Written By: Pádraig Floyd
Things were looking rosy for LGPS valuations early in 2022, but did the Russian invasion of Ukraine, slowdown of the global economy and rampant inflation put the cat among the pigeons? Pádraig Floyd looks at the role of secure income in investment strategies
If the past few years has taught us anything, it is not to rely on things remaining the same forever. Though the 20th century was a time of continual upheaval, innovation and change, the 21st – for all its technological marvels – offers little by way of example for those who occupy today’s pensions landscape.
Many millennials are now approaching middle age and yet their experience of investment markets is largely benign with a few spectacular moments of volatility.
Fixed income, a traditional shelter for long-term investors lost its appeal, with even Gilts losing their lustre in the “lower for longer” environment that followed the global financial crisis.
In the year that local authority pension funds were undergoing valuation, there were high hopes that positive movements, and even moving into the black, might allow greater freedom within investment strategies.
“Most funds will have seen a decent increase in the funding level to more than 100%,” says Jill Davys, head of LGPS at Redington. “Even with the mini budget and the issues that followed it in September and early October, they should still be in a good place from a funding perspective.”
However, local authority funding remains tight, and some employers have been looking to take some pressure off with a reduction to contributions, despite the scheme advisory board advising against this approach.
“This may result in some funds reducing contributions from next April, at the same time a 10% benefit increase has to be covered,” says Davys. I think a few funds will have to revisit their cashflow forecasts, which drives that need for our income.”
No prizes for guessing…
“One of the biggest changes in 2023 will be higher interest rates to counter high inflation, and you don’t need to be an actuary to see that,” says Sally Bridgeland, chair of the London Pensions Partnership Investments board, “because that’s really what matters when you’re valuing your pension funds’ liabilities.”
It will be important for funds to focus on the difference between interest rates and asset returns, the sort of risk premia being targeted and how that matches up against inflation, not only for investment purposes, but how employers will approach any wage demands that arise.
“People won’t necessarily get the full rate of inflation in their salary deals, as there may be caps in place. But pensions in payment is also an increasing part of the local authority’s liabilities, alongside pensions in deferment.”
But a higher inflation environment offers a possibility of a world in which investment returns will exceed the caps on liabilities, opening opportunities for investments that deliver a real return. So property, or some of the infrastructure deals may be more attractive now, says Bridgeland, because they have an upside versus the liabilities.
There are also opportunities from a strategic review that may happen among many private sector schemes this year, because their own funding positions have changed.
Private sector funds are closer to an end game than local authority pension funds. As LAPFs see an increasing part of their liabilities in pensions and deferred members, there may be opportunities where the private sector sells off assets that are less liquid, says Bridgeland. “When private sector pension funds do buyout deals, they end up selling most of their assets and insurance companies will buy different ones because their regulatory regime is stricter and will depend on what they have regulatory approval for to use in their matching assets. “So at the moment, local authority pension funds have a sort of tactical advantage in being able to move on some of these assets above an insurance company because of their liquidity requirements.”
Safe as houses – and offices, warehouses, etc…
Property has traditionally been considered a no-brainer as a secure income asset. It can benefit from capital appreciation, inflation-plus uplifts in rent and with a long horizon, it seems the perfect match for the long-term investor. But it, too, has had problems with certain sectors, such as retail and hospitality, softening as a result of what is happening elsewhere in the economy.
There is also a huge carbon liability in the vast majority of real estate stock that must be addressed, particularly as new reporting requirements will make this all the more apparent. But that isn’t a reason to be concerned about real estate, says Pete Smith, head of sustainable investment at Barnett Waddingham.
“Property managers are very aware of the issue and the additional returns that can be generated with buildings that are better from a sustainability standpoint,” says Smith. “Many private sector schemes may be forced to rebalance following the rise in Gilt yields and LAPFs, as long term investors with open schemes can take account of this and may find some opportunities arising in the secondary market.”
Think global, act local
Of course, things are more complicated than they used to be. Every investment decision requires the balance of the right kind of quality of assets with the right ESG – and in particular – environmental credentials on the journey towards net zero which most local authorities are articulating. This will be an important balancing act to manage.
“How will secure assets help in the future and over the transition,” Bridgeland says, “because chances are you’re going to be holding some of these assets out to 2030 and possibly beyond.”
The use of impact investments plays an interesting and important role in how secure income assets may be deployed in an investment strategy.
The government’s levelling up agenda is not incompatible with either LAPFs’ desire to invest in local projects, or for those investments to deliver above and beyond financial returns. But without the detail, it is difficult to determine whether there is plenty of scope for interpretation, or whether the regulation is overly prescriptive, increasing competition and thereby inflating asset prices.
That said, the strength of the funds and the pools is that they are often better at spotting opportunities that others miss because they don’t neatly conform to existing investment categories.
“There are all kinds of local services that can be improved through investment. Different branches of government may be able to work together to come up with some local ideas beyond the ways we consider some of these classes,” says Bridgeland. “There may be some unique opportunities provided by the fact that they know their locality. It doesn’t necessarily mean they can craft deal opportunities that other people couldn’t, but in the land of illiquid investments, where yields tend to be a bit tailored and one off, it’s a good place to start to get better value.”
Got to be in it to get out of it
The rush to get out of some “dirty” assets from a carbon point of view is not likely to be replicated across all investors’ strategies. Not simply because they cannot be, but because of the greater awareness of how the transition from a carbon economy is as central to the “S” of ESG as the production of carbons is the “E”.
As most will now acknowledge, the decision about carbon cannot be binary, says Smith. “You need to think quite long and hard about what it is you’re trying to support in your strategy, as well as achieve,” he says. “If divesting from certain areas, you should look carefully at how you might benefit from participation in some of the replacements.”
It goes without saying that that no funds or pools actually make knee-jerk reactions about what they are and are not prepared to invest in. And whatever a fund may like to achieve, be it local impact or a global transition, the reality is that whatever assets are selected, they have to meet the ultimate obligation of paying benefits to members.
A proper strategic allocation review is “absolutely critical”, says Davys, to ensure you continue to reflect the cashflows of the fund going forwards. That means thinking about the percentage of illiquid assets and searching for income streams, perhaps among some of the more traditional asset classes that have been out of favour in recent years.”
Old school assets for security?
The fixed income space has become more attractive thanks to rising inflation rates and so Gilts, index linked and corporate bonds may play a bigger role for some funds than they have for the past decade.
“Some funds have been facing the maturity tipping point and it will happen across a much broader range of funds,” says Davys. “The 10% benefit increase is going to happen before many funds have funded those initial private market investments they’ve approved in recent years,” she adds.
That need for income is likely to become an increasingly important feature for the LGPS than it has ever been in the past, says Davys, with a range of multi-asset credit, corporate bonds or traditional fixed income being a part of the mix in addition to opportunities to fund a transition to sustainable energy or invest in local projects that have a meaningful impact on the people who live in those areas.