As political uncertainty continues to cloud the outlook for Brexit, the Local Government Pension Scheme (LGPS) has little choice but to ensure it has the right strategies in place to weather the worst case scenario: ‘no deal’.
Still, it is difficult to come up with a coherent plan. “The ambiguity makes it very hard to map out what contingencies should be put in place,” says Hemal Popat, director of investments at consultancy Mercer.
This is true for all pension schemes but the LGPS has specific complications. Of note is a thorny problem: triennial valuations due on 31 March, just two days after the UK is due to leave the EU.
Because of the valuation date, the impacts of a short-term financial market disruption would persist much longer than any
market corrections, potentially affecting the medium-term strategy of each administering authority.
Sam Gervaise-Jones, head of client consulting, UK and Ireland, at bfinance, says: “Triennial valuations are always nerve-racking for pension schemes because taking a snapshot of the health of a pension always has the potential for long-term ramifications. But this is a particularly risky event.”
Pensions are valued by marking-to-market the assets of the portfolio and comparing that with the value of the liabilities. The most immediate risk is the impact on the asset valuation taking place on 31 March.
If there is a sharp market correction around the date that the UK is supposed to be leaving the EU, and the value of a fund’s assets fall as a result, this could weaken the funding position, says Mr Gervaise-Jones.
The impact on liabilities would depend on how the the administering authorities determine the discount rate, which is used to value future benefit payments. Many authorities use the expected return on investment as a significant factor in their discount rate.
Mr Gervaise-Jones notes: “That rate is smoothed – it’s the average expected return expected over, for example, a decade.”
“Triennial valuations are always nerve-racking for pension schemes. But this is a particularly risky event.”
Sam Gervaise-Jones, head of client consulting, UK and Ireland, bfinance
If the value of the assets falls near the valuation then it could be worth revisiting the forecast smoothed rate, especially if the fall in value is expected to be a short-term blip.
“In those circumstances, it would be reasonable to expect the actuaries to adjust the expected return upwards,” Mr Gervaise-Jones says.
It would only be sensible to adjust the expected return rate if the administering authority thought there was a high chance this would soon return to the previous assumption. If it looked like those growth rates were no longer viable, then the market correction could have a longer-term impact. In those circumstances, authorities might have to revisit their investment strategy.
Determining the right smoothing methodology is more complicated for the LGPS. Although the LGPS is technically three schemes – one for England and Wales, one for Scotland, and one for Northern Ireland – each administering authority has its own investment strategy with its own actuaries and advisers. This results in variation between each authority’s methodologies and assumptions.
The English and Welsh Scheme Advisory Board ensures that while responsibility for asset allocations resides with each individual administering authority, these processes are transparent. “This board could play a role by issuing guidance to ensure that any changes in the smoothing techniques are carried out in a co-ordinated manner,” Mr Gervaise-Jones says.
After all, the purpose of the scheme valuation is to ensure there is an accurate snapshot of the entire LGPS. Mr Gervaise-Jones says: “If the individual [authorities] do not treat the smoothing techniques in the same manner, then the comparability of the valuations could be undermined.”
Another potential implication of short-term market volatility would be the requirement for much greater dealing capabilities as local authorities rebalance their portfolios.
As Mr Gervaise-Jones says: “Market volatility around the Brexit date could have a number of impacts across the portfolio.” For example, there could be a revaluation in sterling if the value of some assets fell and others rose.
The net result would be a drift in the portfolio’s allocation away from the one determined by the investment strategy. That could necessitate some short-term trading to bring the portfolio back to the right position.
“On top of a rebalancing of the portfolio, the scheme [administering authority] might also need to make some active decisions about their allocation,” Mr Gervaise-Jones says. If the results of the valuation lead to authorities changing their long-term investment strategy then they would have to alter their asset allocation.
As sterling is likely be impacted by any increase in political uncertainty, administering authorities will need to think carefully about the potential impact of foreign exchange on their portfolio. It is not only ‘no deal’ that will create a problem for the LGPS.
An extension to the Article 50 process could create problems for those administering authorities that have used insurance against changes in foreign exchange. Mr Popat says: “If the date of exiting the EU changes, then any hedges which have been put in place will either need to be rolled over or restructured.”
There are also complex currency implications for allocations the LGPS has made to alternative assets, such as private equity or infrastructure. An allocation to overseas alternatives comes with two forms of currency risk.
The first is traditional currency risk – the returns are denominated in another currency so there will be an impact when it is converted back to sterling. Simeon Willis, chief investment officer at XPS Pensions Group, says: “This risk can be hedged using conventional approaches, although there is more uncertainty about what the value of those returns will be compared with other assets.”
The second currency risk arises because investing in illiquid assets is a slow process, which usually happens over many years. As a result, there is an exposure to currency risk during the investment period.
For example, if an administering authority has decided to allocate $150m to a US private equity fund, the actual cost of that in sterling could change depending on currency movements around the Brexit debate. The administering authority could be in the position that either it must pay more for that allocation than it had anticipated, or the amount invested is less than anticipated.
“The best way to manage the issue is to try to make commitments in sterling rather than another currency and to diversify your allocations to a number of different jurisdictions.”
Simeon Willis, chief investment officer, XPS Pensions Group
Apart from these moves taken by the alternative manager, it is difficult to resolve this currency risk. According to Mr Willis: “The best way to manage the issue is to try to make commitments in sterling rather than another currency and to diversify your allocations to a number of different jurisdictions.”
But that is not always possible. Mr Gervaise-Jones says: “Many of the LGPS’s global infrastructure investments are made into US-dollar denominated funds.” Once a commitment has been made to such a fund, it can call on an LGPS administering authority to invest, for example, $10m on a set date.
If there is then a significant shift in the value of the currency and the sterling sum set aside is now insufficient to meet the dollar commitment, the LGPS administering authority is legally bound to find the extra investment.
“One way round this issue is to park the cash for this investment in another dollar-denominated investment which will resolve the currency issue but could create a mismatch in values,” Mr Gervaise-Jones says.
Mr Popat agrees. “Some investors try to get round this issue by pre-hedging future capital calls required in other currencies by holding either some kind of feeder fund or cash.”
As many authorities are currently reallocating assets away from equities and into alternatives such as private debt, as discussed on page 16, they could choose to sell the shares today and buy dollar-denominated bonds with that cash. “Then the funds are in the correct currency and the capital should be better preserved as well as having similar investment characteristics to the target investment fund,” says Mr Gervaise-Jones.
While the LGPS could face significant challenges from volatile market conditions, the legal impact should be less onerous. In the event of no deal, an EU-based asset manager would lose its ability to ‘passport’ its fund into the UK. But the Financial Conduct Authority (FCA) has taken steps to handle this crisis.
Ralph McClelland, partner at Sackers law firm, says: “The FCA has put in place a temporary permissions regime for a three-year period.” This will allow any manager to continue to carry out their activities.
From the LGPS’ perspective, this should be seamless.
“But asset managers will need to review how they have set up their permissions and the entity with the relevant regulatory authority might have to be changed,” Mr McClelland says.
Over the longer term, however, cross-border issues could become a problem. McClelland says: “The EU has put in place a strong system supporting the recognition of ‘choice of laws’ clauses and the enforcement of legal judgements across jurisdictional boundaries.”
Beyond the EU, it could be more complicated for administering authorities to work out whether a judgment obtained outside the EU would be recognised as it is now. Mr McClelland says: “The system for the enforcement of English judgments is tied to the current European regime.”
Nor is it clear whether a ‘choice of courts’ − where parties agree that a claim should be brought within a specific jurisdiction – would be recognised in the same way. “What would happen if, for example, a claim was brought in Italy when the parties had agreed to the courts of England and Wales in the contract?” Mr McClelland asks.
“Would the Italian courts need to rule on jurisdiction before settling the substance of the dispute?”
These issues used to be both complex and costly. Mr McClelland says: “In the bad old days, there was a litigation strategy called ‘the Italian torpedo’.” This involved bringing a claim in Italy for an international dispute, as it was famously slow and expensive.
“This was used as a strategy to force settlement,” he adds.
The UK government has signed up to the Hague Convention, which will put in place cross-jurisdiction protections, but this is more limited than the current regime and will not cover contracts entered into before the government entered into that the convention. “That creates uncertainty for both schemes and asset managers,” Mr McClelland concludes.