John Harrison: Is LGPS ready for rising interest rates?

It is understandable that LGPS pension committees are focusing most of their time and thought on responding to the government’s plan to restructure the sector.

However, amid all the hullaballoo we must not overlook the need to ensure our investment strategies are suited to the investment environment we face.

Arguably, the biggest threat to the sustainability of the LGPS in the long term is not so much the structure of decision-making but rather our ability to manage funding deficits in the next few years.

The investment environment is rarely ever clear, but the outlook as we enter 2016 is more than usually foggy.

The dominant global investment theme since the financial crisis began 7 years ago has been the unprecedented level of monetary policy stimulus provided by the world’s most influential central banks. Not only have interest rates in the major economies been kept close to zero, huge amounts of additional stimulus have been provided through quantitative easing (QE).

In effect, policymakers have been pumping money into the financial system in order to raise asset values and boost confidence. It has been a great tailwind for investment markets, but it is a tailwind that is now coming to an end.

The US Federal Reserve scaled back its QE programme some while ago and late last year raised short-term interest rates for the first time in close to a decade.

This is a significant moment for financial markets. For the first time since the financial crisis central banks in the major developed markets are applying markedly different policies.

The UK will probably follow the US lead by raising base rates later this year, but the economic recovery is much more fragile in Japan and Europe, so monetary policy there will still rely heavily on QE.

Big Questions 1, 2 and 3

This change in monetary policy raises a number of important questions for LGPS funds.

First, how quickly will short-term interest rates rise? It seems likely that the pace of interest rate increases will be much slower than in previous economic cycles.

The world faces a range of deflationary forces, such as weaker economic growth in China and falling commodity prices, so there is little pressure from inflation.

The level of indebtedness globally in both the public and private sectors also implies that economies will be much more sensitive to interest rate increases than in the past.

Second, how will investment markets react? One consequence of QE has been to push up the valuation basis for financial assets generally – notably developed market shares, bonds and property.

The current ratings of US equities, in particular relative to earnings and dividends, could prove quite demanding should economic growth disappoint as the tide of central bank liquidity ebbs away.

Third, and perhaps most importantly, will increased short-term interest rates lead to rising bond yields? Many funds will be hoping they do because long bond yields are an important driver of liability calculations.

If long gilt yields rise materially the value attributed to liabilities will fall, which in turn could help reduce deficits.

However, long-term yields do not always move in the same direction as short-term interest rates, particularly if investors become more risk averse.

The LGPS two-step

Overall the current investment environment is one in which central bank intervention is waning, economic recovery is patchy and valuations are high.

This is a cocktail that seems likely to result in greater volatility and lower trend returns in the coming few years.

LGPS funds face a difficult challenge. On the one hand they need to generate good investment returns relative to liabilities in order to reduce funding deficits.

On the other they need to dampen down the volatility of the funding level to reduce the risk that deficits widen further. An environment of greater volatility and lower returns is not at all helpful. So what should LGPS funds do?

Two steps seem sensible. The first is to consider whether a fund’s strategic asset allocation is sufficiently diversified. While developed equity markets have been rising steadily, diversifying into other asset types has been detrimental to returns. That may be about to change.

The second is to establish a framework for monitoring funding levels with a view to reducing risks relative to liabilities as, and when, opportunities arise.

Unfortunately, the headlong dash to restructure the sector probably means very few funds will have time to consider either step.

Which may mean we have to rely on a third approach – keeping our fingers crossed that neither equity markets nor long bond yields fall while we work out the new structure for LGPS investment.

John Harrison, independent investment adviser, Surrey Pension Fund.