Smooth sailing or stormy waters for the LGPS? William Bourne comments on the 2016 LGPS Annual Report
The LGPS 2016 Annual Report was published recently. In many ways it shows a success story. The number of employers is up 22% and, despite almost zero return in the year to March 2016, the long term investment returns show a healthy 3% real return annualised over 20 years. However that is not a reason for complacency, on a whole range of fronts.
The rise in employers is largely driven by councils outsourcing jobs and the creation of academies. The volume of the latter, which tend to be of relatively small size without dedicated HR departments, is undoubtedly putting pressure on fund administration departments. The solution has to be some form of pooling, whether of academies into multi-trust academies, assets and liabilities into a single entity (as was done with The National Probation Service), or at the fund administration level.
The 20 year investment return has, in contrast to private sector schemes, been driven by equities. Some 35% is invested in equities directly, compared to 5% in bonds. Pooled investment vehicles account for 44% and, while these cannot be categorised from the information available, the message is clear that equities comprise most funds’ major ‘growth’ asset class. In contrast, private sector schemes have over 50%* invested in fixed income and, when LDI strategies are taken into account, the true number is probably closer to 70%. In both cases, the level of return over the next five years is likely to be lower: government bonds yielding 1.5% over 10 years will by definition return that annualised figure if held to maturity; while equities would have to go to even higher valuation levels than at present to return more than their dividend (3% today) and the level of long term real economic growth (assume 2%).
Paradoxically that may help funding levels. Regardless of the precise discount rate valuation methodology used, either a fall in the valuation of bonds or equities, or higher inflation will lead to a lower estimate of the liabilities. The 2016 Report, which used individual Fund valuations, gave an average funding level of 85% , whereas the Government Actuary’s Department’s Section 13 valuation of the whole Scheme based on standardised assumptions will, if we can judge by the anonymised 2016 valuations already published for each fund, be closer to 100%. If we allow for market movements between 31st March 2016 and today, the Scheme is almost certainly fully funded.
However, funds are still going to have to make a choice between accepting lower returns from traditional asset classes such as bonds and equities, or branching out into newer asset classes in the search for higher returns. It would be a mistake to be too complacent on the investment side.
The 2016 report also shows that the cashflows from members - ie. contributions minus pension pay-outs - has, for the first time, tipped into the negative. This has been long flagged up and has been delayed by the inflow of active members entering the Scheme from new employers. However, the trend can only accelerate in the future. In the near term, investment income (1.7% in aggregate) will comfortably cover the gap but not forever - now is the time for funds to plan for that eventuality.
Finally, I turn to governance. With less than a year until April 2018, when funds are supposed to turn their investment implementation over to the pools, governance arrangements will need to change. Because Funds will effectively be outsourcing a large part of the investment management, they will need to put in place a clear framework to monitor and govern the arrangements between the various parties, including the Pools, the Section 101 committee, any connected body which has delegated responsibilities, the Pension Board, and outsourced service providers such as actuarial and investment consultants.
In my view, rather than trying to carve up the work between the 101 Committee and the Pension Board, clearer accountability will come from giving them separate functions. The Section 101 Committee should be responsible for all functions including the governance of the various relationships, while the Pension Board’s role should be one of scrutiny and challenge. They should ensure that appropriate governance processes are in place and followed, and provide challenge where they believe there are gaps.
I haven’t even mentioned the General Data Protection Regulation, which comes into force in exactly a year’s time on 25th May 2018 but, while there is plenty of work to do, from a funding perspective the LGPS is not in a bad place. Private sector schemes are reaping the consequences of de-risking: investing in low risk assets results in low returns and, except where schemes are sufficiently well funded or mature, sponsors are having to increase their contributions. In contrast, the LGPS is beginning to look more sustainable in the long term.
* Source: Purple Book 2016, p. 42