Rachel Brothwood: Trienniel valuations and the road ahead

Funds will need to be alert and flexible to deal with demanding changes, says Rachel Brothwood.

As we fast approach the next triennial valuation, there’s plenty of food for thought on LGPS funding.  Record returns have come with stark warnings of market volatility, scheme changes and high-profile employer defaults.

In a changing world, with our new investment pooling partners on board, how do investment and funding plans stack up with those established three years ago?

Horizon for market risk

“Investments can go down as well as up” is something we often hear but have truly lived this past 12 months.  Three years ago the outlook for investment returns was less optimistic and you could be forgiven for thinking that market commentators had it wrong, looking purely at the high return on LGPS assets over 2016-17. The reality of lower growth rates and geopolitical uncertainty has certainly been felt since. Whether you believe in currency hedging or not, it cannot be ignored that these decisions (together with allocations to UK vs overseas assets) will have had a material impact on fund asset values over the period.

Without a doubt, we are all looking closely at markets in the run-up to the 31 March valuation date, with potential for significant volatility at, and around, this key date for assessing LGPS funding requirements. As funds focus more on asset allocation and future investment strategy decisions, the value-add from getting this right will start to become more visible.

Scheme change and evolving cashflow requirements 

With all scheme benefits linked to future inflation, the impact and risk of rising future rates cannot be ignored.  Whilst the LGPS as a whole is cashflow positive, it is maturing. Pension payrolls are set to increase substantially over the next 5-10 years as the baby boomer generation reach retirement.

Allocation to income-generating assets and the search for secure long-term inflation-linked income streams is set to increase, and this could fit well with some attractive opportunities and increasing target allocations to infrastructure.

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Being alert to changing cashflow requirements, as member options and behaviour evolve, should avoid cash shortfalls. For example, as many schemes are seeing an uptake in member engagement, monitoring earlier access to deferred benefits, increasing use of flexible retirement and (albeit modest) transfer elections linked to freedom and choice, will highlight advancing income requirements.  Add to this ongoing local authority restructuring and outsourcing, and the profile of future cashflows are increasingly uncertain.

Challenging the toolkit

With increasing scope for change, having the tools to be nimble and an ability to work with investment pooling partners to develop products aligned to strategic requirements is essential.  Never has it been more important to “stress” and scenario-test long-term funding and investment plans to ensure these remain robust.

Much has been said recently on fund data and there’s no denying “holes” will limit confidence in output.  Member data is at the heart, but accurate cashflow and investment information (including transparency of costs to avoid leakage) also play a huge part.

The recently updated and relaunched CIPFA guide to managing risk in the LGPS should be flying off the electronic shelf!

Understanding the employer journey

Employer contributions to the fund are a critical element of all funding and investment strategies. Diversity, turnover and the number of scheme employers continues to increase with the added dynamic of competition and change to employer income streams.

Financial pressures and restructuring have brought increasing orphan liabilities, mergers (particularly in the further education sector), and new types of employers (for example children’s trusts) through alternative delivery models.

The introduction of employer exit credits and open consultation on the New Fair Deal both have the potential to materially change the employer “journey” and covenant risk to the scheme.  Funds need to be alive to and adapt policies to reflect these changes and ensure recovery of contributions due over the long term.

Outcomes from the 2019 review stand to vary significantly by employer as changing risk, benefit and liability profiles are reviewed, making early engagement essential.  With many new faces to meet, it will be interesting to see how changes within the wide variety of sectors participating in the scheme and their outlook, will impact employer financial resilience.

Conclusion

The valuation marks a wider sense check and challenge on a fund’s path towards delivering members’ benefits over the long term. There’s lots we don’t yet know and can’t control but being sighted on the things that move the needle and looking beyond the next review date should build resilience for the road ahead.

Although funds can (and rightly do) take a long-term view, taking the opportunity to deliver superior outcomes will take more than entering the desired destination into the sat nav.

Rachel Brothwood is director of pensions at West Midlands Pension Fund.

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