Contact: David Wilson, ext 7407

1 Introduction

1.1 At its meeting on 30 October 2001 the Panel considered a brief summary of the Government's ten recommended principles for the management of defined benefit schemes following the publication of the Myners report on institutional investment. In March 2002, the Government confirmed its intention to amend the LGPS regulations so that administering authorities would be required to state their compliance, or otherwise, with these principles in their Statements of Investment Principles (SIPs). The amendment is expected to take effect later this month, and authorities will be required to publish these details within three months.

1.2 This report sets out the extent to which the Hampshire Fund already complies with the ten principles. Each principle is set out in full in italics, followed by a commentary on the Fund's compliance. The Appendix sets out a new version of the SIP which includes a shorter summary of these details. This has also been amended to reflect the new targets for the managers agreed by the Panel at its meeting on 23 May this year.

1 Principle 1 - effective decision-making

1.1 Decisions should be taken only by persons or organisations with the skills, information and resources necessary to take them effectively. Where trustees elect to take investment decisions, they must have sufficient expertise and appropriate training to be able to evaluate critically any advice they take.

Trustees should ensure that they have sufficient in-house staff to support them in their investment responsibilities. Trustees should also be paid, unless there are specific reasons to the contrary.

It is good practice for trustee boards to have an investment subcommittee to provide the appropriate focus.

Trustees should assess whether they have the right set of skills, both individually and collectively, and the right structures and processes to carry out their role effectively. They should draw up a forward-looking business plan.

1.2 The Government has promised to produce non-statutory guidance on the levels of skill and care required for different types of decision but this is not yet available. Failure to meet the required standards could result in civil proceedings against trustee bodies or, possibly, individual trustees.

1.3 There all already a number of workshops and seminars available to Panel members on all pension fund investment matters.

1.4 Many of the detailed investment decisions are delegated to specialist fund managers.

1.5 Advice on asset allocation has been sought from the actuary, Hewitt Bacon & Woodrow, culminating in a new scheme specific benchmark and target for all three current main managers. Panel members are briefed on these and other issues by reports prepared by the County Treasurer.

1.6 The Government also suggests that trustees should be paid unless there are specific reasons to the contrary. At the moment there is no power for administering authorities to pay Panel members for their work on the Pension Fund, although councillors on the Panel do receive councillors' basic allowances in their role as members of the County Council.

1.7 The Government also recommends that trustees should draw up a forward-looking business plan. This could include:

· The overall investment objective.

· A policy for taking advice when necessary.

· A training plan for Panel members.

· Arrangements for reviewing the investment structure and asset allocation.

· Procedures and timing of management reviews.

1.8 Some of these matters have already dealt with in the Fund's SIP. However as yet there is no formal training plan and it may be necessary to carry out a learning needs analysis and develop appropriate training opportunities. Such a plan would imply that Panel members would need to take up opportunities for training. The Panel needs to consider whether a formal training plan should be drawn up. If not the reasons why will need to be incorporated in the SIP. It would also be appropriate in future to consider induction training for new members of the Panel, if only to explain and expand on the Statement of Investment Principles and the role and skills required of Panel members.

1.9 There is no written policy setting out the arrangements and timing of asset allocation and management reviews. Again, this is something which the Panel will need to consider although it is implicit in the mandates set and in the adoption of the scheme-specific benchmark. The policy could be included in the SIP. If not the reasons why will need to be incorporated in the SIP.

2 Principle 2 - clear objectives

2.1 Trustees should set out an overall investment objective for the fund that:

· represents their best judgement of what is necessary to meet the fund's liabilities given their understanding of the contributions likely to be received from employer(s) and employees; and

· takes account of their attitude to risk, specifically their willingness to accept underperformance due to market conditions.

Objectives for the overall fund should not be expressed in terms which have no relationship to the fund's liabilities, such as performance relative to other pension funds, or to a market index.

2.2 The Fund's overall objectives are set out in the SIP. They are to aim for a 100% funding level and stable employers' contribution rates, at around 200% of employees'. In this respect the Fund is in full compliance with this principle. The level of acceptance of risk is addressed in the targets set for the individual managers, and is implicit in the fact that the new scheme-specific benchmark has been set based on the 1999 asset/liability study.

3 Principle 3 - asset allocation

3.1 Strategic asset allocation decisions should receive a level of attention (and, where relevant, advisory or management fees) that fully reflect the contribution they can make towards achieving the fund's investment objective. Decision-makers should consider a full range of investment opportunities, not excluding from consideration any major asset class, including private equity. Asset allocation should reflect the fund's own characteristics, not the average allocation of other funds.

3.2 In 1999, Hewitt Bacon & Woodrow carried out an asset/liability study which provided a recommended overall asset allocation and this has been used in determining the new scheme-specific benchmarks and targets now in place for the managers. These benchmarks set out ranges by investment sector within which the three main managers must work, and targets they must aim for over three-year rolling periods.

3.3 A new asset/liability study will be commissioned in 2005 following the next actuarial valuation as at 31 March 2004. This will be used in reviewing the scheme-specific benchmark when the Fund's management arrangements are reviewed at the termination of the three main managers' contracts in December 2005.

3.4 The Panel periodically reviews its asset allocation as described in paragraph 4.2, and also reviews annually its property weighting. It also regularly reviews other asset classes, such as venture capital. The Panel is considering at items 11 and 12 of this agenda its future allocation to ethical and alternative investments.

4 Principle 4 - expert advice

4.1 Contracts for actuarial services and investment advice should be opened to separate competition. The fund should be prepared to pay sufficient fees for each service to attract a broad range of kinds of potential providers.

4.2 Hampshire's Fund has made relatively little use of consultants in recent years, relying mainly on in-house expertise. Expert advice has been sought when deemed necessary from Hewitt Bacon & Woodrow, for example the asset/liability study in 1999, assistance with the appointment of a second AVC provider, and advice on the role of property in the Fund.

4.3 So at present there is no separate competition for actuarial and investment advice. The case for paying more for possible benefits which are uncertain and unquantifiable remains unclear. The Panel may wish to retain its current policy. The reasons for non-compliance would need to be included in the SIP.

5 Principle 5 - clear mandates for the managers

5.1 Trustees should agree with both internal and external investment managers an explicit written mandate covering agreement between trustees and managers on:

· An objective, benchmark(s) and risk parameters that together with all the other mandates are coherent with the fund's aggregate objective and risk tolerances;

· The manager's approach in attempting to achieve the objective; and

· Clear timescale(s) of measurement and evaluation, such that the mandate will not be terminated before the expiry of the evaluation timescale for underperformance alone.

The mandate and trust deed and rules should not exclude the use of any set of financial instruments, without clear justification in the light of the specific circumstances of the fund.

Trustees, or those to whom they have delegated the task, should have a full understanding of the transaction-related costs they incur, including commissions. They should understand all the options open to them in respect of these costs, and should have an active strategy - whether through direct financial incentives or otherwise - for ensuring that these costs are properly controlled without jeopardising the fund's other objectives. Trustees should not without good reason permit soft commissions to be paid in respect of their fund's transactions.

5.2 The Fund's management mandates have always been specific on objectives and timescales, and are in the process of being amended to reflect the new targets. Risk, is covered by the differential of the target over the benchmarks and limits placed on underperformance in any twelve-month period.

5.3 Annual reports on transaction costs incurred by the Fund's managers are presented to the Panel. Schroders and Deutsche currently use soft commission, and details are reported to the Panel each year. It is suggested the County Treasurer contact both managers asking for further justification for their use of soft commission and further re-assurance that best execution is not compromised.

6 Principle 6 - voting rights and engagement

6.1 The mandate and trust deed should incorporate the principle of the US Department of Labor Interpretative Bulletin on activism. Trustees should also ensure that managers have an explicit strategy, elucidating the circumstances in which they will intervene in a company; the approach they will use in doing so; and how they measure the effectiveness of this strategy.

6.2 The Government intends to legislate to place a statutory duty on fund managers to use their voting powers to intervene in companies in the financial interests of shareholders and fund beneficiaries. This duty may also be placed on trustees, although this has not yet been finally decided.

6.3 The Fund's SIP makes no specific mention of the US Department of Labor Interpretative Bulletin, although it does cover most of the principles set out there. It delegates to the managers responsibility for voting at company meetings on the Fund's behalf following the principles of the combined code on corporate governance, in the belief that good corporate governance is an important factor in company success.

6.4 The SIP also places a responsibility on the managers to take social, environmental and ethical considerations into account when assessing the financial suitability of investments, and notes that all the managers have a positive policy of engagement with companies to ensure that they give these issues sufficient consideration.

6.5 However until now it has not placed any duty on the managers to intervene if companies are failing. The SIP has been amended to include this and the County Treasurer will write to them accordingly.

6.6 The Government intends that failure by managers and trustees to comply with this duty could leave them open to civil proceedings. What is less clear is how any breaches could be clearly identified, as there could be genuine reasons why managers and trustees could take different views on particular issues. This issue will need to be revisited when the Government legislates.

7 Principle 7 - appropriate benchmarks

7.1 Trustees should:

· explicitly consider, in consultation with their investment manager(s), whether the index benchmarks they have selected are appropriate; in particular, whether the construction of the index creates incentives to follow sub-optimal investment strategies;

· if setting limits on divergence from an index, ensure that they reflect the approximations involved in index construction and selection;

· consider explicitly for each asset class invested, whether active or passive management would be more appropriate given the efficiency, liquidity and level of transaction costs in the market concerned; and

· where they believe active management has the potential to achieve higher returns, set both targets and risk controls that reflect this, giving the managers the freedom to pursue genuinely active strategies.

7.2 The new benchmarks and targets approved at the last Panel meeting have been set in the light of the results of the 1999 asset/liability study, and agreed directly with the managers.

7.3 The Panel has taken the view that active management is better than passive or index-tracking, and that multi-asset rather than specialist managers are preferable. Alternatives are reviewed generally with each change in manager.

8 Principle 8 - performance assessment

8.1 Trustees should arrange for measurement of the performance of the fund and make formal assessment of their own procedures and decisions as trustees. They should also arrange for a formal assessment of performance and decision-making delegated to advisers and managers.

8.2 The Panel reviews the performance of its managers formally twice a year. Interim discussions take place between the managers and the County Treasurer.

8.3 With regard to trustees' own performance, the National Association of Pension Funds (NAPF) suggests that trustees should:

· Review the outcome of past decisions in hindsight.

· Assessing whether those decisions could be improved.

8.4 There is no formal system in place for reviewing the Panel's past decisions, although, to the extent that the managers' performance is itself reviewed, this reflects the quality of arrangements set up by the Panel. However, if managers perform poorly this does not necessarily mean that the Panel is at fault. They could still have made the best decision based on the evidence known at the time. Managers' actions over the last six months are reported to the Panel against their views and stated policies at the previous Panel meeting.

8.5 Recent decisions on cancelling Phillips & Drew's mandate in September 1998 were found to be timed well and performance was tracked over the next two years. The decision to terminate Morley's contract when taken over took account of a new trial period, with no evidence of improvement in performance, customer care or consistency of policy.

9 Principle 9 - transparency

9.1 A strengthened Statement of Investment Principles should set out:

· who is taking which decisions and why this structure has been selected;

· the fund's investment objective;

· the fund's planned asset allocation strategy, including projected investment returns on each asset class, and how the strategy has been arrived at;

· the mandates given to all advisers and managers; and

· the nature of the fee structures in place for all advisers and managers, and why this set of structures has been selected.

9.2 The decision-making structure for the Hampshire Fund is already covered in the Fund's current agreed SIP, as is the overall investment objective for the Fund. The new draft version of the SIP in the Appendix to this report gives details of the Fund's newly adopted asset allocation strategy and benchmarks. An indication of the structure of the managers' fees is given, but fee scales are confidential and not quantified.

10 Principle 10 - reporting

10.1 Trustees should publish their Statement of Investment Principles and the results of their monitoring of advisers and managers. They should send key information from these annually to members of these funds, including an explanation of why the fund has chosen to depart from any of these principles.

10.2 This is in line with the Hampshire Fund's current practice. The revised draft SIP in the Appendix includes such explanations where appropriate.

Recommendations

1 That the Panel note this report and the current extent to which the Fund complies with the Government's ten principles.

2 That the Panel consider the revised draft SIP set out in the Appendix and approve a final version for publication.

3 That a business plan, including a training plan, for the Fund be prepared for consideration by the Panel at its next meeting in November 2002.

4 That in future induction training be organised for any new members of the Panel.

5 That a new asset/liability study be commissioned from the actuary in 2005 following the completion of the next triennial actuarial valuation as at 31 March 2004, and that this be used to review the scheme-specific benchmark and the role of alternative investment classes.

6 That a report on transaction costs be prepared for consideration by the Panel at its next meeting in November 2002 and annually thereafter.

7 That the County Treasurer contact Deutsche and Schroders for justifications of their continued use of soft commission arrangements and re-assurance that best execution is not compromised and that a report be prepared for consideration by the Panel at its next meeting in November 2002.

8 That a report on fees paid to the managers be prepared for consideration by the Panel at its next meeting in November 2002.

Section 100 D - Local Government Act 1972 - background papers

The following documents disclose facts or matters on which this report, or an important part of it, is based and has been relied upon to a material extent in the preparation of this report.

NB the list excludes:

1. Published works.

2. Documents which disclose exempt or confidential information as defined in the Act.

None.

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Appendix