LGPS funds face a combination of economic and demographic risks. To manage these risks, we believe in long-term, objective-driven investing.
Assessing long-term risks
Investment solutions should take account of client-specific objectives and manage risk in a holistic way towards them. In particular, long-term objectives such as ‘paying all pensions as they fall due’ should be the primary drivers of all scheme decision making. The two key risks that Local Government Pension Scheme (LGPS) funds face are:
- Economic risks - Broadly defined as scheme assets underperforming or liquidity requirements not being correctly anticipated
- Demographic risks - Our long-term thinking looks at these risks in great depth but the most well-known example here would be longevity risk – the risk that scheme members live for longer than expected
Defining success for the LGPS
Defining success precisely for the LGPS can be challenging. One reason is that some consider that there is a strong covenant in local government. However, funds are not immune to affordability considerations. A higher chance of meeting accrued benefits using only existing assets (ie not allowing for future contributions) has a lower chance of requiring any further deficit contributions. As such, understanding the risk of existing assets being able to meet existing/accrued benefits is important.
Rethinking long-term success
Our approach is, for each possible future scenario, to calculate what we call the proportion of benefits met (PBM) as a measure of success. This is calculated as simply the sum of the pensions that can be paid from existing assets divided by the sum of the pensions promised.
As a simplified example, suppose a scheme has promised payments of £100 per annum for the next 20 years but existing (current) assets only last for 10 years. In this instance PBM would be 50%, as only 50% of benefits promised can be paid.
PBM creates an easier way to think about success, given all the risks and uncertainties LGPS funds are managing. Investment strategy should focus on obtaining the most attractive distribution for PBM as possible, based on many simulations of what could happen in the future.
Setting investment strategy
One approach to investment strategy is to seek a high value for EPBM. While we would not advocate that this is the only measure to be taken into account, it is interesting to see the results of choosing asset allocations that aim to maximise this metric.
As might be expected, higher funding levels are associated with lower allocations to growth assets. At high funding levels, however, there is a substantial allocation to credit. Indeed, even when a scheme is 100% funded on a gilts basis there is some allocation to long-term return-seeking assets, providing a buffer against longevity risk and other residual risks.
In our experience, traditional funding level driven strategies may:
- target an inappropriate level of return in some cases, failing to take into account all the risks schemes faced (such as longevity risk)
- fail to recognise cashflow-matching benefits of credit and other assets that generate contractual cashflows, so only hold them for diversification purposes
Shaping cashflows isn’t just about bonds
Gilts and corporate bonds are very useful in that they can more precisely match liability cashflows than growth assets. But bonds are not the only way to target a desirable profile of asset cashflows. Real assets and equity dividends can also provide a supporting role, as can equity options.
Another potentially attractive option for some LGPS funds could be cashflow generating multi-asset funds similar to those used for income drawdown in defined contribution retirement pots. Other growth strategies that may help include active strategies that focus in selecting companies with sustainable dividends that are likely to grow with inflation. This can help both meet pension cashflows (improving liquidity) and provide ‘implicit’ liability hedging.
Using multiple lenses
Our framework provides a holistic way for schemes to select appropriate investment strategies. However, it is not ‘one size fits all’, so some care and caveats are needed. In practice, schemes should take into account a range of metrics, including more traditional measures before changing their investment strategy. While there is no single ‘right’ investment strategy, we believe that consideration of a range of metrics can help schemes avoid a wrong one.
Our view of success for pension schemes is ‘the assets outlasting the liability cashflows so that all pensions are paid’. We believe focusing on this long-term success provides a holistic way to achieve the right risk balance.
James Sparshott, head of local authorities, Legal & General Investment Management
Column sponsored and supplied by Legal & General Investment Management
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