It is tricky to know what to expect from financial markets in 2019.
Will equity markets remain at historic highs but be prone to bouts of volatility? Or will concerns about slowing global growth and US president Donald Trump’s trade war spark the market correction many anticipate?
While all defined benefit schemes will be affected by market turbulence, it will have a disproportionate impact on the Local Government Pension Scheme (LGPS).
Funds in the scheme have, on average, 60% to 70% of their portfolios allocated to equities. In contrast, closed occupational schemes have only 30% of their portfolio allocated to equities. Given the higher likelihood of turbulence over the short to medium term, such a high allocation looks risky.
Betting on equity
There is good reason for local authorities to have a much higher allocation to equities than their private sector counterparts: their schemes are still open and accruing new benefits.
David Buckle, head of investment solution design at Fidelity International, an investment management firm, says: “If all else is equal, an open scheme needs a higher rate of return than a closed scheme as the liabilities last longer into the future and are harder to forecast.”
While a closed scheme can be thought of as bond with a finite number of future benefits, an open scheme is an indefinite series of much less certain inflation-linked future cash flows. “That makes it difficult for an open scheme to hedge effectively,” Mr Buckle says.
A better policy is to invest in assets which have long-term returns aligned with inflation. “This is why the LGPS has had such a high allocation to equities,” he adds. But while that asset allocation proved sound over the past decade, administering authorities may now be wondering if such a high allocation is still sensible, especially if the likelihood of a market correction is increasing.
“If all else is equal, an open scheme needs a higher rate of return than a closed scheme as the liabilities last longer into the future and are harder to forecast.”
David Buckle, head of investment solution design, Fidelity International
The global financial crisis taught institutional investors an important lesson. “Schemes realised a significant correction could cost them a decade’s worth of market returns,” says Tom Rivers, senior investment strategist at Cardano, a fiduciary manager.
And while such steep correction looks less likely, policymakers now have fewer tools at their disposal. “Interest rates around the globe are extremely low, making it harder to use traditional monetary policy in the event of a crisis,” Mr Rivers says.
Given these risks, it is understandable why the LGPS might want to reduce their allocation to equites, says Mr Buckle. But this is easier said than done. Switching to the wrong asset could have a negative impact on the scheme’s funding levels if the returns generated were less than for equities.
Switch to alternatives
One viable option would be to reduce the equity allocation and increase the amount invested in alternative assets such as infrastructure, private equity or property. Indeed, LGPS funds have been switching out of equities and into these assets.
Sam Gervaise-Jones, head of UK client consulting for bfinance, a financial consultancy, says: “These assets will provide growth to ensure the LGPS does not have to increase the contribution levels materially.” But it takes time to switch to these more illiquid assets so it’s not a viable tactical option – it needs to be part of a longer-term strategic shift. “This is a slow and steady process,” Mr Rivers says.
The illiquid nature of alternative assets means it takes longer to fully fund an allocation. It can take time for a private equity manager to source the right deals. The popularity of these asset classes has compounded the delay, as there is more capital competing for each deal.
Hemal Popat, director of investments at Mercer, a consultancy, says: “Many schemes are finding it is taking longer to make this shift into alternatives than they had thought.” He estimates that the LGPS is roughly half way through a longer-term shift that could take several more years to complete.
The switch out of equities and into alternatives which do not generate income has to be balanced against the high cash requirement of many LGPS funds. Mr Buckle says: “Many are now paying out more money to pensioners than they receive in current contributions.”
That means the funds cannot have too high an allocation to illiquid assets, which take too long to convert to cash to meet benefit payments. Income-generating alternatives have a role to play, provided they don’t reduce the expected growth rate of the overall pension scheme, says Mr Buckle.
According to Mr Gervaise-Jones: “There will be general drift down in equity allocations but a significant decrease is unlikely.”
Protect against downside
The only viable strategy available to most schemes is to use options to protect against equity downside using derivatives. This is much easier to implement than a radical reallocation of the equity portfolio.
“Equity options will give you much more protection because it possible to protect against the whole developed market equity allocation,” Mr Popat says. By contrast, to reduce equity risk by a third by selling equities the scheme would need to reallocate a third of the equity portfolio.
“Local authorities should be aware, however, that implementing an insurance policy will lower the expected returns of the equity portfolio,” Mr Buckle says. That’s because an option strategy will require cash to fund those options. As this insurance will dilute returns, the decision about whether they should put this place will depend on several factors.
A scheme will need to determine whether it could, for example, handle a 10%, 30% or 50% fall in its value of equities. “The fund will need to decide whether it is prepared to sacrifice some upside to protect against any downside,” Mr Rivers says.
A pension scheme will have to take two factors into consideration when determining what type of hedge it wants to put in place and how much it will cost. According to Mr Rivers: “The scheme needs to determine what drawdown they can tolerate and the level of market volatility at the time they take out that insurance.”
It will cost more to hedge a smaller market correction – because there is a greater probability of it occurring – than a larger market correction. The higher the current level of volatility, the more expensive the insurance as the chance of significant market moves is greater. “While option pricing is not as cheap as it was in 2017, it is still reasonably priced,” Mr Rivers says.
“Equity options will give you much more protection because it possible to protect against the whole developed market equity allocation.”
Hemal Popat, director of investments, Mercer
Closed schemes with higher funding levels would be more likely to use equity options to protect against smaller moves. As LGPS funds are open and have a longer time horizon, they are likelier to use options to hedge against larger moves.
Mr Rivers says: “It makes sense to use this type of insurance if the LGPS wants to mitigate the impact of a market downturn over a short time horizon.”
This reflects the change in market conditions. “In 2018, there was a shift from a period of exceptionally low market volatility to more normalised levels,” adds Mr Rivers.
With global growth and monetary policy reaching an inflection point, it makes sense to put these hedges in place.
There is another strong motivation for the LGPS to protect against any equity downside: the triennial valuation is due to happen in March 2019. According to Mr Gervaise-Jones: “This will provide a snapshot of the health of the scheme which will be scrutinised by the press.”
For this reason, over the past year several LGPS funds – Cumbria, Worcestershire, South Yorkshire, some of the London boroughs, Swansea and Merseyside – have all looked at explicit equity risk management strategies. Mr Gervaise-Jones says: “These authorities have looked at putting insurance in place which will provide protection if equity markets should experience a correction of more than 20%.”
There are two key factors that help the LGPS to determine where specific hedging levels are set: cost and client situation.
Smaller falls in markets, of up to 10%, potentially happen more frequently, so are less cost effective. Mr Gervaise-Jones says: “These smaller falls are less damaging and so it is less important to explicitly protect against these.”
Larger falls are rarer and if they were to happen the pension fund may be looking for an opportunity to buy more equity rather than sell, he adds. “The decision to protect against equity downside is linked less to precise funding levels and more to getting useful protection at a cost-effective price.”
Over the longer-term, pooling will help to increase the diversification of local authority portfolios away from equities. Mr Gervaise-Jones says: “Local authorities will have access to higher levels of investment expertise along with scale to give access to different asset classes.”
Mr Popat says: “While individual local authorities will always be responsible for the asset allocation, over time pools could become more involved in risk management which could reshape the way portfolios are constructed.”
He adds pooling could free up governance capacity to focus on more strategic decisions such as risk management and strategy as the nuts and bolts decisions will be dealt with by the pools.