Investing in alternatives – a local authority viewpoint
November, 2011 Print
Local authority pension funds face a dilemma when it comes to investing in alternative assets. On one hand, assets such as private equity, infrastructure, commodities and hedge funds, have some very attractive qualities for long-term investors. These include the fact they should offer diversification from listed equity and bond markets, the reassuringly real nature of the some of the assets concerned and the prospects of positive returns from either market performance or manager skill. In some cases, assets such as commodities or infrastructure can offer returns linked to inflation, which helps pension funds match their long-term liabilities.
But there are also reasons why alternative assets make up a relatively small proportion of the asset allocation of local authority pension funds. According to statistics from the Pension Funds Performance Guide quoted at the LAPF Strategic Investment Forum in February 2012 by BNY Mellon Asset Management head of asset allocation Jamie Lewin, the asset allocation to alternatives rose from 0.4% in 2002 to 4.9% in 2011, with 1.1% in hedge funds and 3.4% in private equity and smaller allocations to infrastructure and commodities, while property, which is sometimes classed as part of the alternatives bucket, had increased slightly from 5.6% in 2002 to 6.9% in 2011. Among the reasons why alternative assets are still a relatively small part of the overall allocation are: a lack of familiarity among trustees, perceptions that some or all of the underlying asset classes are risky, concerns over fees and, importantly for some, the illiquidity of some alternative assets.
The liquidity issue could become more important over the next few years. The age profile of the membership is a factor in investment strategies for defined benefit schemes; schemes with a youthful age profile can allocate more to riskier and less liquid assets, while schemes with an older membership tend to invest more in safer, more liquid assets. In this regard, the UK post-war baby boom generation is moving towards retirement, and the Hutton Report coupled with cuts to public spending could cause a sharp fall in the number of active members of the Local Government Pension Scheme (LGPS), due to redundancies and a higher optout rate. In turn, this will raise the age profile of schemes and could tip many from being cash flow positive to cash flow negative.
Warwickshire County Council, Group Manager, Treasury and Pensions, Phil Triggs said that the Warwickshire Fund has to take more account of short-term cash flows and liquidity in its investment approach. Commenting on the government’s Hutton related public sector pension plans, Triggs said the proposals were far better than first anticipated and he was hoping for a far less significant impact on active members opting out than initially feared. “We have seen the active membership drop, with many active members retiring early and becoming pensioners, and there have also been opt-outs from people who have lost faith in public sector pensions.” As a consequence, Triggs said that Warwickshire was delaying a decision on adding infrastructure to its asset allocation until it saw the full impact of the Hutton Report and its implementation play out.
Triggs’ comments show how one part of government policy, to reform public sector pensions, could have adverse consequences for another stated policy, to encourage greater investment in UK infrastructure by UK pension funds. However, it is likely to that many local authority pension funds will increase allocations to alternative assets, as part of a general move away from relying heavily on equities for growth and to diversify risk among a broader range of asset classes. As well as the investment case for alternatives, there is also a feeling that the eventual number of member opt-outs due to the upcoming change to public sector pensions might be not be as great as first feared.
For example, the increase in LGPS opt-outs, following the changes to the LGPS recommended by the Hutton Report, is not yet known, according to Mercer head of LGPS investment business Joanne Holden. Pointing out that every LGPS scheme is different, she urged schemes to think about the role that they expect each asset class to play in their investment strategy when considering the investment impact of changes to the LGPS. Kent County Council head of financial services, Nick Vickers, said: “The changes that were suggested last year in employee contributions would have been very challenging for those people. But I think we are moving to a solution without big contribution increases for the lower paid members – there are solutions that will keep people in the LGPS.”
Vickers said that his fund has, in the last 18 months, moved £150 million, split equally between HarbourVest for private equity fund of funds and Partners Group for an infrastructure fund of funds. He added: “And late last year, we appointed Pyrford International, a boutique fund manager, to a £150 million absolute returns mandate. The Pyrford mandate is for equities, fixed income and cash, so it is not exotic. £80 million of the mandate has now been funded by reducing our equity holdings.” Vickers explained that this is part of a longterm strategy for the Kent pension fund to reduce its 70% weighting to equities; 10% have now been moved in alternative assets and it also had 12% in property. “We are very comfortable with the managers we’ve appointed and what we are asking them to do; we are doing this in a very measured way.”
One of the features of some alternative assets such as private equity and infrastructure, is that an overall commitment is agreed, but it is then funded in stages as the allocation is put to work. So Vickers said that Kent has funded its private equity and infrastructure mandates through a mixture of its positive monthly cash flow of £5 million a month from contributions and money reallocated from other managers. Vickers commented: “We have dropped two active equity managers because their performance was disappointing, and given the funds to State Street for a passive equity mandate, split 50:50 between UK and global equities. This is partly a reaction to active manager underperformance and we also see it as a transitional arrangement, as it is a very liquid fund.”
Another interesting feature of Kent’s entry into alternative assets is the use of fund of funds managers. On one hand, a good fund of funds manager should be able to select and monitor the underlying managers used. Against this, there is likely to be an additional layer of fees, while larger investors often prefer to invest directly. Vickers said: “There was a strong recommendation from Hymans Robertson that we go this way. For some local authority funds, with the in-house investment expertise and experience, investing directly clearly makes a lot of sense. We are aware of the potential drawbacks of fund of funds, but it suits our way of working. When we did the selection process, we have a very strong field of managers who have fund selection skills that we cannot hope to have ourselves, and it gives us a nicely diversified approach. We think it is a really good starting point for us.”
While some alternatives, such as private equity and hedge funds, make use of market returns, albeit with manager skill as well, infrastructure could be an important asset in the future if economic growth is slow. Many governments are expected to look to greater outside investment in infrastructure. In the UK, Chancellor George Osborne recently announced a new National Infrastructure Plan, with the aim of encouraging pension funds to invest up to 70% of a £30 billion fund through private finance initiative (PFI) arrangements. However, one pension fund manager, who did not want to be named, said that the government might not offer sufficient returns to pension funds in the National Infrastructure Plan. In his view, this is because previous PFI contracts have been criticised for being too generous to PFI managers and investors, and a bad deal for taxpayers. Therefore civil servants are now erring too much on the side of caution. “They think that pension funds will be happy with a 3% return, but that’s not enough. We need a return more like 8% or 9% in return for making a longterm commitment and due to higher risks than, say, government bonds,” he commented.
If local authority pension funds do invest in alternatives such as infrastructure in the next 5 to 10 years, they might find that many private sector, occupational pension funds and insurance companies are restricted from doing so by regulations such as the proposed European Solvency II regime. This would restrict investment in certain assets, such as equities and alternatives, meaning there is more scope for other investors to agree favourable terms.
In conclusion, many local authority pension funds are now examining the case for alternative assets and finding it attractive. Cash flow issues and other obstacles, such as a need to educate trustees, may stand in the way but investing in real assets, which generate cash, or assets which are not correlated to the main listed markets, can help diversify and enhance returns for pension funds.
