The failure of Icelandic banks shone a light on council’s investment policies as some local authorities lost money. Council spokespersons often responded; ‘we paid for this prestigious firm to advise us and they said.’ This is a key benefit of hiring expensive investment firms to provide advice. Decisions made after consulting prestigious financial firms are seen as more defensible if things go wrong. Big recognisable brands reassure customers. It is said that; ‘No one ever got fired for buying IBM.’
I make no judgement about the advisability of purchasing IBM. The company’s name is used merely for illustration; it could easily be Hewlett Packard or Apple, Barclays, or RBS, or any other big company with a recognised brand. The point is that when advised to make a big important decision such as investing the council’s reserves or pension fund assets it is helpful to have big brand support. If you then discover you invested in Icelandic banks, and this was not wise, council public relations can say we hired the experts. Blame is shared. No one individual need be fired.
Council pension funds require the investment of almost £140 billion. It is tempting to subcontract this responsibility to highly compensated and prestigious financial firms but there is a cheaper way. We could invest the majority of this money in index funds. These investments simply replicate a chosen index e.g. the FTSE 100. The chart below shows the returns on the FTSE 100 over the last seventy years. Regular investment in a tracker fund is a low cost means of accessing this growth.
An index fund replicates the index it tracks in two main ways. Physical replication means investing in the companies in the proportion they make up of the index. If BP is three per cent of the FTSE 100 then it will make up three per cent of every index fund unit purchased. Synthetic replication is where a company guarantees you the return of a given index and achieves this by agreements with other banks and holding a representative sample of assets.
Councils can control the amount they spend managing their pension funds. They cannot control the performance of the stock market. Investment firms have little incentive to advocate investment in passive index funds. Index funds charge very low management fees and this means lower profits for financial advisers. Vanguard, ishares, HSBC,Fidelity, Legal and General and many other providers have passive investment funds with annual charges around 0.5 per cent per annum. By buying an index councils do not need to choose individual companies to invest in. No need for large council teams to monitor investment. The volatility of investment portfolios could be reduced as councils will own a broader spread of assets.
Local authorities will still need some targeted advice on asset allocation. Councils need to know how much to allocate to cash deposits to cover payments to current retirees, the percentage of their funds that should be invested in fixed interest products, whether their pension fund reserves are sufficient to meet present and future obligations and if they should invest in a world index fund or allocate more to growth markets.
Councils do not need to invest in individual companies or pay excessive sums for active fund management. They can cheaply invest in all companies on a given index at a low cost.Indexing pension fund assets combined with targeted advice on asset allocation can achieve better returns in practice. Will any council pension fund accept this challenge?
We do not advocate investment in any particular fund and investments can of course go up as well as down so you invest at your own risk.
