LGPS 2014 “destined to fail”
0The 2014 Local Government Pension Scheme continues to generate concern within the sector over contributions, costs and sustainability while investment officers grapple with complex governance arrangements and volatile markets. Against this backdrop we asked two seasoned local authority finance officers to reflect on some of the big questions facing funds, including what does the future look like for the new scheme?
John Raisin, MBA, is the independent investment advisor to the London Borough of Waltham Forest and London Borough of Haringey pension funds. He is CIPFA qualified and holds the Investment Management Certificate.
Peter Scales is the former Chief Executive of the London Pensions Fund Authority and is currently a Senior Adviser with AllenbridgeEpic Investment Advisers, advising pension funds on their governance arrangements.
R151: Do you think LGPS needs new regulatory standards for investment governance?
John Raisin: I feel regulatory standards for investment governance should be applied through new Management and Investment of Funds Regulations. The present regulations came into force on 1 January 2010 and given they have been operating for almost 3 years should now be reviewed by a group comprising the CLG and primarily officers who are involved in running LGPS funds. This should lead to a formal consultation on proposed new regulations.
The CLG should emphasise the current Regulation 11(2) which states “The authority’s investment policy must be formulated with a view –
(a) to the advisability of investing fund money in a wide variety of instruments;
and
(b) the suitability of particular investments and types of investments”
This regulation should, in my view, be treated as a clear requirement on funds to spend a significant amount of their time considering strategic asset allocation decisions and giving truly genuine consideration to investments of a material level in a range of “alternative” assets as a whole, so as to seek to maintain an emphasis on “growth” investments but with somewhat less volatility than experienced with a heavily equity orientated portfolio.
Peter Scales: The LGPS already has a robust regulatory framework within which both elected members and officers can operate, and in my view it works well. Imposing more rules in a form of micro-management governance or more requirements to tick boxes or publish policies in an ever growing annual report seems unnecessary to me.
My fear is that this stems from some misunderstood need to control the management of LGPS funds because those in control have somehow fallen short in their duties. Whereas the most likely cause of the current predicament is as a result of greedy and volatile markets, Government interference, unrealistic accounting rules, longevity, early retirements, and the fact that many are drawing their pensions for longer
R151: How can investment officers manage the transition to negative cash flow?
JR: As recently as July 2010 the Audit Commission stated that “The LGPS does not face an immediate crisis. The scheme has a positive cash flow” Admittedly 2011-12 was a year when there was an unusually large number of leavers because of local authority budget reductions. However I do not believe that investment officers should be preparing to manage a transition to negative cash flow in the near future.
Negative cash flow must be actively avoided for as long as possible so that funds can continue to invest in growth seeking assets to reduce costs. Therefore everyone involved in the LGPS – administering authorities, employing bodies and the trade unions should be doing everything they can to promote the scheme with the aim of significantly reducing the number of employees opting out. This could have a material effect in terms of keeping funds in positive cash flow for longer than otherwise will be the case.
PS: LGPS funds enjoy the benefit of being able to draw on the experience of local authority treasury management teams, who are no strangers to managing cash flows for complex services as well as the pension fund. This is a benefit that is not available to most private sector funds.
That doesn’t make it easy to manage negative cash flows but the practice of forward looking cash management will help. Most LGPS funds have positive cash flows currently, although some are already in negative territory, and the prospect of increasing maturity through contribution decline and lower investment income is already being planned.
A steady focus on liabilities in setting investment strategy and broad diversification of assets to blend the long term expectation with shorter term needs is the way forward.
R151: Where would you look to generate returns in the coming years?
JR: Given that LGPS Funds were, in general, considerably underfunded at the 2010 valuation together with the requirement to undergo an actuarial valuation every three years, achieve 100% funding in the long term and seek to maintain as nearly consistent employee contribution rates as possible, returns need to be generated from an asset mix which will generate “growth” but without excessive volatility.
This therefore indicates that funds should look to reduce their current average allocation to equities of 62% to a somewhat lower figure, perhaps around 50% in the long term, and make a material allocation to a range of “alternative assets.” Infrastructure with its inflation protection plus growth potential and long duration immediately comes to mind. The existing average allocation to property of 7% should be increased. Investment in private equity, hedge funds and active currency management should also be given genuine consideration. For “alternative assets” to make a real impact in terms of delivering growth with more stability than a heavily equity dominated portfolio will require significant allocations to “alternatives” as a whole. Token allocations to “alternatives” will not achieve growth returns with increased stability.
Conventional Government and corporate bonds do not really provide long term “growth returns.” Therefore in terms of bond/fixed income investing (which I think should be about 15% of the fund as a maximum) a better emphasis would be on modern “absolute return” products.
PS: A preference for a heavy weighting in equity investments has been criticised and market volatility over the past 10 years has not helped sustain expected returns. But pension funds are still a long term business. What is required is better planning, strong risk controls, and the ability to be more efficient in investment decision making.
Funds are already diversifying into alternative growth investments which I believe is the better approach than knee-jerk matching to bonds that will most likely lock in deficits. There are many opportunities out there for the well managed fund and I would be looking at areas such as emerging market debt, corporate mezzanine debt, bank loans, infrastructure, global real estate and high dividend equity stocks as return enhancing options.
R151: What does the future look like for the LGPS?
JR: In terms of improving investment returns, that depends on maintaining positive cash flow for as long as possible and reducing the volatility of investment returns while maintaining a clear emphasis on growth assets. Therefore, as indicated above, funds while maintaining a sizeable allocation to equities should make sizeable investments in a range of “alternatives”
The new 2014 LGPS scheme is, I believe, very good for lower and moderately paid employees, those with short service and those approaching retirement. An accrual rate of 1/49 with revaluation based on CPI is a really good deal for such employees. My concern however is that as with the 2008 scheme the fundamental issue of affordability has not necessarily been resolved. The 2014 scheme must however succeed as I fear another review could lead to genuine questions as to whether the scheme should remain an open defined benefit scheme. Therefore it is vital that administering authorities, employers and the trade unions promote the scheme so that as many employees join the scheme as possible to emphasise its value to both local government and the individual employee and to help keep the scheme cash flow positive for as long as possible. The future of the scheme will also be partly determined by the level and stability of investment returns as discussed above and hence the need to carefully consider strategic asset allocation decisions and to invest in a wide range of “growth” assets.
PS: Bleak and tough. Markets and economies need to settle but what chance of that in the short term? Regulatory and accounting perspectives seem set on concentrating more on the short term, and public perceptions don’t help.
The new LGPS seems destined to fail in my view as it will prove to be too expensive and will then be up for further review as the political dimension changes. Don’t get me wrong, I think the LGPS is an excellent scheme and I fully support DB pension arrangements. But we all need to be realistic.
We need to get back to a benefit structure that represents a worthwhile investment for all employees in local government, especially the lower paid, and provides a reasonable pension in retirement. Above all the culture of expectation and the need to save for our retirement needs to change dramatically.
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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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