One of the hotter topics today is whether, when and how LGPS funds should de-risk. At the most recent triennial valuation made on 31st March 2022, many funds found themselves well over 100% funded. Since then movements in markets and inflation have led to further rises in funding ratios for most funds, but not all. In this article I try and unpack what is happening. I caveat it with a disclaimer that I am not an actuary and I shall treat corrections from that profession with respect.
What has changed since March 2022?
There have been four main influences in the changes in funding levels since March 2022. The first and most important is the rise in gilt yields from 1.7% to 4.7% at the long end. Where gilts are a major component in the calculation of the discount rate, the valuation of liabilities will therefore have fallen substantially. There is a smaller but offsetting impact from a higher interest service cost – i.e., the increase in the liabilities’ present value as all pension payments become one year closer. Higher gilt yields will lead to a higher cost.
However, actuarial valuation is an art, not a science, and advisers to LGPS funds have largely over the past ten years moved away from the private sector practice of basing the discount rate on the gilt swaps curve. Instead, they either use inflation or the yield on the asset portfolio as their basis, usually accompanied by a smoothing mechanism.
Funds where the actuary still bases their valuation on gilts or inflation will have seen discount rates rise and liability valuations fall substantially. But those who use the asset portfolio yield will not because allocations to gilts in LGPS portfolios tend to be low. The identity of the actuarial adviser is therefore the second main variable.
The third is the surge in inflation. Actuaries I have spoken to have increased their inflation assumptions used to calculate future service costs to reflect the changed environment of global markets and the increase in historic inflation. However, this is partially offset by a reduction in observed inflation (i.e., the 10% rise in pension payments in April 2023). This is now in the rearview mirror with the consequence that in actuarial terms future increases are tempered.
There are further variables in inter-valuation calculations here depending on how funds and their advisers choose to account for the increase in pension payments – do they accrue them monthly (better practice) or use a single jump each April?
Finally, of course, asset movements matter. Here, experience since March 2022 has been negative relative to the actuarial assumptions. Bond prices have of course fallen as yields rise, and in some cases spectacularly so (e.g., long-dated index-linked gilts fell 80% from their peak). But most LGPS funds have limited exposure here. Valuations of other asset classes which use gilt yields as a basis, such as infrastructure and real estate, have also fallen. However, equities generally have held up.
Should funds start de-risking?
Putting all this together, I have seen funds where the funding ratio has risen by over 30% since March 2022 and others where it has fallen by up to 13%. The biggest single variation seems to come from the choice of actuarial adviser. It will be interesting whether the Section 13 report on the 2022 valuation, which is due out this year, will make any reference to this.
The question for many funds is whether they should start de-risking their asset portfolios. The argument for this is based on the legal requirements to focus on stability of contributions and to take no more risk than is sufficient to deliver the required return. The Scheme Administrator may for reputational reasons wish to avoid a situation where a Fund is substantially over-funded and then returns to being in deficit.
Against this is the strong impetus from many employers to reduce contributions by taking a bit more risk i.e., focus on the other legal requirement to keep contributions affordable. I have found that many committees are reluctant to de-risk their portfolios for this reason.
The biggest strategic risk by far remains inflation
In my view one ‘risk’ trumps all these considerations. That is the long-term path of inflation. I have argued in a previous article that we are off to the magic money tree because of a combination of political incontinence, especially in the United States, events, and the fragility of the financial system. Unless there is an abrupt change in political and social direction, eventually much higher inflation seems to me to be inevitable. Of course, that will have its knock-on effects on bond yields and interest rates, and potentially equity markets too.
But for LGPS funds any ‘de-risking’ should be focused on this first and foremost, rather than on maintaining funding levels or reducing asset volatility. The obvious assets to purchase are assets which have some linkage to inflation.
Index-linked gilts head the list because both capital and coupon are with some minor caveats linked to inflation. Next come infrastructure and real estate where some of the income is explicitly linked to inflation, but the value of the capital is not.
Equities can also provide some mitigation, as they are growing assets whose asset valuations and income stream, despite no firm link, will broadly be correlated with inflation over the long term. Finally there are specialist multi-asset strategies whose objective is to deliver a return linked to inflation. They can also provide some flexibility to take advantage of opportunities, but unlike other assets there is no underlying link with inflation; their success depends on the skill of their managers.
Should funds be buying inflation-mitigating assets now?
I now come on to timing. Here the entry price matters. One of the consequences of higher bond yields has been a negative impact on long-term asset valuations. Private sector DB schemes invested heavily in Index-linked gilts but were undone by the rise in bond yields. The price they paid to obtain protection was too high. More recently listed infrastructure and real estate have suffered in a similar way.
Given that I firmly expect bond yields to rise further, in my view there will be better entry prices for these asset classes ahead. The question for investors is whether the yields on offer today will be sufficient to compensate for the further expected capital losses. Here listed infrastructure leads the pack with yields of up to 10% on offer. I would argue that even Index-linked gilts, yielding around 1% real yield, provide adequate compensation given their much better risk mitigation. The current curve is at the head of this article. But investors should expect price volatility and a strategy of pound-cost averaging over time is likely to be safer than a significant allocation shift.
In conclusion, my answers to the original questions are as follows: LGPS funds should be focusing de-risking on the longer-term risk of inflation rather than worrying too much about asset price volatility or funding levels; they should be looking to allocate to a range of inflation-mitigating assets headed by index-linked gilts; the entry price matters, but it is not too soon to start.