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How the LGPS should chart their course depending on funding

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Local authority and private pensions face different problems when navigating funding. Charlotte Moore reports

Managing a defined benefit scheme today is hard, both for trustees overseeing the Local Government Pension Scheme (LGPS) and those managing a fund in the private sector.

One difference between the LGPS and private sector funds is that local authority schemes are still open, while the majority of those in the private sector are closed. As a result, these two forms of defined benefit schemes have different objectives.

The aspiration of a scheme that is closed both to new members and future accruals is to ensure funding levels are sufficient to meet their liabilities.

In addition, most corporate schemes want to become sustainable so they do not have to rely on the sponsoring company for additional funding. That might be through self-sufficiency or by transferring the scheme to an insurance company.

An open scheme has an alternate set of ambitions.

The main focuses are ongoing affordability of benefits and setting appropriate investment and funding plans.

Colin Cartwright, partner at professional services firm Aon, says: “As the LGPS is open both to current members and future employees, it has much longer timeframe and greater uncertainty about what benefits it will have to pay.”

Different goals

David Walker, head of LGPS investment at Hymans Robertson, says: “The funding and the investment approaches of both should be aligned to those objectives.”

For a closed scheme, there is a much greater emphasis on ‘marked-to-market’ risk. “This is because the scheme will have to pay a price to hand over liabilities to an insurance company or to buy an asset to match them,” Mr Walker says.

In contrast, the aspiration for an open scheme is to generate long-term real yield using an appropriate level of investment returns.

“And the sponsor needs to pay an affordable level of contributions,” Mr Walker adds.

These very different objectives will lead not only to different investment strategies but also shape the way the scheme values its liabilities. Schemes are afforded significant flexibility under the scheme-specific funding valuation.

Under this valuation methodology, schemes can use the expected return from their investments to determine the discount rate – used to provide a net-present value of liabilities.

When closed schemes formulate their scheme-specific funding valuations, they tend to be more focused on market values. Mr Walker says: “That’s because they are focused on insurance buy-outs and that is how these prices are derived.”

In other words, closed private sector schemes tend to use corporate bond rates as the basis for their valuations because insurance schemes will use a similar methodology.

Local authorities have to keep a balance between ensuring they can pay established benefits as well keeping the ongoing funding of accruing benefits affordable

David Walker, Hymans Robertson

But as an open scheme such as the LGPS is not focused on a buyout, it can take a different approach to its funding methodology. Steve Turner, partner at Mercer Investments, says: “There is a far greater variety of methods used by the actuaries to determine the discount rates for the LGPS than in the private sector.”

Some use a gilt rate plus a return premium. Others use a best estimate return approach based on the investment strategy. “We use consumer-price index target plus an additional premium because the benefits are linked to inflation,” says Mr Turner.

As the LGPS is an open scheme, there will be future costs as members continue to accrue benefits.

Mr Walker says: “Local authorities have to keep a balance between ensuring they can pay established benefits as well keeping the ongoing funding of accruing benefits affordable.”

The aim is to ensure schemes are paying an appropriate level of contributions. “The priority is to maintain the sustainability and affordability of the LGPS with less of a focus on market conditions at a single point in time,” Mr Walker says.

That means local authorities will be less concerned about the market conditions on, for example, the date of the next actuarial valuation.

Mr Walker says: “This is appropriate because they are open, ongoing schemes.”

Investment risk

Yet despite these differences, both private and public sector defined benefit schemes must focus on investment risk.

“We have worked with our LGPS clients to help them to define their long-term objectives and affordable contribution rate,” Mr Walker says.

Once these have been defined, the scheme can then focus on how much investment risk it needs to take to make those contribution levels affordable.

In recent years there has been a marked increase in funding levels in both private and public sector schemes.

Mr Turner says: “That’s because equity markets have risen considerably, longevity assumptions have declined and real yields haven’t collapsed further.”

While many LGPS schemes are currently fully funded, it is important for them not to think they have their achieved goal. Mr Walker says: “That funding level could change if they switch their investment strategy.”

Mr Cartwright adds: “The funding level only evaluates past service liabilities. It does not include benefits which have not been accrued.”

In other words, local authorities’ funding levels are less indicative of the ultimate size of the scheme than those for closed private sector schemes.

While the valuation of the liabilities only includes accrued benefits, the actuary will also calculate what future benefits for an open scheme should cost. Mr Cartwright says: “In theory, the future contributions and investment returns should pay for these projected benefits.”

Hymans Robertson has placed greater emphasis on the long-term objectives and affordable contribution rates to ensure schemes do not become complacent about their current funding ratios. The firm also wants to make the LGPS think about the relationship between past liabilities, future benefits, contribution levels and investment risk.

Sponsor strength

For a private sector scheme, a different calculation takes place. A greater emphasis is placed on the strength of the covenant when it comes to determining the discount rate that can be used to value the liabilities. The level of investment risk a closed scheme can take will depend on the financial health of the sponsoring company.

When the scheme is much larger than the company and has a significant funding deficit, this can create a Catch-22 situation.

The size of the funding gap could encourage the company to use a riskier investment strategy, but The Pensions Regulator frowns on a company with a weak sponsor from pursuing this strategy. Schemes in this position have limited options.

Local authorities have a longer investment horizon so they can invest in long-term assets such as public and private equities as well as property

Colin Cartwright, Aon

The LGPS has more leeway. Sam Gervaise-Jones, head of client consulting at bfinance, says: “Local authority schemes do not come under the jurisdiction of The Pensions Regulator, nor do they have to make contributions to the Pensions Protection Fund.” That shapes their attitude to risk and their assessment of the sponsor covenant.

Mr Cartwright says: “The importance of the covenant forces private sector companies to be more pessimistic in their outlook than open schemes.”

Schemes must consider how they will fund their liabilities if the sponsoring company goes bust.

As a result, closed schemes are more prudent. Their appetite for investment risk is constrained and they use a shorter timeframe to narrow the funding gap.

Mr Turner says: “A private sector scheme has to have a very risk-based approach.”

Impact on strategy

Unsurprisingly the differences between running an open and a closed scheme lead to a variation in investment strategies.

“Local authorities have a longer investment horizon so they can invest in long-term assets such as public and private equities as well as property,” Mr Cartwright says.

While closed private sector schemes will also invest in those assets, the allocations are very different.

For example, the average public sector fund has about 60% of its assets invested in equities while a closed scheme only has around 20% of its fund allocated to this asset, says Mr Cartwright.

In contrast, private sector funds will have a much greater allocation to either bonds or liability matching investments such as interest-rate swaps.

Mr Cartwright says: “Closed funds are much more focused on the protection against downside risk.”

Mutual benefit

Even though the investment strategies of private and public sector schemes are shaped by their very different goals, there could be a greater sharing of effective ideas.

Mr Cartwright says: “The LGPS could learn from the emphasis the private sector has put on managing interest-rate risk.”

Local authorities could benefit from focusing on risks as well as returns, he adds.

Some local authority funds are starting to implement these strategies. Mr Gervaise-Jones says: “A number of schemes have put in place liability-driven and cashflow-driven investments.”

That decision has been driven by the greater focus on ensuring contribution rates are sustainable over the long-term, he adds. And changes in regulations have made it easier for local authorities to use derivative instruments.

The company schemes could also learn from local authorities.

“The private sector should remember it needs to generate a long-term return so it should not just focus on risk,” Mr Cartwright says.

The intense focus of some private sector schemes on buyouts has put them off illiquid assets such as private equity and property.

“But these assets can be just as beneficial for a private sector schemes as they are for the LGPS,” adds Mr Cartwright.

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