and accounting requirements are imminent. Against these changes, the Fund has

strengthened its funding level, and is the only LGPS Fund which is currently fully funded.

In the past, the investment management arrangements have evolved in response to changing

circumstances and the need to meet new challenges. As a result of the last review of management

arrangements (2007) a staffing review was conducted and a subsequent report recommending

increasing the internal management team by one Investment Manager and one Administration

Officer was agreed. Agreement was also given to increasing the team again last year with the

addition of an Investment Support Officer.

These additional resources have assisted in managing the Fund; however this review is an

opportunity to appraise the investment management arrangements again with a view on preparing

the Fund for the next five years. Note, this review does not prevent changes in investment

management arrangements being implemented at any time when it is in the best interests of the

Fund.

FINDINGS

1. In terms of costs, the current management arrangements are successful and it would be

extremely difficult to find a more cost effective method of delivering investment

management.

2. In terms of performance, long term performance is above the required benchmark level.

Over the past few years, performance has been more difficult, but this is set against more

volatile markets, staff departures and integration with a new custodian.

33


3. The approach to asset allocation in particular and advice given to the Investment Panel has

been beneficial to performance and increased the funding level for the Fund, currently

100%.

4. There are, however, issues that need to be addressed in order for the Fund to continue and

strengthen:

Key Man Risk & Succession Planning

Recruitment & Retention

Increasing LGPS/Fund Complexity

Increasing budgetary constraints within local authorities

5. There is anecdotal evidence that salary levels in other LGPS in-house managed funds have

increased significantly over recent years. This makes recruitment and retention difficult and

significantly increases the risk that the Fund will be able to maintain the high standards

which it has set.

6. The LGPS is undergoing significant change and it is clear that some funds are developing

different methods of service delivery which best meet their individual needs rather than

wait for Government proposals which would not be individually tailored. Recently

Lancashire County Council has announced that it is to spin off control over its Pension Fund

to a separate entity in a move which will give it more freedom.

7. There is the potential for diversifying the Fund into new business and investment

opportunities. These may include:

Securities Lending – many local authority funds are now involved in stock lending. A

quote from the Fund’s custodian, BNP Paribas Securities Services, estimates income of

£650,000 per annum. However, it should be noted that this estimate is based on the

assumptions that the maximum allowable amount of stock is loaned out (35% of the

Fund), there is no call back of shares to vote on all shares owned, and the collateral is

low risk and set at 105% of assets loaned.

Foreign Currency Management – the current system for buying or selling foreign

currency to match settlements is automated through the Fund’s custodian, and

operationally works well. The exchange price is based on a small margin over the

spread of the widely recognised benchmark, WM Reuters 4PM fix-rate.

However, there are new trading platforms allowing buyers & sellers to cross

transactions without a spread and/or at smaller commission rates, both of which have

the potential to save on transaction costs. The current arrangements need to be

34


reviewed ahead of the next custodian tender and the suitability of these alternatives

investigated.

Corporate Governance – the Fund’s current arrangements is to vote at shareholder

meeting for UK company meetings and liaise with LAPFF where appropriate. However,

many other local authority funds have extended their voting to global company

meetings.

Straight Through Processing – the current system for settlements has a very high

success rate of settlement first time and on time. However, there have been

developments recently which could automate the process and allow trades to settle

without input and checking procedures in the Administration team.

New Investment Asset Classes – the Fund constantly reviews new investment

opportunities to add value to the existing assets owned. This could be greater

investment in infrastructure or investments into new asset classes, such as derivatives.

RECOMMENDATIONS

1. Continue with the current balanced style of investment management, based on an active

management style with selective use of passive management at the discretion of the Head

of Investments and Treasury Management.

2. The Fund remains committed to internal management, with use of managed funds at the

discretion of the Head of Investments where required.

3. To strengthen the structure of the Loans & Investments Section and reduce the key man risk,

increase the staff numbers with the following additional staff, in line with the proposed new

structure (Appendix A3):

1x Investment Manager (Grade L – O)

1x Investment Officer (Grade to be determined)

1x Senior Administration Officer (Grade G)

1x Administration Assistant (Grade E)

The additional staff cost of the new, proposed structure will be approximately £140,000 per

annum. Also, there will be some additional accommodation and other costs of

approximately £60,000, taking the total budget increase to £200,000. The larger staff

resource will also increase the flexibility needed to cope with the increasing complexity of

asset allocation and governance. However, the appointment of additional staff will be as

soon as capacity in the Section allows for their introduction and training.

35


4. A benchmarking exercise is undertaken comparing the Teesside Fund against LGPS funds and

other pension funds to assess whether the current salary grades are correct or require a

market supplement.

5. Consideration should be given to establishing a separate body to manage the Teesside

Pension Fund, under the control of Middlesbrough Council as Administering Authority, in a

similar fashion to that which Lancashire County Council has set up.

6. Review all new areas of business and investment opportunities, as set out in FINDINGS,

which could add value to the Fund, whilst also ensuring the Fund has the skills and

capabilities required for these new opportunities and the increasingly complex investment

environment.

36

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