Pension fund investing has become vastly more complex – and expensive – over the past decade or two, so it is even more important to go back to basics. It is absolutely vital to manage to – and deliver against – local authority pension fund investment objectives which are thankfully relatively straightforward, without in any way wishing to minimise the challenge they present.
While funds will have some scheme-specific variation, typical objectives are:
- Pay benefits as they fall due
- Achieve and maintain at least 100% funding level
- Ensure the employers’ contributions are stable and affordable
- Achieve all this while investing responsibly.
As they mature more and more pension funds are cash flow negative on ‘dealing with members’ (contributions coming into the fund are regularly less than benefits being paid from the fund) so usable investment income yielded from appropriate assets is the efficient way to make up the balance. Along with the significant increase in exposure to illiquid assets, such as infrastructure and private markets, and the gap between commitments and drawn capital as illiquid asset investment can take several years, this has pushed scheme cash flow management strongly up the agenda.
The LGC Investment Seminar Scotland 2021 will take place in Edinburgh on 21-22 October, from lunchtime to lunchtime. Delegate places are free for the LGPS funds in Scotland, NILGOSC and the north of England. Apply to attend here.
Pressure to de-risk
High-level asset strategy is about so much more than just the one-dimensional return. I think of a fund having an investment profile: return, risk (however measured), the trade-off between return and risk (a measure of investment efficiency) and the level of usable investment income. A good strategy balances these with the priority of each appropriately taken into account.
Local authority pension funds, especially in Scotland, currently have strong funding levels, typically comfortably in excess of 100% (ie the value of assets is deemed greater than the value of liabilities) driven by very strong asset returns. While such strong funding levels mean there are no secondary (deficit recovery) contributions, by far the major component of total employer costs is the primary contribution for future service.
This is essentially driven by the prudent (actuarial) assessment of the fund’s future asset return. Current high asset prices and many years of strong past returns possibly vindicate forecasting a lower future return and so a consequent higher future service contribution. There will be discussions – and potentially pressure – to ‘de-risk’, usually by reducing equity exposure in favour of other diversifying alternatives, but this typically reduces the future return which further increases the future service cost.
De-risking basically looks backwards at the past service position and funding level. However de-risking is also, typically, ‘de-returning’ which is forward looking and drives the future service cost. The balance between these has to be very carefully and objectively considered. For example, a strong funding level can be used to provide an asset hedge against the sort of adverse asset experience that ‘de-risking’ seeks to mitigate.
The big inflation question
In addition, and this is a personal view, I think that for true long-term local authority pension fund sustainability employer costs need to be reduced, not just maintained, so the emphasis should be on continuing to achieve high returns. Recently published PIRC LAPPA figures to the end of March 2021 give the average local authority returns over five, 10, 20 and 30 years as 9.5% pa, 8.3% pa, 6.9% pa and 8.4% pa respectively. Are the actuaries, with discount rates typically 3%-4% pa, still being too prudent when estimating future asset returns?
The real liabilities of local authority pension funds are driven by UK inflation: earnings for actives and prices (CPI) for deferreds and pensioners. Both these inflation measures are currently elevated, and a very important question for pension fund investment management is ‘are these higher current inflation rates a temporary spike or an indication of a period of more sustained higher inflation?’
If the latter, this requires serious investment consideration. Some buffer against rising inflation is likely to already exist as typical estimates of long-term future (CPI) inflation are around 3%-3.5% pa.
Local authority pension funds have fully embraced the ESG [environmental, social and governance] and RI [responsible investment] challenge, not least in terms of climate change within the ‘E’. There is naturally intense focus on the risks to the asset prices and returns of some sectors and companies from many aspects of both the wider ESG/RI and especially climate change agenda.
However perhaps insufficient focus has been given to the amazing opportunities and potential benefits these changes could create. As (almost unique) genuine long-term investors with relatively modest liquidity requirements once cash flow has been properly managed, local authority pension funds can fund, support and draw benefit from companies, enterprises and projects that benefit wider society. It is no longer either a straight choice or trade-off between ‘doing good’ or ‘achieving strong investment return’. We can do both.
I expect many of these topics – and much more besides – will be discussed, and in person, at the LGC Investment Seminar Scotland in Edinburgh in a few weeks. See you there.
