Ten years ago, many local authority pension funds would have said equity risk was one of the most important, if not the most important, factors in determining a scheme’s funding level. Now, after a decade of reasonable equity returns, notwithstanding the events of 2008, factors such as interest rates and longevity are seen as bigger risks by local authority pension funds, according to the polling at the recent LAPF Strategic Investment Forum.
Almost a third of respondents gave interest rates as the biggest risk to funding levels, 25% longevity and only 21% equity markets. John Harrison, independent investment adviser to Surrey County Council pension fund, and chair of the conference, said that while the average investment return for LGPS funds in the 10 years to March 2014 was 4% a year above inflation, liabilities went up by far more, due to the very low interest rate environment. Harrison commented: “With this recent history at the forefront of our minds it is perhaps not surprising that close to 75% of responses identified the biggest risk as one of the various liability drivers – interest rates, inflation and longevity.” Karen Shackleton, senior adviser at AllenbridgeEpic, said she agreed with the audience’s assessment of funding risks, saying: “If I had ranked them myself I would have said interest rates, inflation and then longevity in that order. I think the delegates perhaps underestimate the impact of inflation because we have been in a low inflation environment.” Inflation, as Shackleton pointed out, affects the whole liability stream, whereas longevity pushes out the tail risk of liabilities further.
Given the views on funding risks, it is not surprising that 27% of the audience saw liability management as having the greatest impact on the long-term affordability of their fund, with 31% giving asset allocation and 23% economic growth. Does this mean LGPS funds will move towards liability-driven investing? Harrison commented: “LDI appears to be in the category of ‘something we should do, but not just now’.” Adding that it’s because index-linked Gilts are expensive and the audience expected global equities (68%) and real estate (21%) to give the best returns over the next five years. One aim to LDI is to hedge unrewarded risks for pension funds, such as interest rate and inflation risk, so Shackleton said: “I definitely think it will be on the agendas for discussion for LGPS in the next 18 months or so. That said, it is a complex strategy that requires intensive training of members. In some cases, members may opt for a simpler solution such as holding bonds or bond-like assets with inflation protection, to at least hedge the first two risks.”
The future of the LGPS is obviously a major concern for members at this time. Asked how they expected the LGPS to be managed in the future, two options stood out: the voluntary creation of super funds (34% chose this) and the existing structure but with rigorous standards set by a national body, which was the choice of 42% of delegates. Commenting on this finding, Shackleton said: “Because funds have local accountability, it would require a sea change to move to a superfund arrangement. What is more likely to happen – and this is being seen already with LPFA/Lancashire and the London CIV – are collaborative arrangements that allow LGPS to access the benefits of scale without losing their local independence.” Harrison added that good progress is being made on voluntary collaboration, such as the London CIV. He commented: “It would be sensible for the government to let these flowers grow rather than engage in further disruptive mandatory structural change. I believe the creation of voluntary superfunds on the LPFA/Lancs model may well be the future of the sector.”
Another current issue for pension funds in the UK is infrastructure investment. The Pensions Infrastructure Platform is intended to help pension funds pool assets and invest in this area, while some local authority funds are either investing in infrastructure themselves, or working with other funds. Asked if LGPS funds should invest in local housing or infrastructure projects, 87% of delegates said they should, provided the returns are commercially attractive. No-one thought supporting the local economy was sufficient justification, while only 10% said that the conflicts of interest here are too great. Commenting on the finding, Harrison said the outcome was as expected and added: “It was perhaps a mild surprise that only 10% believed that inherent conflicts of interest ought to rule out such investment.” And according to Shackleton, investors are right to look at the investment case for infrastructure, not the politics of it. “The infrastructure debate gets rather influenced by the political angle, but if you park that and assess it as an investment alone, the risk/return profile makes it an attractive investment for an LGPS fund,” she said.
One of the most surprising poll results at the event, according to Harrison, was that 60% of delegates expect that there will be deflation in Europe in the next 10 years. While 47% of the audience do not expect interest rates in the UK to return to normal until after 2018, no-one expected to see deflation in the UK. And asked if returns of 2.5% a year above liabilities over the next 10 years are achievable, 67% said they were for funds with an active approach to asset allocation and liability management.