The overriding requirement of all pension funds is to pay benefits to members. Most Local Government Pension Scheme (LGPS) funds have ‘the ability to pay cash flows as they fall due’ as a main objective.
To meet this objective, committees must understand how their fund’s cash flow position could evolve over the longer term, and ensure it takes sufficient priority at meetings.
The Scheme Advisory Board’s 2017 annual report noted LGPS contributions in England and Wales were about £484m lower than cash outflows, a 0.2% shortfall of total assets. Given this relatively small shortfall, we classify the LGPS as being broadly cash flow neutral. Yet as funds mature, and funding improvements reduce deficit recovery payments, the gap between contributions and benefits is expected to grow, placing more reliance on asset income.
At an employer level, net cash flow position can vary greatly depending on employers’ maturity (see graph). An academy recently admitted to a fund will likely have a better cash flow position than an admitted body close to cessation.
As a funded scheme, the LGPS can generate returns and income from its assets. The ability to pay cash flows alongside return generation should underpin strategic decision making.
A lack of appropriate planning for how funds will pay cash flows in the longer term could lead to ‘cash flow ravaging’. This occurs when a fund must sell assets when markets have fallen in value. By being forced to sell assets at an inopportune time, a fund could potentially lock in to poor returns. This approach can prove costly for funds and detracts from LGPS ambitions to be affordable and sustainable.
Strategically, this supports funds investing in more income-oriented assets, such as infrastructure, to dampen return volatility and boost income generation, taking care to understand the impact on funds’ total risk-return expectations.
Sometimes we see certain employers designing specific income-driven investment strategies to better match their liabilities but such strategies are relatively rare at this time.
What to do?
Acknowledging that the ability to pay cash flows as they fall due is key for the LGPS, the net cash flow position both now and longer term should be examined.
LGPS funds should establish a clear policy for meeting cash flows. Once the fund’s cash flow position is understood, along with its likely evolution over the longer term, funds must consider how to support the payment of cash from the assets as they fall due.
|Managing the cash flow position|
|Taking investment income||Strategic rebalancing||Cash flow matching portfolio|
|Avoids transaction costs||Expected to generate governance dividend over the long term of selling the ‘outperformers’||Most likely for certain specific employers|
In practice, we believe a combination of the two (and potentially three) methods outlined in the box above will be appropriate for most funds. Stress testing and scenario planning of funds’ expected cash flows, and considering how you meet these cash flows during market stress, will give more insight into sensitivity to factors such as inflation, market shocks or structural membership changes at employers. Committees can then consider implementation approaches reflecting their fund’s needs.
None of the above suggests there is an urgent cash flow issue in the LGPS – far from it. Based on the 2017 Scheme Advisory Board information, even moderate investment income from assets will cover any shortfall.
Instead we are highlighting that cash flow positions may change over time (sometimes suddenly, for example in a major redundancy programme), and that there can be considerable variance when you look at employers.
William Marshall and Richard Warden, partners, Hymans Robertson
Column sponsored and supplied by Hymans Robertson