Do stellar returns mean LGPS has cracked the secret to being a good investor?

Last week figures from DCLG showed an extraordinary increase in the value of LGPS funds. However, Colin Pratt warns that though there is “good reason for optimism”, higher than expected returns could prove a “sticking plaster” for some employers.

The value of LGPS funds in England and Wales increased by 21%, or £45bn, in the financial year ended 2016/17. This was a much higher increase than even the most optimistic would have been able to justify at the start of the year and is all-the-more remarkable given the Brexit vote, which would have been almost universally considered likely to be negative for equity markets.

The pernickety would point out that the return was below the sterling return for global equities for the year, but that fails to take account of the fact that most funds hold a significant proportion of assets in other types of investments.

So, does this high return prove that the LGPS is, as a whole, a good investor? The answer has to be “not really”.

Savvy

LGPS Funds are nowhere near as homogenous as they were 20 years ago, when there was a tendency to follow everybody else when setting asset allocation.

Recent years have seen a move towards diversification away from the reliance on equities, which is entirely understandable given their volatility and the increasing maturity of the LGPS, but equities remain the dominant asset class.

Given the high return achieved across the LGPS in 2016/17, it would appear that this diversification was into asset classes that also performed well. In the short term, at least, it would appear that the LGPS has diversified in a savvy manner.

It will always be the case that some funds will perform better than others, and in 2016/17 it would be surprising if those with higher-than-average equity weightings were not at the top of the pile.

But this fails to acknowledge that investment is a long-term game and that different funds will have justifiable differences in their attitude towards the level of risk that they feel is appropriate—a willingness to accept slightly lower future returns with the benefit of lower volatility (and, hence, less scary actuarial valuations) is not necessarily a bad decision.

Bad decisions are generally those taken without a full understanding of the risk/return trade-off of each investment, and do not always actually lead to a bad investment outcome; luck can easily mask individual bad decisions. It is unlikely to be able to indefinitely hide a flawed investment decision-making process.

We are already half way into the 2017/18 financial year and equity markets have continued to rise, albeit at a much more moderate pace than last year. This does not rule out the possibility that the high returns of 2016/17 were simply “borrowed” from future years, and it is long-term investment returns that will ultimately impact onto the financial health of the LGPS.

The improving “professionalisation” of LGPS investment decisions, which will be assisted by the advent of pooling, means that there is good reason for optimism about the future.

But we should not get carried away with one exceptional year of performance any more than we should be despondent when there are inevitable downturns.

Focusing on long-term outcomes and ensuring that investment decisions are taken with sufficient thoughtfulness are what will ultimately prove that the LGPS is good at investment, and I believe that the passing of time will prove this to be the case.

Liabilities

Assets are only one side of the balance sheet of the LGPS, but it is the easiest side to calculate; the market does the job for you.

The calculation of liabilities is based much more on judgement calls, with assumptions of future investment returns, inflation and life expectancy (among many others) having a meaningful impact onto the results.

There is no point pretending that the valuation of liabilities calculated at each actuarial valuation is any more than a guess—admittedly an educated guess—but there are clear differences in the assumptions used by different actuaries and different funds.

Austerity and financial necessity have, almost universally, meant that at least some of the prudence that is supposed to be included within an actuarial valuation has been taken out.

The biggest long-term risk to the financial health of the LGPS might not actually be linked to investment returns, and may be around the fact that some employers are not paying sufficient contributions to improve their position to any great extent.

Higher-than-anticipated investment returns are obviously useful in improving the funding position, but may prove to be no more than a sticking plaster for some employers.

Colin Pratt is investment manager at Leicestershire County Council Pension Fund.