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Markets and membership: the big challenges for the LGPS

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Renewed focus on the Local Government Pension Scheme (LGPS) over the last parliament led to scrutiny of costs, investment returns and the viability of the scheme, dependent on a steady, healthy influx of members.

The new government is intent on making more public service efficiencies and despite two consultation processes over 2010-15 on the topic, the question of how savings could be made from within the LGPS remains unanswered. It is widely expected that once new ministers at the Department for Communities & Local Government have settled in, they will focus on the LGPS once more.

With so much change potentially ahead, the LGPS Advisory Board’s second annual report is particularly salient. It provides a snapshot of the scheme’s health over the period March 2013 to March 2014, and demonstrates how schemes are likely to develop in future.

 

Returns

Local authority pension funds’ average return on investment fell by seven basis points over 2013-14, the figures reveal.

The report says that council pension funds’ average net return on investment - the net investment return divided by the average value of the fund over the year - was 5.9% last year, compared to 12.5% in 2013.

LGPS fund performance over the last three years was determined as 7.5% per annum; 0.3% less than that of corporate pension funds, based on a sample of 85 LGPS funds (market value: £17bn) and 109 corporate funds (60% of UK corporate schemes).

However, over the longer term, LGPS funds’ performance has exceeded that of corporate schemes. Over five years, LGPS fund performance was 12.7% per annum to corporates’ 11.7%, and over ten years, LGPS funds are predicted to return 7.8% per annum to corporate funds’ 7.7%.

 

Asset allocation

The total assets of the LGPS increased by £11.2bn (6.0%) from £180.9bn to £192.1bn during 2014 and on the whole, a

sset allocation stuck to traditional formats.

Across the total assets within the LGPS, allocation to equities saw a slight increase over the year, from 38.4% to 38.5%. Allocation to pooled investment vehicles increased slightly, from 40.8% to 41.1%.

Jig Sheth

Jig Sheth

Jig Sheth, director JLT Investment Consulting, says that in equities the going had been good globally over 2014.

“The LGPS’ largest weighting continues to be in quoted equities,” says Mr Sheth.

“The year ending 31 March 2013 saw strong returns from all regions; the US was highest at 20.1% and emerging markets the lowest at 7.4%.

“By contrast, to 31 March 2014 there were strong returns from US equities (+11.3%), UK equities (+8.8%) and Europe excluding UK equities (+15.7%) but Japan equities (-1.6%), Asia excluding Japan equities (-6.5%) and emerging market equities (-10.8%) affected returns.

“All overseas equity returns were affected as sterling rallied; even US and European equity returns were higher in local currency terms. Whilst some LGPS funds hedge some overseas currency exposure from equities, none are likely to hedge all, for very good reasons.”

Separately, there was also an increase in pooled property vehicle investment, up 0.7% to 4.1%.

However, allocations to fixed interest and index-linked securities fell by 1.2% (to 5.5%) and 0.4% (to 2.4%) respectively.

State Street Investment Analytics (SSIA) commentary that was included in the LGPS Board report says that UK bonds and index-linked gilts “produced a small negative over the year”, which goes some way to explaining the fall in allocations. 

Fixed interest and index-linked securities’ poor performance was largely due to the negative impact of slowing inflation over the period. Consumer prices index (CPI) inflation slowed over the year; having grown by 2.8% in the year to March 2013, it rose by 1.6% over the year 2013-14, finally hitting 0% in February 2015 and raising the spectre of deflation.

Mr Sheth explains in more detail the fall in bond and gilt returns: “Whilst generally they form a much smaller allocation than that to equities, gilts and corporate bonds were positive for the year to 31 March 2013 (long gilts at +8.1% and long corporates at +14.0%), but flat to negative for the one year to 31 March 2014 (long gilts at -3.1% and long corporates at +1.8%).”

SSIA analysis also found that the performance of private equity over the year was “disappointing”, at 5%, as was property, at 11%. LGPS fund allocations to private equity remained at 1.9% and allocations to property increased to 2.6%.

M&G Investments, whose property arm, M&G Real Estate, manages £21.2bn in property investments in the UK, Europe and Asia including for LGPS funds, had no direct comment to make on the property performance recorded in the LGPS Board’s report.

However, an M&G Investments spokesperson pointed out that the International Property Data Bank (IPD) annual index, which holds data on the performance of 80,000 property investments worldwide valued at USD 1.7 trillion, recorded a return of 17.8% for that period. This suggests LGPS funds’ choice of property investments failed to return as highly as the asset class at large.

Roger Pim

Roger Pim

Roger Pim, managing partner at private equity investment firm SL Capital Partners, agrees that the 5% return on private equity is disappointing.

“I’m surprised it’s so low,” says Mr Pim.

“Our portfolios are significantly higher. Although it’s a challenging market and we’re not predicting the 20+% that we used to, we’re still seeing opportunities for private equity to generate attractive double-digit returns. However, you have to look at the whole life-cycle of the investment, not just at a single year.”

 

Membership

As LGPS funds strive to maintain good investment returns to pay out benefits and tackle deficits, active membership continued to increase over 2013-14, helping to keep the scheme cash-flow positive.

The report found that in March 2014 total membership of the scheme hit 5 million people, up from 4.8 million the previous year.

There were shifts in the types of members within the scheme. The number of deferred members of the scheme increased over the period, from 1.6 million to 1.7 million. Deferred membership was growing faster than any other type of membership with the rate of increase growing from 5.7% per year in 2013 to 5.9% in 2014.

Pensioner membership increased from 1.4 million to 1.45m over the year, with the rate of increase rising far more slowly than within the other two categories of membership.

Barry McKay, partner at Hymans Robertson, says there are a number of reasons for the increase in deferred membership.

He says that the increased in deferred members is fairly long-term.

“Deferred membership has been increasing year on year (by number of members) for some time now,” says Mr McKay.

“In fact, there was a similar increase in deferred membership of 5.7% in 2012-13 and looking at atypical LGPS funds the number of deferred members increased by around 15-20% over the three-year period of 2010-2013.”

There are a variety of reasons for this, Mr McKay explains: “The vesting period for deferred members was three months. If an active member was employed for three months or more they accrued a deferred benefit and could not take a refund of contributions and so were more likely to remain in the scheme as a deferred member.

“Under the 2014 scheme the vesting period is two years and so we may see a smaller increase in deferred membership in future years.”

However, Mr McKay adds that redundancies have also had an impact on the deferred membership, as people leaving local authority employment would become deferred members as well.

Active membership increased from 1.7 million to 1.8 million over the year, with the rate of increase jumping from 1.4% per year over 2013 to 5% over 2014.

This is partly due to automatic enrolment, Mr McKay says: “Many of the larger employers participating in the LGPS will have reached their staging date for auto-enrolment. This may have less of an impact in future years as it is the smaller employers that will hit their staging date in the future.”

Mr McKay says the membership shift is a cause for concern.

“Even though all categories of membership have increased in terms of numbers of members, there is a decreasing proportion of contributing members relative to non-contributing members,” Mr McKay says.

“This is an important consideration for LGPS funds as it will affect cash-flow requirements and ultimately investment strategy, as funds may need more income from their assets, rather than growth, to pay benefits.”

 

Administration standards

The Pensions Act 2013 brought oversight for the governance and administration of the LGPS under the control of The Pensions Regulator (TPR), heralding a renewed focus on the scheme’s standards.

The LGPS, according to TPR figures from 2013, compares favourably in governance and administration terms to other public sector schemes such as those for fire fighters or teachers.

Administration costs on average fell from £21.42 in 2013 to £20.75 in 2014, the LGPS Board report says, but greater efficiency does not appear to have led to a drop in service standards.

Research from The Pensions Advisory Service (TPAS) and the Pensions Ombudsman (PO) found that the vast majority of LGPS members (99.99%) are satisfied with the way their benefits are administered and the communications they receive from their fund.

There are, however, still areas that LGPS funds could improve on administration.

TPAS and the PO have recorded that 0.01% of LGPS members have made formal complaints about their scheme. The majority of those complaints, as in private sector pension schemes, relate to how their funds dealt with their requests for ill health retirement benefits.

Over 2014, TPAS accepted 129 new complaints from LGPS members, while a further 75 complaint cases were closed with one letter as the service was able to give the complainant a satisfactory explanation of their situation.

Of those 129 accepted complaints, 50% were about an LGPS fund’s decision regarding awarding pension benefits, and of these, more than 75% were about ill health early retirement.

Within the other 50% of complaints, 47% were about entitlements, mistakes and delays and 3% were miscellaneous other problems.

When pension scheme members are unsatisfied with TPAS’ handling of their complaints, they can escalate the matter with the PO.

Here too, in 2014, ill health retirement complaints dominated. Over the year, the PO received 186 enquiries from LGPS members – 36.5% of which related to ill health retirement. The ombudsman upheld or partially upheld 14.5% of complaints.

Writing for LGC Investment on the TPAS and PO figures, George Graham, director of the Lancashire Pension Fund, says the three-tier system for calculating ill health claimants’ entitlement is fraught with difficulty. He adds that LGPS officers must learn from each appeal, and that Lancashire will ask its new local pension board to look into how ill health retirement claims can be better handled.

 

Scheme view

The LGPS Advisory Board’s 2014 annual report demonstrates that LGPS funds in general are some of the best run in the UK. In investment terms, they outperform private sector defined benefit schemes over three-, five- and seven-year periods, even during times of constricted markets. They compare well to other public sector schemes in terms of administration and although their performance on dealing with ill health retirement could be improved, this is in line with other large defined benefit schemes.

The real challenges over the coming year will be maintaining membership and reducing deficits. Membership may suffer if hard-pressed staff opt out of schemes in order to boost their take-home pay, while further redundancies over the coming parliament are likely given the government’s appetite for further spending reductions.

Meanwhile, the overall deficit of the scheme stands at around £47bn according to 2013 estimates (the next triennial valuation will be in 2016). Healthy investment returns will assist employers in paying down this deficit, but plans for a concerted and standardised effort to close the gap (see page 24) will be a major focus for the next year and are likely to be welcomed by employers and scheme members. 

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