Stephan Van Arendsen: Allocation strategies for the LGPS

Stephan Van Arendsen is senior manager, corporate finance, at Cheshire West and Chester Council, administering authority for the Cheshire Pension Fund. This article was originally published in Issue 2 of Room151 Quarterly magazine. 

Every three years the role of every administering authority within the Local Government Pension Scheme comes to the fore. As the valuation process is undertaken, officers and trustees have the task of evaluating the overall status of the fund and employers, as well as agreeing contribution strategies that are fair and affordable. With increased financial pressure on all employers within funds, and not just the traditional tax raising bodies, these conversations are becoming more difficult when treated in isolation.
Of course, agreeing a contribution strategy that supports a fund’s deficit recovery plan is only one of the levers available to administering authorities as they seek to meet their overall funding objectives- the other is the question of what our assets are trying to achieve?
In considering this basic principle it is important to remember why the LGPS exists and what the primary objective all administering authorities is: we have made a pension promise to pay pensions to scheme members when they arise. We are not investment managers, we are here to ensure we have sufficient assets available when required to pay pensions. This principle is fundamental when we consider the direction of travel that the LGPS has taken since 2010. All administering authorities have seen a huge increase in the number of employers within their funds due to the outsourcing of traditional council functions to the private sector and third parties, plus the movement of schools to academy status.
Each of these employers, in addition to those already within the LGPS, has, in effect, their own balance sheet. But as the range of employers within funds is expanding we are seeing that they have a range of characteristics and funding objectives. For example, within the £3.5bn Cheshire pension fund, traditionally 85% of the liabilities have been held by four tax raising bodies. The objectives and deficit recovery plan for these four councils dominated investment strategy and asset allocation decisions with the objective being to move from an 80% to a 100% funding level over, say, a 20-year period.
Move to the present day and the Cheshire fund has more than 150 employers, the objectives for each employer vary significantly and the administering authorities need to respond accordingly both in determining contribution strategies and developing investment strategies and subsequent asset allocations that suit these different needs.
These differences can be illustrated with a comparison: why would a tax raising body that is 80% funded, with a strong covenant and 20- year recovery plan, have the same investment strategy, and take the same level of investment risk, as a private sector company that has a seven-year contract with a local authority and was set up with a 100% funding level?
At an objective level, the aspirations of both employers are fundamentally different, but most importantly for administering authorities, the risks that they present to funds are also fundamentally different. It is on this key point that the Cheshire fund believes that a different approach is required to the development of investment strategies within the LGPS in order that funds meet their primary objectives of having sufficient assets available to pay pensions when they fall due, and also meet one of the minister’s primary objectives in the recent call for evidence, which is to manage deficit recovery more effectively.
This different approach to the funds’ investment strategies and asset allocation is based on the conclusion that a single strategy is no longer sufficient to meet the overall needs of a fund and its individual employers.
The Cheshire Fund has therefore worked over the last 18 months with its investment consultant and actuary in order to define the key issues for each employer in the fund based on its:

• Funding level
• Strength of covenant
• Cash flow profile
• Maturity profile; and
• Proposed contribution strategy.

This has allowed the fund to group all of its employers into one of four notional pools which have their own characteristics and objectives. The next stage in this process has been to determine for each pool the optimum risk based strategy that will enable the objective of reaching a 100% funding target to be reached.
Again, this work has been undertaken following the completion of an ‘interim valuation’ in 2012, and these investment strategies have been set up to compliment the contribution strategies that will come into effect from 1 April, 2014 as part of the 2013 valuation.
The strategies that have been developed are:

• high growth – for a majority of the large employers in the fund who still need a level of growth from their investments (has 70 or 80% growth assets depending on employer)
• medium growth – well funded or recently set up employers (certain admission bodies and housing associations (50% growth and 50% defensive assets); and
• low growth – employers who have closed or left scheme (100% gilts)

While such a change is significant, this approach presents the fund and its employers with a more tailored suite of strategies that will support both parties in meeting their pension objectives.
Having concluded that a range of investment strategies that better reflect the individual risk characteristics of each employer, as well as containing defined ‘flight paths’ to meeting a 100% funding target over time, the fund has also taken the opportunity to enhance this risk based approach still further with a formal set of de-risking triggers being applied to each strategy.
So, for a strategy that has an overall funding level of 80% at this time, there are defined funding level triggers at various points up to 100%. Under this process, as the funding level in an investment strategy is reached, for example 84%, the fund will aim to capture this gain by reducing its exposure to growth assets in the strategy and increasing its defensive allocation. It is hoped that not only will this allow the fund to capture some of the upside from an increased funding level by reducing the exposure to more risky growth assets, but it also offers the fund greater downside protection.
It is on these principles and benefits that the fund has developed the concept with its trustees and communicated the approach to its employers who, importantly, have been advised that the de-risking approach will complement their contribution strategies.
Feedback from employers as part of the 2013 valuation process has been positive and all have engaged fully in the new approach. The appreciation of the fund managing their long-term pension risk through positive and innovative investment strategies has allowed a true collaboration to take place that will see both the objectives of the fund and employers alike to be met. It is on this premise that the Cheshire pension fund continues to see the development of appropriate investment strategies and asset allocations as key in helping it meet its primary objectives.