The LAPF Strategic Investment Forum: an interview with the chairman

With the second annual LAPF Strategic Investment Forum just round the corner, Brian Gielty, editor of LAPF Investments, asks Forum chairman John Harrison about some of the key issues which are emerging for local authority pension funds.

Brian Gielty: In advance of this year’s conference, we canvassed the opinions of local authority pension fund investment officers to see what concerns are uppermost in their minds. I’d like to discuss some of the issued raised, and would start by asking you first about scheme mergers. It seems that the potential for mergers has become a hot topic in the last year – how do you think this will play out ultimately?

John Harrison: I don’t know. There is no clear consensus about how the large versus small arguments stack up in the three key areas – admin/investment costs (which is usually believed to favour fewer, larger funds), opportunities for return generation (is simplicity better than complexity?) and governance/control (do the benefits of more complexity justify the loss of local control?). It does seem likely that the sector will continue to explore opportunities for shared services and framework agreements to gain cost savings. What is less clear is how far the LGPS will go in terms of creating their own pooled funds or encouraging scheme mergers.

BG: Do you see many LGPS funds bringing asset management in-house and potentially administering investment with other LGPS funds?

JH: In terms of investment management, this depends on the extent of collective investment described above. Broadly speaking, in-house management is only economically viable for asset pools of several £ billion, so few LGPS funds are currently large enough. If the sector does combine asset pools more formally, one way to extract cost savings would be to adopt in-house management for at least some of the assets. In administration it is easier to extract scale economies through combining with other LGPS funds, and we are already seeing some funds move down this route.

BG: How do you think funds plan to deal with negative cash flow and changing liabilities?

JH: The life of a pensions fund has three stages – accumulation (contributions alone are enough to cover pensions in payment), steady state (contributions and investment income combined are enough to cover pensions in payment) and decumulation (contributions and investment income combined are not enough to cover pensions in payment). LGPS funds are moving from accumulation to steady state, but are unlikely to move to decumulation for at least another 10 years. This does not mean they have to change radically their investment strategy now, and we are still a long way from having to sell assets overall to meet pension obligations. However, investment strategy should probably become (a) a little less tolerant of illiquidity because it will be harder to change asset allocation purely by redirecting excess cash flow, and (b) a little more keen on income generating assets and income units in pooled funds. How that will pan out is one of the themes we expect to be discussed during the forum.

BG: Do you foresee a low growth, low return environment persisting for many years and if so, what changes should LGPS funds be considering to increase returns?

JH: For highly indebted developed economies it does seem most likely that economic growth will be subdued for some years, and in such an environment, monetary policy could well keep short-term interest rates very low for a long time. However, this does not automatically mean that investment returns will be low. Much of the world’s population lives in economies that are not highly indebted, with rising consumer incomes and strongly positive demographics, so it is less clear cut that the economic prospects globally are as bad as it sometimes appears from our Western perspective. Given most large companies operate on an international basis, and markets are in any case driven by confidence in the future as well as fundamental factors, market returns are often not closely linked to domestic economic growth.

BG: Should all asset managers give LGPS funds fee rebates for all below benchmark performance?

JH: No. It is up to each LGPS fund to negotiate the fee basis they want from their providers. This can be defined by asset values alone or be linked to performance achieved. It can also include clawback provisions if performance is poor. But remember that a performance-related fee implies a higher business risk to the investment manager and a fee clawback raises the commercial risk even further. It is logical to expect to have to pay more for a service that is more risky to the provider, so adopting such structures across the LGPS as a whole would probably raise investment management costs overall.  It would also further discourage managers from moving too far from their benchmarks or sticking to their guns when a view is out of favour.

BG: With the large amount of cash available from savers, pensions funds, emerging economies, government interventions etc. to invest – is there too much money chasing too few good investments?

JH: Possibly. The forum is a good opportunity to ask a range of fund managers their views.

BG: Is a high equity weighting appropriate for schemes with a funding ratio below 75%?

JH: It is not obviously wrong. Most LGPS funds have a large funding deficit and this is unlikely to improve before the next actuarial valuation. In the absence of substantial extra employer contributions or reductions in benefits, the only way to close this gap is through high investment returns. The majority of investment  strategists (consultants, asset managers, etc.) believe equity markets offer higher long-term returns than most other asset types, albeit with high levels of volatility relative to the pension fund’s liabilities. At the same time the asset types that most closely align with liabilities, such as bonds, offer low prospective long-term returns. There may be scope to dampen risk relative to liabilities by diversifying into other asset types or by hedging some of the liability risks, but it is often quite difficult to make the funding projections add up without retaining a material allocation to equities.