William Bourne, independent advisor at Nottinghamshire and East Sussex, comments on the third Annual Report for the Local Government Pension Scheme
The recently published LGPS annual report in many ways confirms how well the scheme is doing: asset growth has been around 8% annualised over 20 years, in line with that seen by the corporate sector; member numbers have grown by 3% to around 5.2 million; and employer numbers by nearly 10%, largely as a result of the creation of academies. Meanwhile, cashflow remains just positive and administration costs fell slightly in real terms from £20.75 to £18.68 on a per capita basis. The Scheme appears to be doing its job capably, so what’s not to like?
Any answer must start with the liabilities. Despite the growth on the asset side, 30 year gilt yields have fallen by around 130bps in the three years since 2013 and long dated index linked real yields are sitting at -1.5%. The swaps curve, used by private sector funds to hedge longer-dated liabilities, has declined by more than 200bps over the same period. As a result, the Scheme’s aggregate funding level today would undoubtedly be lower than the 2013 level of 79% if the same actuarial methodologies were used. The corporate sector, by comparison, was at 83%, albeit using a strict gilt yield discount rate methodology.
In practice, for the 2016 valuation, there is an increasing recognition that the gilt yield curve is distorted, and increasingly inappropriate for an active and open scheme. It is likely that the Government Actuarial Department, when it puts together an aggregate valuation of the Scheme using standardised assumptions, will use an inflation based discount rate, as they do for unfunded public sector scheme liabilities. That would mitigate any sharp fall in the headline funding level number.
The report also highlights the different investment strategies being employed by private and public sectors. In March 2014, the private sector held around 47% of its nominal assets in fixed income compared to the LGPS’s 16%. In practice, private sector exposure is probably more like 65% because of the use of derivative-based LDI strategies. Since the financial crisis, both fixed income and equities have delivered good returns, and so returns have been similar, but it is hard to imagine a world where that continues. If disinflationary trends remain dominant, bonds will perform well in the short term and equities less well, but this is not sustainable in the long term. If on the other hand inflation ends up being the mechanism through which the world’s indebtedness is reduced, equities may not flourish, but conventional bonds will certainly do much worse.
The risk for the LGPS today is that regulatory pressure forces it down the path of de-risking just as the world shifts to a significantly less bond-friendly environment. The quantitative easing (QE) experiment of the past eight years has done no more than prevent the global economy from collapsing. Growth and inflation today are well below trend levels in all western countries, which makes reducing debt levels almost impossible. Central banks are recognising that future QE has to involve putting money directly into the economy, and that increasingly means using fiscal policy in order to engender some growth and inflation. In the UK, with a new Government and in all probability a new Chancellor, a policy shift in this direction would be helpful for all liability valuations, and less unhelpful for LGPS assets than for the private sector.
In the short term, two of the LGPS pools are now FCA authorised and up and running, while the other six have mostly decided on what structure to use and are now looking at governance and how to operate the pool. Some key issues have been identified: not every investment asset will fit neatly into a single structure; maintaining democratic accountability may be difficult if pools are to take the manager selection role and net cost savings are unlikely to be seen for at least five years. However, given the short timeline prescribed, the progress made in the creation of pools is considerable.
The criterion to make it easier to invest in infrastructure is perhaps where there is least meeting of minds. The Government has over £400bn of projects to finance, but these largely involve construction risk (e.g. HS2) and do not match with the lower risk annuity-like streams into which most pension funds ideally wish to invest. The solution to this could be the government either financing new construction projects itself and then selling the built projects on to investors, or mitigating the risk from the start. Until now, Osborne’s rules have precluded the first, and there seems as yet little understanding on the second. However, if as part of a relaxation of fiscal austerity as described above, the new Government is willing to share the burden of financing new construction projects, that could suit it and pension funds alike.