LGPS Q&A – David Walker of Hymans Robertson on the triennial valuation

The upcoming review will be an important yardstick for how funds have performed and provide an opportunity to review investment strategies. David Walker shares his thinking on the outlook for the LGPS.

Room 151 (151): Are you anticipating much higher valuations at the upcoming triennial review in March, and if so, how are you advising your LGPS clients to respond?

David Walker (DW): Yes, I think we are going to see improved funding levels for the majority of the funds in the LGPS, unless we see some further volatility in the coming months. So, I think that is a positive position that most funds will find themselves in.

In terms of how we are advising them to respond, I think there are a number of balancing issues. Though funding levels have improved, the cost of funding future benefits, in many cases, will have increased as well, and that will impact the ability to alter the level of investment risk they are currently taking. In some cases, funds will be acting on the back of improved funding levels to try and reduce risk, but they need to balance that carefully with the ongoing affordability of contributions.

151: The triennial valuation provides an opportunityto review investment strategy. Are your LGPS actuaries making more muted assumptions for future investment returns, and what are the implications if that is the case?

In the case of our firm, our actuaries are focusing on long-term affordability, rather than focusing on discount rates at a single point in time. So, it is about ensuring the contributions being paid are sufficient to pay the benefits now and in the future.

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Again, I think there is a bit of a balance there in terms of the current market climate and the impact of the current outlook and the ability to take investment risk. So, I think most funds will be reviewing their investment strategy. There has been a lot of discussion in the market about derisking. I think it is important that the LGPS funds think about what their long-term objectives actually look like, and where they are trying to get to. I don’t think we will see automatic derisking switches. I think there will be some reductions in risks as part of a strategic review. Again, that needs to be balanced with contribution affordability.

151: A lot of the LGPS funds are fully funded, or nearly fully funded. Are they sill invested too much in equities?

I think there are a number of funds that are looking to reduce the level of equity risk. Equities will remain the main driver for performance in the majority of funds, but certainly, some funds have been taking steps to reduce their exposure. And that has been either through looking to diversify and investing in other asset classes, or looking to put some sort of protection strategies in place. Again, this is to allow them to maintain a reasonable allocation to equities but alter the risk profile. So, I think the question is difficult to answer as it should be specific to the level of return that each fund needs to generate. On the whole, however, we are seeing steps to reduce the level of equity risk that funds are taking.

151: Are you encouraging funds to invest in alternatives, such as private markets, infrastructure and property?

Yes. That has been one of the areas that we have seen funds move into. Particularly asset classes where a greater element of return stream is delivered through visible income. So, asset classes like infrastructure or private debt where the asset classes offer an attractive level of income that gives a bit more visibility to the returns, and a bit more certainty in being able to achieve those returns have been in demand.

151: And what is your view on infrastructure in the UK at the moment? There has been some comment in the press about it becoming a hostile environment for investment, particularly following the ending of the private finance initiative funding and expectations of a harsh new regulatory period from Ofwat.

I think there will be opportunities, but funds will need to be quite selective, particularly in terms of the pricing that is currently available in the market. There is a need to balance the desire for return with the level of risk being taken. I think there are some who are a bit cautious of the political environment, and I think it is valuations that are a concern for others.

I think there are still opportunities, but funds will look to be quite selective in the types of investments they make. The regulatory environment is still seen as being quite a strong one in terms of investor protections for those in the asset class.

151: Some administering authorities tell us that pooling has failed to reduce costs. Do you think that overall it has been successful in this regard?

I think the experience has probably been mixed. Some funds have definitely seen reductions in the costs that they pay to fund managers through the terms negotiated by the pools or the sub-fund options that have been made available to them. For others, I think it is still quite early days.

The new guidance on pooling that is coming out also includes some references to looking at the costs on a longer-term basis. So, it acknowledges that in the short term not all funds might see an immediate benefit, but it does encourage funds to look longer term.

151: So, are you confident that in the longer term costs will be reduced?

That would be our hope. I think there has been some positive experience to date, but it is still quite early to tell.

151: There is some evidence that the smaller funds are performing well. Is there a danger that future performance is going to be inhibited pushing everybody into large big funds?

There has been a mix in terms of the big and smaller funds performing well, and there is a variety of drivers behind that. Over time the range of investment options offered by the pools will expand. Initially, they are very much focusing on listed markets. Over time, that will expand and allow all funds a greater choice of how they can invest their strategic allocation across the sub-funds offered by the pools.

 I don’t think it will mean a convergence of performance. More likely there will still be sufficient choice out there under pooling so that all funds are allowed to implement their locally determined investment strategy.

151: On that point, some administering authorities have complained that the removal of the decision from them on choosing the fund managers means that their asset allocation decision is restricted as well, because the funds offered by the pools are not always a good match for what they had before. How big a problem is that, do you think?

That it is something that should be addressed through the new guidance on pooling that will come into force. The pool governance bodies should be engaging with the pool to ensure that there is sufficient strategic choice in terms of the range of asset classes and strategies that are offered to meet their needs.

If in time, there is quite a clear requirement set by the government that all investments should be made through the pools, then it is particularly important that the pools are able to offer a sufficient range and a sufficient choice of strategies to allow the funds to invest in the way that they want to.

151: And with pooling, as we’ve already said, the decision on the role of the managers lies with the pool. That is something that has been taken away from your area of work. Does that mean that you, as consultants, have been frozen out of a large source of revenue? How are you responding to that?

The roles and responsibilities of a lot of the stakeholders within the LGPS have changed under the new pooling structure. It is certainly the case that the consultants will become less involved in ongoing manager selection activity.

However, one of the key roles for us will be continuing to provide strategic advice. The funds need to be able to set their strategy. And a second part will actually be helping funds engage with the pools and ensure that the pools – who will effectively be an asset management organisation – are scrutinised and evaluated to make sure they are delivering the service that the funds need.

We have retained our independence in the market, in the way that we are able to provide fiduciary oversight services, which can extend into the new world of pooling where the pools, to some extent, are acting as some form of fiduciary manager. 

151: And the general state of the LGPS, how are the individual funds funded overall in your opinion?

There is quite a broad range, but overall, the LGPS is probably in a stronger position, than it has been for some time. Asset performance has been good, funding levels have generally improved. So, I think that is a really positive position.

Balancing this is the ongoing affordability of contributions, which means that we are not going to see wholesale derisking. There will be a need to retain a reasonable level of investment risk to maintain the affordability of contributions at the same time. I think from a funding perspective, funds are in a good position.

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