John Harrison: Four steps for LGPS in the age of Covid-19

Covid-19 has had a devastating effect on people and markets. John Harrison offers a way forward for LGPS through asset allocation, income, performance and governance.

The global Covid-19 pandemic has been devastating. The continuing human cost in lives lost is horrific and the economic cost of sudden and widespread lockdowns to limit the spread of the virus may take years to correct. The very foundations of modern society have been shaken, with perhaps profound implications for the future. It is a future that is even more uncertain than usual and one that poses challenges for LGPS investment committees as they meet on Zoom.

The immediate impact of Covid-19 on funding positions will clearly have been negative. Equity markets and other risk assets fell sharply as investors realised the potential depth and breadth of the crisis. Government bonds, by contrast, held up well.

The impact on the funding position of individual LGPS funds will vary greatly depending on the extent of hedging or equity protection strategies used, but it is likely that the funding level of the average LGPS fund worsened by as much as 15% between December 2019 and March 2020. Authorities in England and Wales will be relieved their triennial valuation date was a year earlier, unlike those north of the Border.

Sentiment and fundamentals

The first few weeks of the new financial year have seen a partial recovery in financial markets, although it is hard to have much confidence in market valuations. While we can be sure that global economic growth will be significantly negative in 2020, the impact in each region and speed of potential recovery is impossible to predict accurately. The outlook for company profitability is even less certain. Almost every metric used to value equity markets—earnings, dividends, cash flows, asset values—is impossible to forecast accurately, so short-term market movements are more indicative of sentiment than fundamentals.

The broad strokes we can predict are not encouraging. Governments across the developed world have adopted drastic fiscal measures, increasing debts to finance health spending and provide support for businesses and workers. This is likely to increase the tax burden for many years to come. In time it may also prove to be inflationary, although the more immediate concern given the collapse in economic activity is to avoid deflation.

It seems likely that social distancing will remain for some time, which has implications for the way we all work, travel and socialise. This will challenge business models in a wide range of sectors—most obviously leisure, transport, hospitality. It may also change the way we work and how we shop, which would have longer term implications for office and retail properties.

What to do?

What should LGPS funds be doing in this environment? In my view there are four things investment committees should focus on.

First, make sure asset allocation is rebalanced regularly. The LGPS has limited scope to make significant changes to strategy because we need the long term returns from growth assets to make our pensions promises affordable.

Many funds have been gradually allocating more to illiquid asset types, but this takes time and is probably not best achieved during market turbulence. Market volatility will also make most derivative-based equity protection strategies more expensive.

What we can do cost effectively, though, is make sure market movements do not push asset allocation too far away from the agreed long-term strategy. Regular rebalancing enables funds to take advantage of short-term falls in equity markets and widening yield spreads.

Second, review your income position. Investment income will be under pressure as companies are forced to cut dividends and property tenants are unable to pay rents. Many income streams will not recover quickly, if at all. At the same time some employers within the fund may struggle to continue making pensions contributions. Pensions Committees should consider whether they need to make adjustments to offset this double income pinch – for example, by suspending reinvestment of investment income.

Performance and governance

Third, discuss with your asset pool how the characteristics of various investment capabilities impact on investment performance. In equities, there have been huge swings in relative performance during the crisis, with value styles performing poorly.

In bonds, yield spreads have widened and a number of corporate issuers are now below investment grade. In property sector weightings are important, with retail and offices potentially more vulnerable to valuation adjustments.

Fourth, consider whether the fund’s current governance arrangements are suited to more volatile market conditions. As a general rule, LGPS funds have been wary of delegating asset allocation decisions to their pools. Is this still the best structure or should pools be encouraged to launch a broader range of multi-asset capabilities more responsive to changing market conditions?

The Covid-19 pandemic represents the first significant period of market stress since LGPS asset pools were created. It is too early to say whether or not pooling helped funds cope with the crisis, but in due course we may find that the requirements of partner fund have changed.

John Harrison is