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xx Month 2010 Local Government Chronicle xxlgcplus.com?? Local Government Chronicle 25 March 2010

1Investment

LGC’s regular special report

How one fund is responding to the squeeze on resources p18

Wales fl ies the fl ag for the benefi ts of collaboration p10

Minister puts the record straight on pension reform and the opportunity for engagement p4

Scotland prepares for an uncertain future p12

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1 LGC’s regular special report ▼

NIC PATONSUPPLEMENT EDITOR

‘‘ Local government pension fund managers don’t need to be told these are ‘interesting’ times

Investment

2 Local Government Chronicle 27 June 2013

LGPS reform, the 2013 actuarial valuation outcomes, the implementation of the 2014 scheme, new governance requirements, auto-enrolment, continuing market volatility – local government pension fund managers don’t need to be told these are ‘interesting’ times.

What comes through in this special LGC Investment supplement is how well the pension fund community is responding and rising to these challenges. As local government minister Brandon Lewis concedes in our opening feature on pages four and five, those managing the LGPS “are doing an excellent job in difficult and trying circumstances”.

Yet, as Mr Lewis also makes clear, there is still a keen debate to be had about the future shape and, crucially, the future affordability of the LGPS. His indication that there will need to be further work to “assess whether the structure in which the new scheme will operate is both fit for purpose and represents the best value for money” should be something pension fund managers need to sit up and take notice of.

Another intriguing challenge is next year’s referendum on Scottish independence. As Richard McIndoe of Strathclyde Pension Fund has identified, this is adding a whole level of

uncertainty to an already complex picture for funds north of the border. A ‘yes’ vote would, naturally, have massive implications. With Scotland going through an actuarial valuation next year (rather than this year, as in England) and a new CARE scheme due in 2015, the investment headaches there are certainly stacking up.

Other highlights in this issue include Mark Womersley of Osborne Clarke on the legal ramifications of the Public Service Pensions Act, Alison Murray and Colin Cartwright of consultancy Aon Hewitt on the 2013 valuations and, more reflectively, Pat Luscombe, pensions administrations manager at Kent CC, looking back over the battles that have taken place around LGPS reform.

Finally, investment strategy is very much on the radar, with Geik Drever outlining how West Midlands Pension Fund is responding to the current climate and Graeme Russell at Torfaen CBC giving a timely Welsh perspective. I’d also recommend taking a look at our reader survey about attitudes to, and the appetite for, passive management. Interest in passive strategies is continuing to grow. Nevertheless, and rightly, the trend appears to be a relatively gradual one, with the wider climate still so uncertain.

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Contents

In our latest reader survey, LGC Investment, in association with State Street Global Advisors, asks what is driving the trend for passive investment strategies p6

Following his recent call for evidence on Local Government Pension Scheme reform, minister BRANDON LEWIS sets the record straight p4

GRAEME RUSSELL offers a Welsh perspective on the savings and improvements in efficiency that collaboration on pensions could achieve p10

As the independence debate continues, RICHARD MCINDOE says it’s business as usual for Scotland’s Local Government Pension Scheme funds p12

MARK WOMERSLEY explains how the Public Service Pensions Act 2013 offers a step forward for LGPS governance structures p14

ALISON MURRAY and COLIN CARTWRIGHT believe the signs are encouraging for the 2013 valuations p16

With resources being squeezed and the burden of liabilities increasing, GEIK DREVER explains how one fund is responding p18

PAT LUSCOMBE reflects on reforms to public sector pensions and the battles that have helped to shape where we are today with the LGPS p20

27 June 2013 Local Government Chronicle 3LGCplus.com

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There are many fascinations of being the minister responsible for one

of the largest funded occupational pension schemes in the UK. Near the top of my list is seeing how my speeches on the Local Government Pension Scheme are reported by the media. My recent speech at the NAPF’s Local Government Conference has proved to be no exception.

The specialist media have an important role in communicating policy announcements to a wider audience. But there are occasions when some of the context and thinking behind these announcements gets lost in translation. I am grateful, therefore, to be given this opportunity to put the record straight.

I could start by suggesting that the speech needs to be read in its entirety, courtesy of the NAPF’s web site www.napf.co.uk. Having done that, you will see that I was equally honest about those areas of the LGPS where I want improvement and greater efficiencies to be made, and those where praise is properly justified. I am excited by the prospect of seeing a new-look LGPS scheme in place by April next year but, at the same time, steps must be taken to ensure that the new scheme operates within an effective and affordable structure. Taxpayers deserve this.

Much of the post-conference focus has been about outcomes, in particular the

suggestion that the number of LGPS fund authorities should be reduced. Much less has been said about process and how we achieve these outcomes. To make the scheme more efficient and cost-effective, we need a much better understanding of where funds are at the moment and why they are in such different places.

That is why we are working closely with the LGA in a call for evidence on structural reform. We are asking a number of serious questions about the way in which the scheme should be managed and administered in the future, including questions about the sort of data we need to make robust policy decisions that can stand the test of time. I am only too well aware of the shortcomings of the data we hold at the moment. We have all tried in the past to make sense of these numbers and all failed. We need to start afresh.

I also commented about the amount of collaborative work that is taking place around the country. I applaud those who have gone down this route and would strongly encourage others to follow. But I think we can go further. I have already announced that later in the year we will be coming forward with a high-level consultation paper on structural reform. It is no secret that I question whether the current number of LGPS funds is achieving the best value for money for those who pay the scheme’s costs. But I also recognise that savings

can be achieved in other ways.For example, I am keenly

following the proposal in London to establish a collective investment vehicle. To me, this has the advantage of both reducing fund management fees through bulk buying and retaining

Opportunity for pensions engagementBRANDON LEWIS puts the record straight following his call for evidence on reforming the Local Government Pension Scheme and the process of achieving it

local accountability. Local accountability has

been at the centre of all my discussions with interested parties on the future structure of the scheme. It therefore features large in our call for evidence and I hope that you will all find the time to respond

Help inform the debate and be a vital cog in the new-look LGPS scheme

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COMMENTCHRIS URWIN Global research manager, real estate, Aviva Investors

In February, we identified signs that this could be a turnaround year for UK real estate. We are now seeing further evidence in Q1 2013 data releases that supports this view.

For the first time in two years yields did not rise in any of the secondary UK sectors, according to data released by CBRE. Although capital values and rents continued to decline in Q1, the pace is slowing and we are increasingly confident that we are now approaching an inflection point in the market.

Our 2013 total return forecast for UK all-property is 7.4%. On a risk-adjusted basis, higher yielding sectors are likely to outperform and the yield gap between primary and secondary real estate is likely to erode.

The IPD Quarterly Index showed that upward pressure on yields removed 0.4% from UK capital values in Q1 2013. However, this was not enough to completely erode income returns. Overall, UK property delivered a positive return of 1.1%, its strongest quarterly return since 2011.

In this persistently low-yield environment, the appetite for riskier assets continues to grow. Real estate is benefiting from this trend, especially as it looks very cheap compared

with other assets. Prime property yields in some sectors have fallen recently and the IPD Index shows that valuations more generally are stabilising. Furthermore, anecdotal evidence suggests that transaction pricing is improving ahead of valuations.

Although occupier markets remain weak, the supply of new real estate is severely constricted. Excluding central London offices, new supply is likely to be extremely limited during the next few years and selective strategies targeting better-quality secondary assets are likely to outperform. In particular, we favour offices outside of central London and industrial assets outside of the capital.

We may now be seeing the first signs that demand is broadening from prime London assets to good-quality secondary assets in and outside London. The decline in capital values of secondary assets appears to have stabilised and we believe the market is now positioned for improvement. This year could be a good entry point to UK real estate: with the aid of yield compression in the second half of 2013, this year’s total returns are likely to be relatively strong.

First quarter data points to real estate turnaround

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and help to inform the debate on the importance of local accountability, whether it should be maintained and whether it represents a serious obstacle to any reduction in the number of fund authorities.

Some of you will be staunch

defenders of the status quo. I have never doubted that for the most part, those involved with the scheme are doing an excellent job in very difficult and trying circumstances. But I have a responsibility to ensure that the scheme continues to be affordable, sustainable and, above all, fair to taxpayers.

We have come a long way in reforming the scheme’s regulatory framework since Lord Hutton was asked in 2010 to review the affordability of public service pension schemes. We now need to go further and assess whether the structure in which the new scheme will operate is both fit for purpose and represents the best value for money for those who pay its costs.

The call for evidence we have embarked on is an opportunity for all interested parties to engage with us on this key programme of work and to help design a new scheme that can continue to be held up as a shining example of best practice. Brandon Lewis is minister for local government

‘‘ We now need to go further and assess whether the structure in which the new scheme will operate is both fi t for purpose and represents the best value for money for those who pay its costs

Opportunity for pensions engagement

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COMMENTKEVIN CULLEN Relationship manager, State Street Global Advisors

Recent data has shown local authority pension funds are increasingly switching to index management, with the proportion of their portfolio allocated to actively managed strategies falling.

The LGC survey in this issue (opposite) also indicates an increase in interest in so-called ‘smart’ or, as we term them at State Street Global Advisors, ‘advanced’ beta strategies – which expand the range of indexing investment opportunities beyond those that track traditional market-cap weighted indexes.

Cost and performanceThe focus on performance and cost issues is of ever-increasing importance for local authority schemes. Combined with increased scrutiny of the performance of active managers and the focus on fees, it is perhaps not surprising local authority pension funds now have almost a quarter (24%) of their equity portfolio in passive strategies.

Why advanced beta?So what can advanced beta strategies offer schemes looking to broaden the suite of indexing approaches in their portfolio? Traditional index investment strategies track indices that weight equities or bonds according to their market capitalisation – meaning that companies with the largest market capitalisation

automatically have the largest weight in the index, regardless of merit. While this still represents the primary type of indexing approach adopted by our local authority clients, we at SSGA are increasingly having conversations about indexing strategies that seek to capture particular factor exposures.

Investors are interested in understanding more about how these advanced beta strategies can help diversify portfolios and their potential for higher absolute, or risk adjusted returns.

In the equity market, alternative approaches to security weighting encompass a range of different strategies. One effective example is ‘value’. The value premium is based on the characteristic that, over the long term, low valuation stocks have outperformed high valuation stocks. Historically, investors may have paid an active manager to identify these low value stocks.

However, indices are now available that enable investors to target the value premium by simply tracking the index. Why pay active fees when the premium can be accessed in an index? Advanced beta therefore expands the opportunity set for investors – as a complement to an indexing portfolio or, indeed, a possible replacement for some elements of active.

Advances in indexing

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The race to passive: our survey asks ‘what’s behind the trend?’That was the over-arching question posited by LGC Investment in its latest reader survey, in association with State Street Global Advisors

A range of other factors were also identified, and extended between the specific impacts of the 2013 valuation, the effect of declining member and employer membership and a belief that existing strategies were satisfactory and required no change. Of these, risk and changes in liabilities were thought important, along with views that relied on existing strategies and monitoring arrangements.

This emphasis on market and manager performance points to concerns over investment returns, argues Bill Street, head of investments EMEA for State Street Global Advisors.

“Managers face scrutiny over their ability to deliver performance in line with expectations. Volatile markets over the past few years have played havoc with growth objectives and will make for some challenging decisions over the coming months as fund authorities review their investment strategies,” he suggests.

A number of clear opinions were expressed on question two – what do you see as being the main drivers of the broader trend to passive investing over recent years? The vast majority of respondents (97%) saw fees as being the main driver, followed by performance

Against the challenging backdrop of the triennial valuation,

reviews of investment strategy, continuing market volatility and, more widely, the reform of the Local Government Pension Scheme, it is only too understandable that investment strategy is under scrutiny. Part of this broader picture is continuing interest in both passive strategies and alternative investments – and it was the appetite for passive strategies and how this might change in the future that was at the heart of our poll, carried out in April.

Our respondents were asked first to select or rank those market or policy events over the coming year they felt were most likely to influence their fund’s investment strategy.

Three key factors were cited. Top, perhaps unsurprisingly, was the outcome of the 2013 valuation, followed by market performance and, thirdly, manager performance.

Others highlighted were the influence of government fiscal policy and costs generally. However, all the factors identified were inextricably linked, even if their impact on individual funds varied in proportion to local fund authority circumstances and their intrinsic characteristics.

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The race to passive: our survey asks ‘what’s behind the trend?’

(85%). Risk budgeting (25%) was the next most significant factor. More minor influences identified included diversification and risk budgeting.

“The data confirms that the financial market turbulence of recent years has seen many investors searching for more reliable returns from their investments. Many have turned to passive investment solutions, as these can provide lower risk relative to return objectives – and at lower cost,” argues Mr Street.

“This style of management can offer investors cost-effective and diversified exposure to a wide range of asset classes, regions and sectors. It also avoids the potential pitfalls of making the wrong ‘active’ investment decisions.

“Trading costs erode returns. Because passive managers only adjust portfolios when the stocks in the index they’re

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Continued overleaf

tracking change, costs are much lower than with active investing. Passive management fees are considerably smaller too,” he adds.

Our third question looked to gauge the incidence of passive investing approaches compared with five years ago. The survey found that just over half (53.3%) of replies confirmed it was a more important facet of investment strategies, with a further 29% confirming it was about the same.

This was clear evidence of the increased, and increasing, status of such strategies. By comparison the survey found only a small proportion of replies that felt it was less important (8%) than five years ago, while a further 8% had the approach under consideration.

These figures were also consistent with WM Local Authority Universe figures, points out SSGA’s Mr Street,

which illustrate that local authority pension fund authorities have almost a quarter (24%) of their equity portfolios in passive strategies, up 10% since 2002.

“The data indicates that the trend is likely to continue – particularly viewed in line with the responses of question two, which highlight that fees and manager performance issues remain primary concerns,” he says.

Question four drilled down into which asset classes local authority pension fund managers believed were best run on a passive basis.

UK (75%), global (44%) and emerging markets (3%) were between them strongly identified in this context, with fixed income (22%) and diversified funds (8.3%) being significantly less so.

When it came to selecting a passive investment manager, 39% rated cost, again, as their main criterion, while 26%

cited the strategies on offer as being important. Somewhat surprisingly, given the increasingly global nature of the market, only 8% saw ‘global reach’ as a criterion, along with the service on offer.

“Passive investing enables schemes to target particular markets or asset exposures relatively inexpensively relative to active – so the cost comparison of providers is perhaps an obvious selection criterion,” agrees Mr Street.

“The return achieved by the active manager must first beat the active fees as an initial hurdle just to equal the passive manager’s return. No doubt selection criteria also balances the costs of passive managers relative to each other where all else is equal.

“The capacity of the provider to offer the desired or specialist index strategy is also

More important for our scheme 53.3%

Less important 7.9%

About the same 29%

Under consideration 7.9%Performance

Fees

Transparency

Diversification

Risk budgeting

Degree of understanding

Other

What do you see as beinG the main drivers of the broader trend to passive investinG over reCent years?

Compared With five years aGo, passive investinG approaChes are:

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important as they aim to achieve their asset allocation goals across global, regional and country equity and fixed income markets,” he adds.

In considering the ideal balance between passive and active strategies, a clear majority – 55% – felt the balance should be between 25-50%, although a relatively high proportion (37%) felt it should be less than 25%. Only 8% thought it should be greater than 50%.

This, argues Mr Street, indicates a timely awareness of the importance of passive building blocks as part of the overall asset allocation decision for schemes.

“In an index fund, there is broad, diversified, and consistent exposure, without style or size drift, giving investors control over their strategic asset allocation. Also, investors can quickly and cost-effectively rebalance back to the appropriate strategic asset allocation after periods of extreme market volatility,” he explains.

A strikingly similar distribution of responses saw passive strategies being beneficial for individual fund authorities. Some 57% believed they were an efficient way of gaining market exposure, while 35% saw them as building blocks for fund asset allocation. Against that, just 8% saw passive strategies as providing tactical medium term exposures to particular assets.

Question eight asked: how would you rate your level of understanding/awareness of smart/advanced beta (ie non-cap weighted) indexing approaches?

Our survey highlighted that just 8% had no knowledge of the area but – and promisingly – some 80% were either undertaking research, or had

heard about them and had researched the area. However, as only 13% included such approaches as part of their investment strategies, the survey certainly indicated scope for greater development in this area.

“Traditional passive investment strategies track indices, such as the FTSE 250, that weight equities or bonds according to their market capitalisation – meaning that companies with the largest market capitalisation automatically have the largest weight in the index,” explains SSGA’s Mr Street.

“While this type of indexing still dominates the world of passive investing, a growing range of strategies that seek to capture certain risk premia, or systematic factor exposures, are becoming increasingly popular.

“Typically they offer investors the ability to tilt a portfolio to capture more than just the standard equity market risk premia that traditional cap-weighted indexes provide. They enable investors to unlock factor exposures – such as valuation, volatility, size or quality – to capture specific returns, diversify portfolios, reduce risk or express specific investment views that may not be achievable simply by tracking capitalisation-weighted indices.

“They also have the potential for higher absolute, or risk-adjusted, returns than those available from more traditional indices, as well as offering broad diversification. Significantly, these advantages are combined with the transparency, predictability and low costs of traditional passive investing,” he adds.

Nearing the end of our poll, there were a range of replies as to which factors would lead pension fund authorities to consider smart/advanced beta approaches.

Continued from previous page ‘‘ They have the potential for higher absolute, or risk-adjusted, returns than those available from more traditional indices, as well as offering broad diversifi cation

Have heard about them, but not researched 35.9%

No knowledge at all 7.7%

Less than 25% 36.8%

Undertaking research 43.6%

25-50 %55.3%

Part of our investment line up 12.8%

typiCaLLy, WhiCh asset CLasses do you beLieve are best run on a passive basis?

hoW WouLd you rate your LeveL of understandinG/aWareness of smart/advanCed beta (ie non-Cap WeiGhted) indeXinG approaChes?

the ideaL baLanCe of passive vs aCtive strateGies for a LoCaL authority fund is:

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Equities UK

Equities Global

Equities EM

Fixed Income

Diversified Funds

8 Local Government Chronicle 27 June 2013

Greater than 50% 7.9%

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The most important factor identified by respondents was the consultant/advisor, followed by the process of diversifying from a cap-weighted passive strategy and an underperformance of active strategies.

Almost as significant was the desire to access a particular market exposure within a strategy, with the least influence being the herd factor being shown by other local authority funds in this direction.

“Consultant/advisor recommendations obviously weigh heavy – and, with 44% indicating in question eight that research in this area is under way, local authorities are looking for informed input as they investigate these strategies,” argues Mr Street.

“Decisions over diversification of portfolios and the decision over active versus passive underpin some key decisions for authorities’ investment strategies – in

other words whether to allocate globally or regionally, and whether to use active or passive equity managers in the context of the portfolio’s overall return and risk objective.

“Considerable research suggests that various advanced-beta premiums do exist within the equity market, and strategically tilting an equity portfolio in the direction of these premiums can enhance the overall return. Importantly, in many cases, these strategic tilts can be obtained at low cost, utilizing elements of rules-based passive investing,” he adds.

Finally, our local government pension fund

about the survey

The survey garnered responses from 38 senior local government pension fund managers, representing as many funds and equating to 42.7% of the LGPS funds. There was also a wide range of respondents, including:• Heads of treasury and pensions • Heads of strategic finance • Heads of finance or financial services • Investment officers • Chief financial officers • Strategic directors of resources • Directors of pensions • Divisional directors • Treasury and pensions managers• Corporate heads of finance and commerce • Senior managers of corporate finance • Strategic finance managers • Group managers

manager respondents were asked what more would they need to know before adding a smart beta strategy to their investment line-up?

Half (50%), understandably, saw a proven track record in isolating the desired market return as being important, closely followed by 40% seeking a better understanding of the range of approaches available.

In conclusion, therefore, the trend to passive is a clear one, but there is further understanding required in advanced beta type strategies before many local authorities will be prepared to consider whether they may be a suitable part of their passive portfolio.

‘‘ Considerable research suggests that various advanced-beta premiums do exist within the equity market, and strategically tilting an equity portfolio in the direction of these premiums can enhance the overall return

27 June 2013 Local Government Chronicle 9

COMMENTARYBy PETER WALLACH Head of pension fund, Merseyside Pension Fund

The survey suggests there continues to be a divergence of opinion as to the efficacy of passive management versus active management.

Although the interest in passive strategies continues to grow, active management remains dominant. Ahead of the triennial valuation and concomitant review of investment strategy, there is an understandable reluctance to make any major changes to allocations or managers.

There appears to be greater conviction in relation to managing equities passively and a recognition that markets deemed to be more developed/efficient are difficult for active managers to outperform and best accessed through passive strategies. More than 75% of respondents believed UK equities (an efficient market) are best run on a passive basis.

This is confirmed by the fact that only 44% recommended a passive approach for global equities and 3% for emerging markets

equities. Along with the shift to passive equities in developed markets, we are perhaps seeing a move towards less constrained mandates in markets and regions where there is a belief that active management can add value.

Nearly every respondent mentioned low fees as a principal driver in the trend to passive management. Low fees have come about partly through the continuing consolidation of investment managers providing passive funds but also a greater range of passive funds, enhanced competition from exchange traded funds (ETFs) and availability of derivatives, such as futures, which have vied for investors’ assets.

There is less appetite for fixed interest to be run passively. The survey does not differentiate sovereign bonds from corporate bonds. Corporate bonds mandates are widely held in the LGPS and managers have, in general, been successful in

outperforming benchmarks making the use of passive strategies less desirable.

The interest in smart beta demonstrates a willingness to consider other approaches. With many funds having experienced the sharp underperformance of quantitative strategies in 2008, the caution in investigating and understanding the various styles and approaches is understandable. Also, fees are considerably higher than for traditional passive funds and often similar to active management fees, and funds will be seeking assurance that this is not another fad.

Many are looking to consultants for this and with several longstanding smart beta approaches available, it is surprising that there are not more funds on consultants’ buy lists and participation in this area.

Once we have put the triennial valuation and review of investment strategy behind us, it will be interesting to see the extent to which the views expressed in the survey are implemented by LGPS funds.


In March 2010, the pensions sub group of the Society of Welsh Treasurers (SWT),

representing the eight LGPS funds in Wales and acting as a project board, commissioned a study by PwC. The aim was to build on the collaboration already undertaken in Wales and identify the potential for collaboration/partnership working across the Welsh Local Government Pension Schemes. The PwC report established a ‘prima facie’ case to look further at the organisational structure of the Welsh LGPS with the potential to improve efficiency and service standards.

Following a ‘pause for reflection’, and to allow for the publication of the Simpson Report in Wales (Local, Regional, National: What services are best delivered where? – March 2011) and the finalisation of the Hutton report on public sector pensions reform, which both provided important context, a further report was initiated and an interim report has been produced by the pensions sub group of the SWT.

The aim of this further report was to determine the optimal number of LGPS funds in Wales and the most appropriate organisational structure.

Four options were considered: an ‘as is’ option; an enhanced collaboration option; a mid-range option based on a number of grouped/regional funds; and an option based on one all-Wales LGPS Fund.

Working together: a Welsh perspectiveSavings and improvements in efficiency could be achieved through enhanced collaboration on pensions, writes GRAEME RUSSELL

The report was undertaken by officers from within the eight administering authorities using specific work groups covering the areas of investments and financing, administration, governance and financial modelling.

This was done to ensure appropriate expertise and understanding of the Welsh context/environment and to allow ‘ownership’ of the work undertaken. It was supported by a number of bespoke task and finish commissions carried out by third parties to test various propositions identified by the work groups.

The number of officers involved and the need to co-ordinate the various strands of work inevitably took time and effort but the benefit is a clear understanding of the reasons behind the conclusions reached.

The report makes clear that there is no simple and quick solution that answers the question: “What is the optimal number of LGPS funds in Wales and the most appropriate organisational structure?” Given the existing organisational picture, and the funding complexities, any change would require careful planning and would take time to implement/achieve meaningful benefits.

The work undertaken, however, clearly indicates that, despite collaboration already being part of the Welsh fabric for pensions, there is more that can be done.

The report concludes that medium-term savings and potentially improved

investment returns could be achieved through enhanced collaboration. This is the option where the balance of service delivery and efficiency, cost of change, time and resource can be blended in the most effective way, and it should be pursued further. In particular, the grouping of investment assets via a collective investment vehicle could achieve the apparent benefits of size without the organisational upheaval.

The report illustrates that the potential financial benefit through any change varies considerably with the smallest

Collaboration is already part of the Welsh fabric for pensions

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gains being in the benefit administration area, increasing in size through joint procurement initiatives, combining investments to reduce the level of fund manager fees and finally via the potential for larger funds or groupings of investments to potentially achieving better investment returns. This latter option is about grouped economies of scale and could generate sufficient additional investment returns to help manage employer contributions over the medium term through a collective investment vehicle

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COMMENTSTEPHEN CASTLE Client relationship manager, Legal & General Investment Management

The Bank of Japan is the latest central bank to provide an exceptional liquidity injection to markets. In the midst of what appeared to be limitless central bank support, corporate bond markets have posted phenomenal performance in the face of subdued global economic growth. It is a baffling and counter-intuitive environment for many investors as performance tends to be driven by technical liquidity factors rather than fundamentals.

With such significant moves over the past eight months, finding an optimum portfolio position is not without its difficulty. A portfolio should be balanced in order to gain from the technical support, but also nimble enough to defend itself if concerns over the stubborn mountain of sovereign debt, insufficient GDP growth and inflationary pressures resurface.

There is evidence some central bank measures are gradually becoming less effective in financial markets, while other non-conventional measures, such as the Funding for Lending Scheme in the UK, is gaining traction. However, a repeat of the poorly handled bailout of Cyprus, or any significant weakening of economic data, could ultimately trigger a loss of confidence in central banks’ ability to steer the global

economy back to self-sustaining growth rates.

Successful fund managers must take a risk-focused approach. Weakness in growth, high debt levels and regulatory changes around senior bond holders means cautious risk positioning is warranted, especially in sectors such as European banks. Nevertheless, it would be very painful to fight the risk rally in sterling credit markets as the search for yield continues and the net supply of corporate bonds falls. The rally seems to be technically supported in the near term, but taking risk in the right sectors and names, as well as getting the long-term macro themes right in portfolios, is absolutely essential in order to protect portfolios.

In the short term, there may be further tightening in credit spreads but with valuations already stretched in sectors such as banks, the extent of further large gains may be limited.

The strength of the market since last summer has shown that confidence in policymakers – or at least an unwillingness to doubt them – can outweigh fundamentals for some time. Achieving optimal portfolio positioning requires a risk-focused management approach that combines forward-looking macro themes with rigorous analysis for stock selection.

The great credit limbo

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Working together: a Welsh perspective

across existing structures without the need to merge funds.

A collective investment vehicle is attractive because it has the potential to generate the same benefits as a merger without the lead time, complexity or transition costs associated with the latter. Changing funding strategies could also have a destabilising effect with a loss of local accountability. While this may merit additional investigation in the right environment, it is not recommended for further work at this time.

The report goes on to recommend the creation of a full business case for a common investment approach to encompass the common attributes that benefit larger funds with the aim of implementation thereafter; and the creation of an appropriate and responsive governance structure to drive and manage future collaboration initiatives within Wales which will:● Explore the potential in the longer term for consistent valuation and funding assumptions and standards ● Develop minimum administrative service standards for Wales and an agreed measurement framework ● Take advantage of joint procurement initiatives to help consistency and efficiencies.

Exactly what a common investment approach, if pursued, would look like is yet to be determined but subject to the outcome of consultation, its definition and

functioning could form an important component of any subsequent piece of work. The report produced is, however, an interim one. A process of consultation began on 1 March with all the local government pension funds in Wales, together with scheme employers, trade unions, Welsh government and other interested parties in Wales, designed to inform debate and enable consideration of any subsequent steps.

With the recent close of the consultation period, the results are now being analysed and considered by the project board. It is known that responses have been received from a wide range of stakeholders and the views captured will inform the debate and enable any subsequent steps to be considered, both in terms of approach and content.

The recent call for evidence by local government minister Brandon Lewis at the NAPF’s local authority conference has also proved timely in enabling the project board to consider the next steps within the wider context of future potential developments in local government pensions.

What will happen next is not yet clear. What is clear is that within Wales there has been detailed and measured consideration and activity across the funds designed to provide clear and objective evidence for any future pathway that may be followed.Graeme Russell is head of pensions and employee services at Torfaen CBC


1

Three things we do not have in Scotland: an actuarial valuation this year; a

new CARE scheme next year; and UKIP.

Three things we do have in Scotland: an actuarial valuation in March next year; a referendum on independence six months later; and a new CARE scheme six months after that.

Some other things we do have in Scotland: auto-enrolment, real time information, funding deficits, maturing liabilities, changing cash flows, shrinking resources and no end of investment challenges.

So, different but not so different. Most of the current concerns facing pension funds are common across the UK and probably beyond these shores. The differences between Scotland and the scheme in the rest of the UK are mostly of timing, emphasis and starting position.

In terms of timing, Scottish funds are currently finishing the last strands of changes from our 2011 actuarial valuations and reviews of investment strategy. Those changes? Further retrenchment from active management; the beginnings of a shift towards alternative forms of passive – smart beta or fundamental indexation; increasing use of specialists either in niche areas of listed

Scotland the braveWhile the debate on independence continues, Scotland’s LGPS funds are facing the same concerns as the rest of the UK, writes RICHARD MCINDOE

markets – small companies, frontier emerging markets, absolute return bonds – or in select alternative markets – private real estate, mezzanine debt, emerging market, private equity. A gradual change of emphasis then, no wholesale change of direction… yet. At Strathclyde we are laying plans for a more fundamental shift into fixed interest and other assets that are more aligned to our fast-changing liability profile. But not yet. Not at these yields.

One area where we do start from a position of relative strength is our funding level. We have just closed our March 2013 accounts with a fund value of more than £13bn for the first time. We were almost fully funded at the last actuarial valuation, albeit some way below that level right now; we do still have time on our side to manage our liabilities. Time creates opportunity and we intend to make asset allocation changes as and when that opportunity arises.

Opportunity comes in different guises. The past few years have presented many visible crises. These have produced new investment opportunities and at Strathclyde we recognised that in 2009 with the creation of our eponymous ‘New Opportunities Portfolio’. Predicted initially on the withdrawal of banks and other traditional providers of

capital from the market, we were looking to plug or exploit the resulting gap (you choose the verb, it’s a matter of perspective).

We started by taking some small (typically £5m) stakes in local private equity and private debt funds. Selectivity is the key. The current environment leaves many initiatives needing funding. There is a difference between funding and investment. Only a few will sit well within an institutional investment framework and provide the returns required to pay pensions.

Those that do ‘fly’ in terms of potential returns can bring many rewards. Relatively small stakes can be pivotal. This has the dual benefit of getting a project off the group and giving the investor a meaningful, hands-on role in the setting the terms. One good example is a deal we recently completed to provide cash flow for construction of the athletes village for the Commonwealth Games, which will be held in Glasgow in 2014. Our contribution represented the last piece in the financing jigsaw, so we secured a very attractive fixed rate of return leaving all parties happy. Being a founder investor can also ensure an ongoing role in the governance and direction of an investment initiative, which is often absent in the

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mainstream activities of pension funds.

This can also apply on a much larger scale. Hence our immediate reaction to the Pensions Infrastructure Platform (PIP) was that it was the right idea at the right time – ‘by pension funds, for pension funds’, and that we wanted to be at the table in bringing it from concept to the reality which it will shortly become.

Scheme merger anyone? This was already a familiar question, with some well rehearsed answers when I was first involved in the Local AL

AMY


Scotland the brave

Government Pension Scheme (1996, since you ask). Scotland is not directly involved in the current call for evidence on this subject, having already asked and answered the question for ourselves in the past couple of years.

Our conclusion was that it was all too easy to overstate the benefits and

underestimate the costs of merger and that there was a much quicker win available in first exploring options for more collaborative working. Again, we started from a reasonably strong base.

Centuries of clan warfare notwithstanding, the LGPS in Scotland is in fact quite a close community with long-

established officer groups on both the investment and benefits administration sides of the business. It does help that all 11 funds in Scotland can sit round a single table.

Building from that base, we have recently added a LGPS Conveners Group. As well as this forum for exchange of views, practical collaboration has progressed with framework agreements initiated by individual funds now routinely opened to other Scottish administering authorities.

Recently, Strathclyde led a procurement exercise on behalf of all the Scottish LGPS

funds. This has just resulted in a framework agreement for member tracing services. In a broader sense, PIP itself represents a good example of how pension funds can work together without losing control of their own destiny.

That said, it is worth mentioning that in April this year the individual police and fire forces in Scotland, which had previously been structured along the same regional lines as the Strathclyde Pension Fund, were merged into single Scottish forces. Law and order is being maintained. Conflagration has been avoided, at least in a literal sense, but it may be a while before the inevitable back office issues are all resolved. And once that’s done it’s probably only a matter of time until that scheme merger question is asked again.

A bigger question stands to be asked and answered in September 2014. At this stage the independence debate has probably raised more questions than it has answered. Clearly a ‘yes’ vote would bring fundamental changes to many of our key conventions and institutions. It may be tempting as a route to avoid the clutches of HMRC and The Pensions Regulator, which will both have significantly more power over the LGPS as a result of the Public Service Pensions Act.

But we should probably be careful what we wish for. There’s a degree of uncertainty in the air as the debate rages on but it is business as usual in the meantime.Richard McIndoe is head of pensions, Strathclyde Pension Fund

‘‘ Centuries of clan warfare notwithstanding, the LGPS in Scotland is in fact quite a close community with long-established offi cer groups on both the investment and benefi ts administration sides

A ‘yes’ vote may be tempting as a route to avoid the

clutches of HMRC and The Pensions Regulator but

Scotland’s future remains uncertain


We should start with Lord Hutton. His final report

referred to “inconsistent standards across schemes”, observed that “sometimes there is no clear separation of duties” and suggested that “some form of external security would help build trust and confidence”. Translating this out of official-speak, it was clear changes were ahead. The Act does much to give legal definition to those changes.

Or rather, it does so potentially. The Act is enabling, defining the principles, not the finer details. Debates in parliamentary committees about the governance provisions gave a fascinating insight into what legislators had in mind, but until we see the details those debates are of theoretical interest only.

We now know the governance regulations won’t take effect until April 2015, and we await their publication in draft. Following the minister’s recent announcement of a broad-ranging structural review, we are left in a limbo world. The new scheme will arrive on time in nine months, but substantial structural and governance changes will follow later. It is stating the obvious to say that this will be a challenge for funds and their managers.

Despite these uncertainties, the Act does define the broad sweep of governance changes. But before considering these, it is worth focusing attention on what governance means in this context. Legally, it is difficult to

define what governance is all about – it has the capacity to be all things to all men most of the time. The 1992 Cadbury report defined it as “the system by which companies are directed and controlled”. In 2003, the Higgs report referred to “an architecture of accountability”. These principles from the corporate world apply equally in the pensions world. But in all of corporate and pensions legislation there is no definition of ‘governance’. It is a compendium of quasi-legal principles, which those running large enterprises, including pension funds, must observe.

For LGPS funds, the 2008 Guidance on Statutory Compliance Statements was a key step. This noted that administering authorities are responsible for the “prudent and effective stewardship of their funds”, and “have a fiduciary duty in the performance of their duties extending to members as well as employers and tax payers”.

Up to then, the line was that funds exist simply to defray the pension costs of councils, but the 2008 guidance went further by recognising wider fiduciary obligations. While councils and their funds operate under public law, this resonates strongly with trust law in the private sector.

As for the governance problems to be fixed, Lord Hutton summed it up – inadequate separation of roles, inconsistency in representation and voting practices on committees, lumpy standards of skill and knowledge, differing quality in

The new Act defines the principles, not the finer details about governance provisions

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Pensions Act offers a step forward on governanceMARK WOMERSLEY gives a legal view of the Public Service Pensions Act 2013 and its application for existing Local Government Pension Scheme governance structures


disclosures and reporting, and so on. In his recent speech the minister [Brandon Lewis]remarked on funds’ enviable record on scheme administration, and generally he could have said the same on governance matters. While it is not therefore a case of fixing a governance crisis, the minister’s remarks do nevertheless fit with the growing tide of change.

This brings us full circle to the new Act. Its key governance provisions are brief and easily digested. Sections 4 to 7 deal with the structural changes, and section 17 and schedule 4 define the new oversight role for The Pensions Regulator.

To my mind, the biggest governance change by far is the new status given to committees, soon to be called boards. The tasks for boards under the Act are unremarkable – securing compliance with legislation and regulatory codes sums it up, at least until we see the new regulations. The much bigger point is that the Act gives statutory recognition to the separation of powers and

‘‘ I predict that from that change will come a slow revolution in governance. We must get used to an LGPS version of the employer/trustee distinction in the private sector

Pensions Act offers a step forward on governance

roles between (a) councils as sponsoring employers and (b) pension boards as the incarnation of councils in their administering authority (or scheme manager) role.

I predict that from that change will come a slow revolution in governance. We must get used to an LGPS version of the employer/trustee distinction in the private sector.

The Act reinforces this change by its explicit focus on conflicts of interest, again to be defined further in the new regulations. Where will that leave elected councillors, or the delegated roles of Section 151 and other officers? Private sector funds have been grappling with this, and some have decided that senior management should be excluded entirely from trustee boards. Hopefully, a sensible approach will emerge for LGPS funds, but there will be some awkward conflicts issues to resolve.

Requiring equal numbers of employer and member representatives will also reinforce the independent status of boards. The word ‘representatives’ in this context is problematic. The Pensions Act 1995 refers to member ‘nominated’ trustees. No fiduciary on a trustee board should ‘represent’ a factional interest. It is hoped that the act’s provisions don’t justify divisions according to member/employer loyalties. Much hangs on how the new regulations are drafted.

In addition to making these internal changes to boards, the Act puts new focus on oversight

from external bodies. Most obviously, there is a new role for The Pensions Regulator. This has been tightly defined in the Act (see schedule 4), with the focus on increased administrative efficiency and better standards of knowledge and understanding. It is the bits that are missing which are striking – in particular, there is no Regulator role on funding and investment matters. As these are the main focus of the Regulator’s remit for private sector funds, Regulator mission-creep seems inevitable.

The new scheme advisory board signals yet another type of external oversight. The shadow board is in preparation mode, and has plans for a standards and governance sub-committee. We will have to see how this turns out. In the meantime, it’s notable that the Act refers to the advisory board as providing “advice” to new boards (ie committees), who must in turn “have regard to that advice”.

To a lawyer, the word ‘advice’ is heavy with meaning and consequences. Some tensions may emerge, particularly as boards act and think more independently. And it will be interesting to see how the new advisory board relates to the Department for Communities & Local Government.

So is the Act a step forward on governance? From the legal perspective, most certainly yes. But I doubt it will all be plain sailing as funds get to grips with the changes ahead.Mark Womersley is partner and head of public sector pensions at law firm Osborne Clarke AL

AMY


1

Work on the valuations has begun in earnest. Administering

authorities are gathering and processing annual return information from their employers (the accuracy of which determines the reliability of the valuation results) and their actuaries are busy preparing systems, planning resources and formulating their advice on funding strategy.

The valuation result is generally a product of asset strategy, membership data and funding strategy. For the 2013 valuation there is the added ingredient of the new CARE scheme, expected to be implemented with effect from 1 April, 2014.

From an asset perspective, there are reasons to be cheerful: average returns over the three years to 31 March, 2013 have comfortably beaten the returns allowed for in the 2010 liability calculations (typically 6%-7% per annum).

However, the good news soon runs out. LGPS funds are large, reasonably immature schemes, so membership changes have tended to have limited effect, at least at a whole of fund level, but the 2013 valuation may be different.

The number of employers is likely to have increased for most funds, due principally to new academies, leading to increased complexity and additional calculations and advice being required, while the number of contributing members will almost certainly

The 2013 valuations – the story so farAs work on the valuations progresses,ALISON MURRAY and COLIN CARTWRIGHT believe the long-term signs are encouraging

have fallen, particularly among the local authority employers. Any employers with falling payroll that continue to pay deficit contributions as a percentage of pay may be in for a shock.

From a liability perspective, the past three years looks depressingly familiar to the previous three (and several cycles before that): real index-linked gilt yields have fallen; and the pace of longevity improvements shows no sign of slowing. Both of these, if reflected in the 2013 valuation assumptions, will increase the value placed on the accrued liabilities (producing a lower funding level) and the assessed cost of benefits accruing in future (higher employer contributions).

The new scheme offers a glimmer of relief but may be of much less help than employers expect. It will reduce the cost of benefits accruing in future by between 1% and 2% of pay for the ‘average’ employer. However, some employers will see an increase in their contribution rates (primarily where the extra cost of the more generous pension formula is greater than the savings from moving from a final salary promise to a career average benefit linked to CPI).

Against this backdrop, delivering unchanged employer contributions (likely to be all most employers can realistically afford) will be as challenging as ever. However, if we take a closer look, the

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Delivering unchanged employer contributions will be as challenging as ever

The 2013 valuations – the story so far

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The 2013 valuations – the story so far

situation may be better (for the long-term employers at least).

Firstly, most LGPS funds have only a small portion of the fund invested in assets whose returns track gilt yields. Thus, where the discount rate is derived as the expected return on assets, the fall in gilt yields would be of only marginal impact. It does not follow that, just because gilt yields have moved, so the discount rate must religiously track them. In particular, an analysis of the expected return on assets is likely to justify a higher discount rate than simply adopting a ‘gilts+’ approach that tracks the fall in gilt yields since the 2010 valuation.

However, a robust analysis and audit trail must support the derivation of the discount rate and funding strategy. Actuaries can make use of the research and analysis carried out by investment consultants, which culminates in a set of expected return and volatility assumptions for each asset class. These assumptions underpin asset-liability modelling exercises but are of far more value when harnessed as part of the valuation exercise – they

enable the actuary to set a discount rate and employer contributions which are associated with a given probability of funding success.

Crucially, such risk-based analysis enables the administering authority to determine how prudent it wishes its funding strategy to be, and hence the degree of comfort it requires that its solvency target will be met.

Administering authorities can consider the optimum combination of funding and investment strategy to deliver their objectives, rather than find their asset strategy constrained by the assumptions made in the valuation when they commission an asset-liability study after the valuation.

Secondly, many employers are already paying deficit contributions as monetary amounts in anticipation of falling payrolls, so falling active membership will not, in isolation, lead to higher deficit contributions.

The scheme is still very immature by private sector standards and while falling active membership/increasing maturity does have cashflow implications, these are largely operational; knee-jerk changes in investment or funding strategy are not required.

Thirdly, there is a trade-off between risk taken in the funding strategy and the resultant contribution rates. How much risk should be taken is a matter for debate,

but many administering authorities may feel there is scope to marginally increase risk in relation to long-term employers (in the interests of more stable, affordable contributions), as long as the funding strategy remains within a prudent envelope. This relies on the actuary providing appropriate risk measures as part of the valuation process.

What are the implications for investment strategy?

We see little reason for most funds to deviate from their growth-biased investment strategies in the short term, at least at a whole-fund level. However, rather than adopting the traditional approach of reviewing investment strategy after the funding strategy has been agreed, a far more beneficial approach is one that integrates a risk-based review of investment strategy with the valuation process.

While no one should be under any illusions that the 2013 valuation will be easy, the picture is not as bleak as some might have you believe.

Our advice to administering authorities is to get your funding and investment strategy sorted for the long-term employers as soon as possible and give yourself plenty of time for some difficult discussions with employers that don’t have the luxury of a long-term view.Alison Murray and Colin Cartwright are principal consultants at Aon Hewitt

‘‘ While no one should be under any illusions that the 2013 valuation will be easy, the picture is not as bleak as some might have you believe


Local authority pension funds are facing difficult challenges. Budgets

are under pressure and, as public sector spending cuts have resulted in a reduction in the workforce, funds have seen a considerable reduction in active membership; thereby cash flow position will change from positive to negative.

All of this comes at a time of great change for the Local Government Pension Scheme, with the 2013 actuarial valuation outcomes, the implementation of the 2014 scheme, new governance requirements, auto enrolment and consultations on mergers.

What, then, is West Midlands Pension Fund doing about the issues raised?

The 2013 actuarial valuation exercise confirms to us that the profile of the fund is maturing; cash flows are moving from positive to negative and employer’s risk profiles need to be addressed and managed. The fund also needs to manage and, wherever possible, mitigate interest rate and inflation risks.

In the present economic climate employers increasingly find themselves under pressure to ‘balance the books’, challenged by falling active members (albeit automatic enrolment may dampen some of these falls), low bond yields and increased longevity, factors, which align themselves to higher contribution rates, as well as grant reductions, funding cuts and restrictions on credit. As a result, some

A grip on the situationWith employers facing a squeeze on their resources and the burden of increasing liabilities, GEIK DREVER explains how West Midlands Pension Fund is responding

employers are finding it an ongoing challenge to meet their current and future pension liabilities.

With the maturing profile of the fund and the divergence of employer categories, risks, covenant strengths and so on, the fund will be looking at offering varying investment strategies based on employers’ covenant strength, and their risk appetite. We won’t be able to manage too many strategies, three or four at most, but we understand each individual employer has a different profile and risk appetite.

The reforms of the LGPS in the 2014 scheme are estimated to generate a cost saving of about 2% on future service contribution rates. This is based on the average employer profile following anticipated outcomes from the 2013 actuarial valuation exercise. However, we do not believe that this will be the case for many employers; some will see a reduction but,

dependent on their employees’ category, some will see an increase.

The fund has implemented a framework for the monitoring and assessment of covenants for all participating employers, primarily with a view to mitigating the liability risk that the overall fund would be exposed to should any of these employers be unable to meet their pension liabilities.

The principal outcomes of this process have been to enhance employers’ understanding of the issues involved, to complete a comprehensive review of existing guarantees and, where possible, to request and implement additional securities as appropriate.

The fund’s structured employer engagement strategy and consultation process is aimed at improved comprehension of the relevant issues and stimulating engagement. The engagement strategy allows the fund to adopt a proactive, rather than reactive position, helping to identify any particular difficulties being experienced by employers and to work to alleviate the associated risks of a closure being spread across the whole fund.

It is clear that the LGPS is at a critical juncture with regard to investment strategy and how best to protect the funds for the future. The deterioration in the funds’ cash flow puts greater emphasis on income generation and not just capital growth. Yield-generating

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investments with appropriate inflation-based targets will become more of a focus in the future. Index-linked bonds and long-term infrastructure investments become even more appropriate as we seek investments linked to inflation.

With cash flows moving from positive to negative, income generation is crucial to avoid the selling of assets to pay benefits. Investments that generate steady cash flows and inflation protection, such as the Pensions Infrastructure Platform (PIP) are used. The WMPF is a founding member of PIP, which will facilitate access to infrastructure investments at a lower cost with the return profile being linked to inflation.

New investment products are continually being developed to counter some of the risks and the fund will continue to consider these.

The minister for communities and local government has called for evidence on mergers with an emphasis on cost effectiveness in mind. The investment industry needs to align their interests, in particular management fees, with that of pension funds. Costs can be reduced through in-house management.

The WMPF is changing the way it operates internally and similarly how it engages with its stakeholders to weather the current economic storm.Geik Drever is director of pensions, West Midlands Pension FundAL

AMY


COMMENTALEX VEROUDEHead of credit markets, Insight Investment

Over the past decade, local authority pension schemes have benefited from being ‘early adopters’ of more esoteric asset classes such as property, infrastructure and private equity. However, diminishing cash flows and volatile investment returns have continued to put pressure on funding levels.

At Insight, we recognise that local authority pension schemes face particular challenges that influence the type of asset that they buy. A premium is rightly placed on assets that offer the following investment characteristics:● Stable returns across economic cycles● An inflation hedge● Generate income ● Diversification

Given today’s uncertain investment outlook and the low yields on most traditional fixed income assets, there is renewed appetite for alternative investments such as illiquid credit.

Right risk/reward trade-offThe grab for yield across investment markets is likely to remain a significant driver of investor behaviour. Investors need to generate returns regardless of the economic backdrop. While nominal yields are relatively low, the additional pick-up offered by the spread on credit will continue to be attractive. Credit markets could therefore remain a primary beneficiary of the hunt for yield, especially given the greater certainty of return that they offer relative to volatile equity markets in an uncertain economic environment.

As the search for yield continues, however, there is potential for increasingly bubble-like conditions in credit markets. Both in the developed and the emerging world, investors could bid up prices beyond levels that are justified by fundamentals. But even if there is as yet no bubble to burst, total returns in 2013 are unlikely to be as

Illiquid credit: an opportunity for local authority pension schemes

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FIGURE 1: SPREADS ON EUROPEAN CORPORATE BONDS ARE AT HISTORICAL LOWS

Source: BofA Merrill Lynch Euro Corporate Index

high as those seen in 2012, as credit yields were significantly higher at the end of 2011 than they are today. The starting point for credit is not nearly so promising, as figure 1 shows.

Investors looking to maintain relatively high returns are faced with a choice. They can reduce credit quality and increase the risk of default, or explore more niche areas of credit markets where they can expect to be paid for accepting lower levels of liquidity. In our view, going down the route of accepting lower liquidity offers a better balance of risk and reward.

Generating income and hedging inflationTwo areas of illiquid credit we believe are worth considering are secured corporate loans and commercial real estate loans. The first area is a good example of an asset where investors are well rewarded for giving up some liquidity.

The absolute yields of secured corporate loans are now more attractive than those from high yield corporate bonds. Loans are also senior in the capital structure, which means investors are given a higher priority claim on a borrower’s assets than a bondholder. Because of the secured nature of the asset class, recoveries are generally higher in the event of a default. Another interesting characteristic of

loans is that they typically pay a floating rate coupon that is reset in line with market interest rates. This provides a natural interest rate hedge.

Another opportunity is investment in European commercial real estate loans. Against a backdrop of regulatory change, demands for higher capital buffers and deleveraging, many European banks have shrunk their balance sheets. This new financial landscape has created an opportunity for new lenders to enter the institutional commercial real estate loan market. Loans of this nature are currently trading on average around 3% over sterling Libor, which compares very favourably to pre-financial crisis levels of less than 1%. The investment case improves further when you consider that the average loan-to-value of pre-crisis loans was around 75%, compared with the current average of 50-65%. All else being equal, local authority investors in this market have the potential to be paid considerably more income to take significantly less risk than before the financial crisis.

In conclusion, we believe the more illiquid areas of the credit market have the potential to offer a return profile closely aligned with the needs of local authority pension schemes in today’s economic environment.


It is almost 20 years to the day that I commenced my second career, when I became the pensions

administrations manager for Kent CC. I previously worked for 26 years in the banking industry, which enabled me to gain a range of skills and management experience but did not prepare me for the steep learning curve presented by my new vocation.

Pace of changeWhen I look back over those years, stretching back to the early 1990s, the pace of change has at times been frenetic. The changes have not only come in the form of amendments to our statutory pension scheme regulations but also to the overarching pensions legislation by which we administrators are all bound, be it in the public or private sector.

There is no substitute for ‘life’s experience’. In the twilight of my working days I must of course agree. However, my life as a manager has taught me, if there is one thing that tests us humans more than any other, it is change itself. I therefore applaud all those people across the UK who are engaged in the pursuit of administering public service pension schemes for their fortitude, energy and sheer stamina, in coping with the endless barrage of changes they have had to endure! I would also add that if the past few years have seemed demanding, then it is my belief that the next few will be significantly harder.

Challenge of administering the LGPSPAT LUSCOMBE considers public sector pension reform and how we have got where we are today

The ‘holy grail’I recall attending meetings throughout the 1990s at which we endlessly debated what reforms were needed to public sector pensions to meet the ever-increasing envy of the private sector. People were living longer, pension costs were increasing sharply and the private sector had already embarked upon the process of ‘eliminating’ defined benefit schemes, from their reward packages. This process today is almost complete, with few such schemes remaining open to new employees.

The backdrop of this environment created uncertain times for the public sector schemes. As a result, we faced new scheme regulations in 1995 and then in 2006 with ‘A-day’ and all. This was closely followed by a new-look LGPS, effective from 1 April 2008. All were designed to make the LGPS sustainable, affordable and fair to council taxpayers.

Here we are now facing yet another significant round of change to all public sector pension schemes, still seeking the ‘holy grail’ of at last meeting the ‘acid’ test of being affordable, sustainable and fair to taxpayers.

Some commentators would have you believe that, within a further five years, we will once more be facing further significant change. Despite the promises being whispered in the corridors of Parliament I cannot say with hand on heart that I believe we have reached the end of the road in terms of reforms. The next step, if it is left to the politics of public

Public sector pension schemes are seeking the ‘holy grail’ of at last meeting the ‘acid’ test of being affordable, sustainable and fair to taxpayers

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xx Month 2010 Local Government Chronicle xxlgcplus.com

COMMENT LEIGH HARRISON Head of equities Threadneedle Investments

Investors searching for income are increasingly looking at equities as one of the few places where yields are still attractive. The risk of owning equities is, to some extent, compensated for by their attractive valuations while the valuation of low risk assets is currently unsustainably high.

While volatility in equities adds to the risk of owning them, quantitative easing by governments to manipulate bond yields has driven down yields on debt to a point where investors are not receiving an adequate return for the level of risk taken.

Across the globe investors with plentiful liquidity are seeking out income-generating assets. This has resulted in bond markets trading at valuations never seen before, while equity markets still look relatively cheap against historical valuations. In some cases we even find companies that have a dividend yield above the yield on their corporate bonds.

As established income investors, we have considerable experience constructing equity income portfolios to deliver above-market yields. We have demonstrated that income investing can result in superior performance and believe that the volatility risk of owning equities can, to some extent, be offset by being prepared to invest

patiently and for the long term, allowing the benefits of a rising stream of income to drive value creation.

High dividend stocks do tend to exhibit defensive characteristics, which can see them outperform in weaker markets, while our portfolio managers work hard to ensure portfolios also perform in rising markets. One way to do this is to favour exposure to growing companies with high dividends, as opposed to investing in very high dividend bond proxies.

Historically, our home market in London has been an attractive source of higher-yielding companies but today dividend culture is strong in many other world markets. This means global investors have a wide opportunity set from which to construct a portfolio of attractive companies with a high dividend yield. Clearly, the most significant advantage of a global income approach is the ability to select from a range of high dividend-paying companies in each sector.

There is also the opportunity to invest in the faster growing parts of the global economy, such as the emerging markets. Given these advantages and the increasing demand for income from investors, we expect continued growth of the global equity income sector in the years ahead.

Global equities can help with the search for yield

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ALAM

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Challenge of administering the LGPS

envy, will surely be a move to defined contribution/money purchase.

The structure of the Kent schemeOur local government scheme in Kent consists of some 40,000 active contributors, 38,000 deferred benefits (the largest part of which are in trivial amounts, entirely because of the three-month vesting period in the previous regime, which is about to be changed back to two years in this current round of change) and finally 34,000 pensioners.

We have more than 400-plus employers, ranging in size from the county council, inevitably the largest, down to a small parish council, employing a part-time clerk. These active contributors are engaged on a myriad of different contract types, ranging from ‘as and when relief employees’, part-time staff, multi-contract staff, fee-only earners, fixed-term contracts, term-time-only contracts through to full-time staff. Some have a combination of different jobs.

For this multitude of contributors, we have to calculate pensionable pay, itself the subject of no less than two pages of descriptive text in our current regulations, using a wide range of decimal and percentage calculations, in order that each may share, equitably one to the other, in the benefits of a ‘final salary’ pension offering. It has to be

Continued overleaf

LGCplus.com22 Local Government Chronicle 27 June 2013

said that ‘final salary’ does not fit well with such a diverse population and a move to CARE, while presenting its own unique issues, will fit a lot more easily

When each layer of regulatory change is passed by Parliament it inevitably introduces another set of transitional regulations that describe, in as many words as possible, how the changes are to be implemented for existing contributors. So, while they are effective from some approaching date for all new staff and most existing members, a selective band of current scheme members will be provided with protection from the changes. Yet another issue for us to consider when calculating the pension for these chosen few.

By retaining this legacy, in part or full, for each preceding set of rules, the level of knowledge needed by the administrator is increased. I am fortunate to have no less than 20 members of my original team still with me but, without them, the task would be made significantly more difficult and at times impossible.

Employer roleOur employers are, naturally, free to choose the payroll, HR and accounting system that best suits their requirements. This may not always be a system capable of holding the data we need to administer the pension scheme. We now live in an age where the need to electronically store/share and transmit data is essential. The sheer volume of data we need to effectively deliver our service demands the larger employers be able to transmit data electronically (we currently hold in excess of five million documents/electronic images). Not all employer systems have the capability to do so.

LGPS 2014 ‘fundamental change’The proposed reforms of the LGPS will be the most fundamental changes in the history of the scheme.

We are now moving from a ‘final salary’ structure to a CARE arrangement. The accrual rate will then have moved over just a few years from 1/80th to 1/60th and then to 1/49th. In the CARE arrangement, accrual will be based upon the actual pay received by members, compared with the current and complex definition of final

‘pensionable pay’ described earlier.

Contributions will remain on a tiered basis, with the greater percentage being paid by the higher earners. However, the percentages and tiers in the new scheme will be different to the present arrangement. Annual pensions accrued will be increased by Consumer Price Index.

In addition, we are for the first time to have an option for members to pay 50% of contributions for a trade off of 50% of the benefits. Following the long and at times heated discussions that preceded the proposed new scheme, it was announced, perhaps by accident rather than design, that anyone within 10 years of retirement was exempt from these changes. They are to be able to choose between the two regimes and select the most beneficial to their personal circumstances at retirement.

This inbuilt legacy of the former scheme requires employers to retain and maintain two streams of data, to calculate two and potentially three separate pay figures, collect one set of contributions and all manner of ancillary information, to

support the administrator, in readiness for when that person ultimately retires. For our part, we will inevitably have to undertake two calculations, for a large number of beneficiaries, to provide the detail, to inform the option open at retirement. We must also remember to consider those who may have opted at some point along the way to take the 50:50 alternative. Also, the retirement date of scheme members is to be linked to future state retirement age, which we all know will be changing as life expectancy increases in the future.

CommunicationWe must consider the enormous communication exercise that will be necessary to ensure our pension scheme members are notified of the changes and understand the key elements of the new scheme, how it is different to that which they have now and how it may interact with the current benefit range in future.

On the basis that scheme members do not generally understand the vagaries of ‘pension speak’, how they will deal with terms such as revaluation, assumed pay, 50:50 option and transitional protection may be a challenge that needs to be addressed.

And finally, the one thing that never seems to change is the ability of the administrators to rise to the challenge. I take my hat off to them.Pat Luscombe is pensions administrations manager at Kent CC

‘‘ The proposed reforms of the LGPS will be the most fundamental changes in the history of the scheme

Continued from previous page

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Investment

Accrual will be based upon the actual pay received by members


ALAM

Y

COMMENTBERNARD ABRAHAMSEN Head of institutional sales and distribution,M&G Investments

Since 2009, financial headlines have been anything but uplifting. So, you may be surprised to hear that we think it’s an exciting time to be an institutional fixed income investor. ‘Mainstream’ fixed income asset classes have been performing well since the height of the crisis and there is also an ever-growing number of less mainstream, but perhaps more exciting, investment opportunities offering security, safety, impressive returns and potential capital growth. They also offer extra diversification against an investor’s more traditional fixed income assets.

These less mainstream investments have become all the more attractive as banks scale back their financing activities in response to new regulations and have to pay more to borrow money themselves. Institutional investors are therefore more able to replace the banks as financiers in a whole host of markets.

Innovations in residential housing financeWe have a long history of investing in the sale and leaseback of commercial properties. The idea behind such a transaction is to buy a ‘prime’ property and lease it back to its previous owner (maybe a supermarket like Tesco, for example), guaranteeing decades of rental income which increases in line with inflation.

The resultant cash flows

look a lot like those of a long-term inflation-linked corporate bond, but with the added benefit that they’re ‘secured’ against prime real estate. If the tenant defaults, this property can be rented out to another retailer or simply sold for the proceeds.

But why exactly would a company like Tesco be interested in selling one of their stores and then leasing it back? For very similar reasons to those that would cause the supermarket chain to issue a bond, take out a bank loan or issue new shares. Sale and leaseback is another source of funding, and can be used to finance new investments, projects or expansions. With less bank funding available to companies, sale and leaseback has proven to be a viable alternative for a number of companies.

While institutional investors have been entering into the sale and leasebacks of commercial properties for some time, residential property sale and leasebacks have been less common. We believe the investment case can be every bit as compelling, however. We recently completed a £125m

sale and leaseback of 401 market-rented units in a brand new residential housing development near London’s Olympic Park in Stratford.

We purchased the units of this development from Genesis Housing Association, which has been given ‘AA’ ratings by the ratings agencies, on behalf of the M&G Secured Property Income Fund. The deal is a 35-year fully repairing and insuring lease, which means that Genesis will continue to manage the development in exactly the way it did before.

The association’s rental payments will increase in line with the retail price index (RPI), between zero and five per cent. The fact that the rents of the actual properties rise in line with inflation provides a natural inflation-hedge. Furthermore, there’s also the potential of a capital gain on the value of the property.

For housing associations, finance like this helps them to build new social housing developments, and continue to maintain existing ones. The social housing sector certainly has a great deal of potential

for investors, and we believe that more institutional investors and asset managers should get involved. Sale and leasebacks, as well as secured loans, have the potential to deliver secure and predictable cash flows to investors. No investor has as yet made a loss when lending to a housing association registered provider, so we think it’s a very interesting proposition for long-term investors like pension funds and life insurance companies.

The benefits of non-main-stream fixed income assetsTraditional fixed income portfolios can be enhanced by adding private transactions such as those offered by the long-lease property market. They offer diversification against public debt, and relatively attractive risks and returns.

Of course, separating the attractive deals from the less attractive ones requires a great deal of resource and experience. Specifically, long-lease property transactions require both fixed income and property expertise. Investors need the capacity to analyse both the credit quality of investors they transact with and the properties they are purchasing. Being able to do both is vital. Once all the appropriate skills are in place, we believe that those attractive, ‘less mainstream’ investments, which benefit institutional investors and ultimately, the UK economy, can become a more integral part of institutional portfolios.

Innovative fi xed income opportunities: the real deal

COLUMN SPONSORED AND SUPPLIED BY M&G INVESTMENTS. WWW.MANDG.CO.UK

Residential property sale and leaseback schemes, such as the one recently completed in Stratford, offer a compelling investment case

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