John Harrison: The triennial challenge

John Harrison looks at the likely changes in strategies following the upcoming valuation, and potential friction between pools and their partner funds.

A lot can change in three years. When we drew the line for the last triennial review in March 2016, our world was very different. The EU referendum had yet to take place, so dictionaries did not even contain the word ‘Brexit’. Donald Trump seemed unlikely to become president of the United States. And most LGPS pension funds had a substantial deficit that we thought would take many years to close.

As we approach the next triennial valuation point, LGPS funding levels appear on average to be much better than we had dared to hope three years ago. The referendum result played its part, with our overseas assets gaining from the sharp fall in sterling. The more important drivers though have been an extended bull market in equities and a modest rises in gilt yields. It is perhaps dangerous to predict where funding levels will be at the end of March this year given the uncertainties of a Brexit date just two days earlier, but the current position is healthier than it has been for many years.

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An improved funding level may lead some funds to change their strategic asset allocations. Most LGPS funds have previously had little choice other than to invest forgrowth through high equity allocations. The alternative would have been toaccept lower discount rates, higher liability valuations and increasedcontribution rates. This may change if the next triennial valuation suggeststhe funding level is much closer to 100%.

The scale of any potential changes should not be over stated. Funding level calculations typically assume relatively high future returns, so the strategy bias will have to remain tilted towards growth. There is also a widespread reluctance to invest in the natural ‘liability matching’ asset, long-dated index-linked gilts, on real yields that are still worse than -1.5% pa.

To the extent that changes are made, the broad themes are predictable. Equity weightings that have drifted higher through market movements are likely to be reduced to dampen potential volatility. Less clear is how the regional weightings within equities will change – will the UK and emerging markets proportions be reduced further or will their relative under-performance over the last few years make them more attractive?

It seems likely that any monies taken out of equities will be allocated to alternatives rather than to bonds or diversified growth funds. Bond yields remain very low – there is little appetite to invest in gilts on nominal yields of 1.7% and real yields of -1.6% for the next 20 years. Diversified growth funds have also fallen out of favour by generating lacklustre growth during a period when equities have delivered above-average returns with below-average volatility.

Consultants are likely to advise their LGPS clients to invest in a broad range of alternatives instead. More will be allocated to illiquid assets, such as private markets, property and infrastructure, although it will take a while to build up weightings. More may also be allocated to ‘liquid’ alternatives, particularly multi-asset credit and absolute return bonds.

The other major change since the last triennial valuation has been the development of LGPS asset pools. Most did not exist in 2016 and are still in the early stages of rolling out their investment capabilities. The forthcoming valuation cycle poses challenges for the pools.

It takes several months for a pool to launch any new vehicle, with the less liquid alternatives being more complex than mainstream assets. The pools will therefore need to discuss priorities with their partner funds well in advance. The pool must also satisfy itself that there is sufficient long-term demand to justify the time, effort and cost of creating a capability. It is hard to justify launching a new fund if the capability may not be required in a few years’ time.

The imminent valuation cycle may also highlight a potential tension point between the pools and their partner fund advisers. The business model of the pools requires the range of capabilities to be kept narrow to derive the maximum benefit from pooling. By contrast, the business model of a consultant firm may incentivise allocating to as broad a range of capabilities as possible, either as a point of differentiation from competitors or to support a revenue stream from future manager searches. It will be interesting to see how this tension is resolved over the coming year.

In time, I would expect pools to develop a closer relationship with their partner funds – they are after all an ‘internal investment resource’ that should be well-aligned to the interests of the LGPS funds they serve. The capabilities offered will become broader but focused on asset types that help the partner funds collectively achieve their objectives. For now, however, the trend may be the other way, with different consultant firms advocating different ‘new’ ideas.

John Harrison is an adviser to Border to Coast Pensions Partnerhsip and a visiting professor at Cass Business School.

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