As the world faces global meltdown and investors are set to receive lower and more volatile returns for the next decade or more, new research suggests that some local authority pension schemes may be overestimating their potential growth.
Safe haven assets could give temporary respite from market storms, but ultimately will deliver paltry returns, the analysis showed.
The average Local Government Pension Scheme fund can expect returns of just 4.9 per cent annually over the next 10 to 15 years – nearly half of the 8 per cent registered on a long-term historical level.
Most LGPS funds forecast returns below this in their discount rates, which averaged 4.4 per cent at the 2016 valuation, but JPMorgan Asset Management estimated that they have a 38 per cent chance of underperforming this figure over the next 10 years, and a 25 per cent chance of falling short by more than one percentage point.
If this were to happen, an extra £20bn could be required from sponsors.
If LGPS funds were to invest in assets that were expected to generate lower returns, contributions from employers (and possibly members) would have to increase
Bart Huby, LCP
Despite diversification, equities continue to account for 80 per cent of expected returns and more than 90 per cent of portfolio risks in the average LGPS fund, JPMAM found.
Other dangers for the local schemes abound, warned David Davison, director at Spence & Partners: “The decline in new LGPS members could be something of a cliff edge coming for LGPS, as employers who have closed to new entrants reach the point where they have no active members, and therefore trigger unaffordable gilts-based cessation liabilities.
“The transition from ongoing to gilt-based liabilities will hugely impact on deficits for these organisations.”
Diversification is mission critical
More diversification is the answer to the looming funding crisis, according to Sorca Kelly-Scholte, Emea head of pension solutions and advisory at JPMAM. She said this could be “mission critical”.
As we come into a tougher period in the market, “security selection matters” with a more “granular approach” needed, Ms Kelly-Scholte noted.
She explained: “That comes down to knowing the individual security, understanding their exposure and which ones are going to be more resilient, and getting ahead of the ratings agencies, which tend to lag the market in understanding the credit risk inside individual securities.”
She warned investors not to rely on the credit ratings agencies: “I think there is empirical evidence that markets price in a ratings downgrade ahead of the actual ratings downgrade.
“We do believe globalisation of the portfolio is the first line of defence. What comes with that is currency risk.”
She added: “The dollar is quite overvalued from a long-term perspective, and over time we expect that will revert and act as a drag on returns. Managing that exposure will also be a critical part of how to secure a portfolio for the next 10 to 15 years.”
When it comes to choosing an asset class to invest in, Ms Kelly-Scholte favours real assets, emerging markets, the broader credit risk, and the broader private market.
Bart Huby, partner at LCP, agreed with this view, noting that diversification into “non-traditional types of real assets can help LGPS funds reduce their exposure to market volatility”.
He said: “In the private sector, we have seen pension funds investing in infrastructure assets and long-lease assets (eg, rental streams from supermarkets), and even corporate bonds from universities and housing associations.”
Safe haven assets still matter
However, Ms Kelly-Scholte stated that the current market environment underscores the importance of having safe haven assets in the portfolio. These could include government bonds, and the dollar, “notwithstanding our expectations that in the long term it will devalue”.
Nonetheless, if markets go back to normality, with economies entering a period of growth, interest rates normalising and the dollar begins to revert, “the long return on those assets is going to be pretty paltry”, she warned.
Simeon Willis, chief investment officer at XPS Pensions Group, noted that “the fall in government bond yields implies lower returns for long-term savers”.
Local authorities to have ‘absolute discretion’ on LGPS exit credits
Local authorities will have “absolute discretion” in determining the amount of any exit credit payment due to employers in the Local Government Pension Scheme, the government has said.
“However, depending on the level of hedging, some schemes will be largely immune to this issue, while others will be far more detrimentally affected.”
The issue could bring further concerns for the local authorities, warned Mr Huby.
“If LGPS funds were to invest in assets that were expected to generate lower returns, contributions from employers (and possibly members) would have to increase,” he said.
