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

Agenda sdf 1

LGC’s regular special report

The Greater London Authority raised funds via a bond issue to help pay for Crossrail. Is this the way forward? p10

The Chancellor is seeking investment in £250bn of economic infrastructure projects p8

Why running a pension fund can be similar to fl ying p4

Learning lessons from the post-mortem into the banking crisis p6

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1 LGC’s regular special report ▼

NIC PATONSUPPLEMENT EDITOR

‘‘ Since the 1990s pension fund managers have been battered by an array of (and it has to be said increasingly frequent) crises

2 LGC Finance 15 March 2012

I still remember the somewhat pained expression on my father’s face when I came home from sixth-form college and announced I was going to be focusing on post-1945 ‘history’ for one of my A-levels. That, of course, to him was very much living memory and, probably in fact to his mind, current affairs.

It’s much the same now for me when my children say they’re being taught about the miners’ strike or the fall of the Berlin Wall.

But if we’re going to understand the context of what’s happening around the world or politically today, and in turn even hope to anticipate or evaluate what might happen in the future – an absolutely key skill-set of course for the modern-day local government pension fund manager – then history matters.

As Warwickshire CC’s Phil Triggs has highlighted on pages 4-5, since the 1990s Local Government Pension Fund managers have been battered by an array of (and it has to be said increasingly frequent) crises – the bursting of the ‘dotcom’ bubble, the equity meltdown of 2003, the financial collapse of 2007-08 and now, of course, the eurozone and sovereign debt crises and LGPS reforms, to

name but a few. Each has required (or still

requires) the keeping of a measured, calm, long-term perspective as much as skilled financial expertise.

Similarly, as the Local Authority Pension Fund Forum’s Keith Bray writes, exactly why banks in the UK and Ireland failed in 2008 may already have been much analysed but, as time begins to give us distance, local authority pension funds, as key institutional investors, need to be ensuring the lessons from that time are well and truly learned.

Finally, what continues to be clear is that the current climate of austerity is, if anything, encouraging rather than stifling innovation.

How, or even whether, pension funds can innovate by investing in infrastructure projects is examined by London Pensions Fund Authority chief executive Mike Taylor, while Barclays’ Chris Hearn makes the point that regular review of funding sources and funding flexibility will need to remain the imperative for fund managers in the future.

After all, in challenging times the last thing any of us wants is to become an ‘object lesson’ to be pored over in the history books of the future.

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LGC’s regular special report

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Contents

LGC Investment Awards’ Finance Officer of the year PHIL TRIGGS talks about his career in pension fund management, today’s pressures and how he see the challenges changing in the years to come p4

Research has found that in 2008 financial decision-makers mistakenly believed that the banking crisis was an issue of liquidity, rather than solvency. KEITH BRAY explains why it is so important to learn from this error p6

Chancellor George Osborne wants pension funds to invest in a £250bn programme of British infrastructure projects. But would this be in the interest of the pension funds themselves? MIKE TAYLOR investigates p8

Spending cuts and the rising cost of borrowing from the Public Works Loans Board is leading to an increasing number of local authorities turning to the bond markets to meet their borrowing needs, writes CHRIS HEARN p10

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Tell us about your background and route to Warwickshire.My local authority career started in a council rates office, straight from sixth-form college, the day after my final maths A-level paper.

For six years I specialised in rating valuation and rate recovery at Havant BC, qualifying as an associate with the Institute of Revenues, Rating and Valuation.

This might have remained my career but I was highly sceptical of the pending poll tax and I jumped ship and became a Chartered Institute of Public Finance & Accountancy trainee with Chichester DC in 1988.

My lucky break into treasury management and pension fund investment came with a move to Buckinghamshire CC in 1999 at a time when pension funds and stock markets were certainly not the headline news they are today.

This new speciality was the start of a very steep learning curve and the best thing is, some 13 years later, I still feel that curve towering above me. There is no investment practitioner who knows it all.

The move to Warwickshire came in 2003.

How has pension fund management changed from when you started? When I started work in pension funds in 1999, it was the dawn of many crises that had to be faced down over

Piloting a steady fl ight pathPHIL TRIGGS is group manager of treasury and pensions at Warwickshire CC and LGC’s Investment Awards Finance Officer of the Year. So, what makes him tick?

the next decade: the Argentine, Asian and Russian crises of the late 1990s, the bursting of the ‘DotCom’ bubble in 2000, the equity meltdown in 2003, the collapse of Northern Rock, the Icelandic banks, Lehman Brothers, RBS, Madoff and latterly, of course, the eurozone.

Each event has needed a calm and measured response and, undoubtedly, there will be more trials and tribulations over the coming years. Indeed, experience of crisis and change management are now vital composites of any good CV.

Having qualified as a private pilot ten years ago, I see running a pension fund very much like flying a plane. You have at your command a lot of very expensive kit and you have much faith in the kit to do the job it’s supposed to do.

However, the impact and unpredictability of the outside elements are a different matter. It is those elements, if not properly managed, that will bring a pilot crashing to earth.

Similar to planning a flight, asset allocation is now very much designed with risk in mind and how it can best be reduced and managed as much as is possible. Events certainly seem to be faster moving and sometimes you wish for a pilot’s speedy, dynamic response.

However, there is nothing like the measured approach

The outcome is far, far better than first anticipated and we need to sell this to the active membership with the significant privileges and benefits of belonging to a defined benefit pension scheme. The fact it will be implemented a year earlier than the original tight deadline means some project and change management timetables, communication strategies and effective leadership will be needed.

Second, pending the Hutton implementation, we need to assess the effects on the fund concerning its maturity and cash flow. Any significant deterioration will

and informed decisions of a well-trained investment board, and I have come to value this at Warwickshire over the years.

What would you say are the key challenges facing pension fund managers today, both internally in terms of their function and role within local government and in terms of the external pressures they face?I see five key challenges ahead. First, the major task is the Hutton implementation, which is still very much a moveable feast. We have a framework and principles on which to negotiate.

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Running a pension fund is like flying a plane – the outside elements must be managed

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COMMENT BEN CLISSOLD Senior Liability-Driven Investment Manager, SSgA

Planning for retirement is something most are happy to leave until later – the problem is that later is often too late. Auto-enrolment is fast approaching and having your employer help provide for retirement sounds like a great idea.

Members of the Local Government Pension Scheme do not have to worry about where the funds are invested, though I do – I have a defined contribution pension scheme to which my employer contributes on my behalf. I get to choose, within reason, where my contributions are funnelled into. I have the advantage of working in the pensions industry and advise clients on asset allocation and liability matching.

Personally, all my investments are in equities and biased towards emerging markets. I have, in fact, limited diversification.

How does this tally with the conservative, diversified risk-aware Liability Driven Investment (LDI) solutions I recommend daily to large defined benefit (DB) pension scheme clients? Why shouldn’t LDI apply to me? Well, it actually does but, crucially, my time horizon is different: I will be paying into my pension pot for another 30-plus years.

In finance speak, my pension scheme is cash-flow positive and will be for a long time yet. Because I contribute monthly, today’s

equity market declines are actually a positive as I continue to invest at a lower price and have a relatively limited amount of assets losing money when equities fall. This is no longer true for the vast majority of DB pension schemes, where – since the schemes are shut to new members, closed to future accrual or just maturing with a growing proportion of pensioners – they are close to, if not already, cash-flow negative.

To a lesser extent this is true even for the LGPS. Changes in regulation, pension scheme take-up rates and job cuts have brought forward the point at which it will become a net seller of assets. The LGPS remains one of the few where contributions more than cover benefits, to say nothing of investment income. Nevertheless, changing cash flows, as well as low interest rates, are forcing members and advisers to reconsider how they manage risk.

Interest rates and inflation are two of the biggest risks facing funds and considering these factors before cash flow becomes an issue makes good sense for the overall health of the scheme.

The views expressed are the views of Ben Clissold through to 15 March 2012 and are subject to change based on market and other conditions

Managing pension risks

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Piloting a steady fl ight path

affect our investment strategies and we are continually monitoring this, with active membership having already fallen.

Third is the challenge of risk management in terms of volatility, which is now featuring higher up on the Local Government Pension Scheme agenda than, say, ten years ago. We are monitoring extremely stressful situations with the aim of averting permanent capital losses.

Fourth, it is important to add to this the risks facing individual employer bodies going into administration or liquidation, and the resultant shocks on the LGPS funds.

This will be an especially significant challenge over the next decade, with the significant increase in admitted bodies to the LGPS funds. Strategies will be needed to counter this threat.

Finally, fifth, auto-enrolment is due over the next year and although regarded as an employer responsibility, the serious implications of missing deadlines are being mulled over by LGPS managers.

All of the above will require insight, influencing, decision-making and leadership skills. Overall this means it is an exciting time to be in this speciality field.

Finally, what do you think is going to be the most exciting or challenging element of your role over the next five to 10 years?The obvious answer is keeping the good ship LGPS afloat. We’ll have a new scheme from 2014, a scheme that will still be regarded as fair and equitable after Lord Hutton’s work.

The challenge will be to convince the membership they should remain within the fold because a high opt-out by active members will result in the scheme becoming mature far more quickly than envisaged.

Add to that the uncertain investment climate and the eurozone debt crisis, and how our investment strategy evolves to adapt to a constantly moving landscape.

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It has become increasingly apparent that the bank failures of 2008 were only the first

round of the global financial crisis and that further reforms to the financial system will be required. Institutional investors, such as local authority pension funds, have a significant role to play in this economic reform and reconstruction.

The oversight role of shareholders is, of course, now set out in quasi-regulatory terms in the form of the UK Stewardship Code. However, if investors are truly to be part of the reform effort, they first need to understand what went wrong in the banking sector.

For this reason, last autumn the Local Authority Pension Fund Forum commissioned research to examine the causes of the bank failures, which subsequently led to our report UK and Irish Banks Capital Losses: Post-Mortem http://staticweb.pirc.co.uk/LAPFF_Post_Mortem_report.pdf.

Understanding the true causes of the crisis is particularly important, given that in the early stages some key decision-makers felt the principal problem was the liquidity, rather than the solvency, of the banks. This proved to be a disastrously mistaken view.

However, by June 2011 the Bank of England was clearly stating the crisis was not one

Anatomy of a crisisThe near-meltdown of the banking sector was caused by a misdiagnosis of the underlying problems. KEITH BRAY explains why a true understanding of the issues is crucial

of liquidity; it was always a capital (solvency) crisis. Sir Mervyn King, governor of the Bank of England, said: “From the very beginning … an awful lot of people wanted to believe that it was a crisis of liquidity.

“It wasn’t, it isn’t. Until we accept that, we’ll never find an answer. It was a crisis based on solvency … initially financial institutions and now sovereigns.”

Why there was such a deficit in analysis from domestic institutional investors is one of the key things the report sought to address, and it concluded there was a failure to identify the current accounting standards as a root cause of the initial phase of the banking crisis. This led to the misdiagnosis of the problem.

In essence, a relatively simple error was introduced into the financial accounting system in 2005 under International Financial Reporting Standards (IFRS) with severely detrimental effects on governance and regulatory oversight of corporate financial reporting. The result of this error was the near-collapse of the UK and Irish banking systems.

IFRS has run contrary to the ‘true and fair’ view in accounting, and has painted a false picture of the solvency of financial institutions. Banks that appeared to be solvent sometimes just a few months later required an enormous amount of

Financial Policy Committee. In remarks made to members of the Institute of Chartered Accountants in December, he advised: “A distinct accounting regime for banks would be a radical departure from the past. But if we are to restore investor faith in banking sector balance sheets, nothing less than a radical rethink may be required.”

Clearly, there were various and multiple factors at play in the crisis and different groups will put a greater or lesser emphasis on different issues. None the less, LAPFF believes the concerns raised in our report require attention from all those involved in reforming finance.● Keith Bray is forum officer at the Local Authority Pension Fund Forum

taxpayer support to survive. However, shareholders have not as yet seriously questioned why the weak position of such banks was not flagged up in their financial reporting.

The forum’s analysis argues that the UK and Ireland were at risk because they adopted IFRS more comprehensively than other parts of the EU. Forum research has also estimated that the total loss of capital of UK and Irish banks has been in excess of £150bn, with investor losses even greater.

Pertinently, it is not just the LAPFF that is now taking this stance. Similar concerns have been expressed by Andy Haldane, director of financial stability at the Bank of England and a member of its

A LAPFF report examined the cause of bank failures

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COMMENT ANDREW SWAN Director of Fixed Income M&G Investments

To say the financial crisis has changed the face of public finance is one of the most obvious statements anyone in Britain could make.

However, what is less obvious is the fact that changes in the financial environment have created an intriguing opportunity for public sector investors to provide an important role in financing key parts of the UK economy, while benefiting from doing so.

Due to incoming regulations and an increase in their own cost of borrowing, banks have been lending a great deal less. The era of cheap credit is over, and we may never see another one.

This has left a ‘funding gap’, and many creditworthy entities and, indeed, entire sectors are less able to borrow and refinance. This includes medium-sized and small companies, infrastructure projects, commercial mortgage borrowers and the social housing sector. And it’s in these areas that public sector investors have a chance to step in.

On the subject of social housing, the Housing Association Registered Providers (HARPs) who build and maintain social housing in the UK plan over the long term and are

therefore more suited to receiving long-term loans.

While the banks provided almost all of these loans over the past decades, we believe they may not be the natural lenders, partly because they have short-term liabilities. A more natural lender may be an entity with long-term liabilities instead, such as a pension fund.

We think such an arrangement suits the UK’s social housing sector and public sector investors.

To date, no large-scale social housing lender has ever suffered a loss, partly because the sector’s strong and decisive regulators are focused on maintaining the economic stability of the HARPs.

The cash flows largely come from inflation-linked rental payments, and much of this arrives directly from housing benefit.

Finally, almost all lending is secured against property. This allows for long-term, predictable and secure cash flows that suit the needs of public and private sector pension funds.

The social housing sector represents close to 10% of the entire nation’s housing and so is a hugely important sector to the UK, and there is a political consensus that more social housing is needed, and thus

new construction will need to be financed.

We believe that matching institutional investors with HARPs helps finance both public sector pensions and essential social housing in the UK.

However, the matchmaking process has been a gradual one, and the level of institutional lending to the sector has been comparatively low so far.

We are confident that progress is being made though. We recently closed the first social housing fund with £200m of client capital, targeting returns of 2% to 2.5% above the annual inflation rate (as measured by the UK retail prices index, limited between 0 and 5%).

But far more lending is required, HARPs need billions of pounds in 2012 alone, and pension funds are in need of reliable income streams, so we hope more investors will want to get involved.

Social housing is, of course, only one sector, and as I mentioned earlier, the ‘funding gap’ affects several others, meaning there are more opportunities for institutional investors to provide finance.

The opportunities, however, are not always clear-cut and there are

potential pitfalls to consider. We advise investors to stick with managers who are experienced in the area.

The world has changed since the financial crisis, and may never switch back to what it was.

The need for new finance in the UK is substantial, and public sector investors could be a key player in financing the nation’s future.

● For more information, please contact us at 020 7548 3414 or consultant.relations@mandg.co.uk

This article reflects M&G’s present opinions reflecting current market conditions; are subject to change without notice; and involve a number of assumptions which may not prove valid.

This is not an offer of any particular security, strategy or investment product.

It has been written for informational/educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product.

Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents.

Public sector investors could help fund the future of the nation

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In his autumn statement last year, Chancellor of the Exchequer George Osborne called for an

ambitious programme of investment into infrastructure by UK pension schemes. He said: “We need to put to work the many billions of pounds that British people save, in British pension funds, and get those savings invested in British projects.”

In total the chancellor was seeking investment in some £250bn of economic infrastructure projects over the next five years. The question for pension funds therefore is: does this provide investment opportunities or is it just a political stunt?

Discussions are already at an early stage between the Treasury and private and public sector pension funds about creating investment vehicles for funds to invest in UK infrastructure.

But in reality, to answer the question we need to go back to first principles. The purpose of a pension fund is to pay pensioners, not to boost growth in the UK or local economy. Yet can those two objectives be reconciled?

Pension fund liabilities are long term and relatively predictable, with three main variables: interest rates, inflation and longevity.

The holy grail is to find asset classes that provide returns to match these liabilities without excessive risk or volatility. Some pension funds believe there is

Putting funds into UK plcIn the wake of the Chancellor’s call for pension funds to invest more in infrastructure projects, MIKE TAYLOR explores the rise of an asset class that could offer real opportunities

the potential to create infrastructure investment platforms that match the liabilities better than the traditional mix of equities, bonds, real estate and other alternatives – or at least add infrastructure to the mix of those assets.

Infrastructure as an asset class has been around since the late 1990s when the private finance initiative (PFI) was launched in the UK and a number of overseas funds were launched, particularly in Australia.

Up until the financial crisis of 2008, many of the infrastructure funds were similar to the private equity fund models of leveraged buy-outs, with investors being attracted to short-term returns fuelled by high levels of leverage and cheap debt.

The way funds were sold and structured prevented investors and institutions from having access to infrastructure’s most attractive features, namely long-term stable cash flows and liability matching.

The financial crisis removed the leverage and it has become easier to identify assets that have a strong correlation to economic performance, sensitivity to leverage or susceptibility to changes in regulation.

Investors also realised that management of assets was important and that public-private partnerships were mainly uncorrelatedto the rest of the asset class.

‘‘ We need to go back to fi rst principles. The purpose of a pension fund is to pay pensioners, not to boost growth in the UK or local economy

Three main trends have emerged:● fund lives have started to increase (for example 25-year funds launched) compared with private equity funds (predominantly 10-12 years);● there has been an increase in fund specialisation (mega, mid-market, sectors and debt funds); and● the desire of larger investors for co-investment, rather than through funds.

The government’s initiative fits well within this analysis and it is therefore opportune

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Putting funds into UK plc

Infrastructure allocations by UK funds are the exception rather than the rule

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COMMENT PHIL REDDING MD, UK Institutional Sales Aviva Investors

Investment in UK social housing offers a win-win solution for pension schemes and social housing providers alike.

The underlying dynamics of the social housing sector are compelling, with unsatisfied demand estimated at 2 million households. A large quantity of new social housing will need to be built over the next five years at a time when government grant aid and bank lending are being curtailed.

UK pension funds and annuity businesses are especially well placed to provide finance, and some asset managers acting for pension funds and insurers have established track records in this field. Aviva Investors, for example, has been investing in residential units leased to housing associations since 1997.

In our view, the social housing sector is among the most secure and conservative industries in the UK. It is highly regulated by the Homes & Communities Agency, and is well suited to providing long-term cash flows, from long-term leases and to providing indexation, as housing benefit and the underlying rents have traditionally increased in line with the retail price index.

Under our approach, the freehold interests in good-quality modern properties are purchased by a specialist social housing

fund and leased to a registered provider or local authority for 40-50 years. Under the terms of the lease, the registered provider is responsible for letting the properties and all ongoing repair, maintenance and void costs, and pays rent to the fund, which is typically reviewed annually in line with the retail price index, with a 0% floor. At the end of the lease, ownership of the assets reverts to the registered provider, so there is full amortisation of the initial investment over the lease term.

This approach can offer advantages to all parties. The registered provider receives long-term finance that is consistent with its own cash flows.

Meanwhile, the investor has access to a highly secure and stable investment that provides long-term inflation-linked cash flows, and could help to reduce any underfunding by providing a real return materially above index-linked gilts.

Prepared for professional clients only. Unless stated otherwise any opinions expressed are those of Aviva Investors Global Services Limited. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Authorised and regulated in the UK by the Financial Services Authority

Social housing’s potential

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Putting funds into UK plc

to reconsider the role of infrastructure in the asset allocation strategy and the appropriate weighting.

Because of the longer time horizons of the Local Government Pension Scheme funds, infrastructure funds should sit well within their asset allocation strategies.

Infrastructure allocations by UK funds are the exception rather than the rule. Those that do invest tend to have low allocations, with the average for the larger funds around 3%.

The London Pensions Fund Authority began investing in infrastructure as an asset class in 2004, initially through PFI and clean energy funds, using the experience gained in private equity investing. We are attracted by the prospect of uncorrelated, stable, inflation-linked, long-term returns that are a good match for our long-term liabilities.

The portfolio was broadened out to encompass three sectors:● economic infrastructure;● environmental and renewable energy infrastructure; and● social infrastructure.

The target allocation of 5%, or £120m, of the fund’s return-seeking assets is now deployed in infrastructure, primarily through limited partnership funds. There is a further level of commitments to funds of some £60m.

The investment approach was to gain exposure by

building out the portfolio to the target allocation through listed funds, then sell those down to meet limited partnership calls. That process is almost complete.

The infrastructure portfolio initially contained funds that bore strong similarities to private equity funds – shorter life, high levels of leverage and an expectation of early distributions. More recently, the fund has invested in longer-term funds of up to 25 years where the approach is buy and hold.

The key investment drivers have been to secure good diversification by sector, geographically, manager and type of fund, with a target investment return of inflation plus 5%. LPFA is too small to co-invest on its own; however, we are interested in investing though consortia alongside the bigger funds.

At the moment we are reviewing our investment strategy as a result of a sharp decline in active membership because of the austerity measures in the public sector.

We remain attracted to the match to liabilities, which may lead to an increase in the infrastructure allocation, but are concerned at the rising level of illiquidity in a rapidly maturing fund.● Mike Taylor is chief executive of the London Pensions Fund Authority, which runs one of the larger LGPS funds with assets of some £4bn on behalf of 80,000 members

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During the past 12 months, the combination of spending cuts and

a hike in the cost of borrowing from the central Public Works Loan Board (PWLB) has led to the subject of bond issuances reappearing on local agendas for the first time in nearly two decades.

Back in July last year, for example, mayor of London Boris Johnson called on local government to consider accessing funds through the public markets after the Greater London Authority successfully raised £600m via a bond issue to help pay for its share of the £14.8bn bill for Crossrail.

It was the first time in 17 years that a local authority had used a bond to raise finance.

By this time, conversations in relation to local authority funding had already been fast-tracked by the introduction of self-financing and the abolition of the Housing Revenue Account (HRA) subsidy system.

But since the government’s surprise decision to offer a cheaper one-off PWLB rate for HRA payments, the question I am being asked most by local authority finance teams is whether conversations should stop, or whether local authorities should press on with discussions with the ratings agencies and the banks around the bond market as a

Time to reconsider the bondWith local authorities reviewing their options as funding becomes more squeezed, CHRIS HEARN explains why the bond market is emerging as a credible alternative

means of providing funding flexibility?

We continue to recommend that investing in funding flexibility should remain a priority for all involved in the sector.

The PWLB, even at the new gilts+100bps (basis point) rate, remains a highly competitive and flexible form of funding. It is, however, only a single funding source. It is worth stressing that few other businesses would accept having access to a single funding source of liquidity, regardless of how attractive it was.

In the short term, we are unlikely to see a dramatic change in the status quo. In the current environment other sources of funding are struggling to be competitive compared with the PWLB rate of gilts+100bps.

Markets will change, however, and a number of local authorities are looking to understand and, in some cases, prepare for the scenario where the PWLB is less competitive on a relative basis.

Therefore I expect the bond market for local authorities to develop and become a credible alternative once again, but it will be more of a middle-distance race to the finish line rather than a Usain Bolt-style sprint.

So, what should local authorities be thinking about during the next few months? The public markets will be

‘‘ I expect the bond market for local authorities to develop and become a credible alternative once more, but it will be more of a middle-distance race rather than a Usain Bolt-style sprint

right for some councils but not all, so finance teams would be wise to continue to invest time in understanding how the bond market might work for them. We have already spent a considerable amount of time helping local authorities understand how to access the various debt capital markets and whether each option is appropriate for them, and we expect these conversations to continue.

Helping councils engage with the credit rating agencies is often a useful first step as they try and become more focused on the options open to them. For many local authorities, a bond would be

The Greater London Authority raised £600m via a bond issue to help pay for Crossrail

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COMMENT KENNETH ETTLES Investment Principal & Actuary, Aon Hewitt

Sovereign debt crises, stagnant growth and ongoing market volatility have unfortunately become daily headline news.

Yet, in stressed markets, there will always be opportunities for investors who are sufficiently nimble and flexible. With local government pension schemes already facing the additional challenge of radical reforms, any such opportunity is welcome.

As long-term holders of high-quality liquid assets, pension schemes are well placed to meet the liquidity needs of banks that are finding it increasingly difficult to raise finance on an unsecured basis.

With gilt yields at low levels and with no immediate need for access to these assets, pension schemes can make these assets available for lending to banks in the form of a ‘liquidity swap’. In return, the banks will provide less liquid assets as collateral, plus a premium.

With the struggles faced by the banks, the current premium is very attractive, at about 1% to 1.5% per annum, a significant additional return in today’s low-yield environment.

While swaps involving insurance companies are closely examined by the Financial Services Authority (FSA), deals involving pension schemes are not, as the FSA does not regulate pension schemes.

However, the Government Actuary’s Department appears supportive of a pension scheme’s right to find opportunities in the liquidity swap market – which is not to say that investors should ignore the FSA’s call for careful attention to counterparty credit risk management, collateral risk management and a proposed exit strategy should the bank get into difficulties.

The practicalities of the transaction for a scheme putting their own arrangements in place are complex and may require legal agreements with the bank, a third party collateral agent and a fiduciary third party to monitor and manage the process. However, where the transaction is sufficiently large (for example £50m), the potential additional returns would outweigh the implementation costs.

While the minimum transaction size is unlikely to be off-putting for local government pension schemes, the extra governance burden involved is likely to be.

However, for schemes that find the concept appealing, these obstacles will soon be avoidable with the advent of pooled opportunities, which will provide a straightforward way for schemes to make this liquidity trade, assuming their policy on stock-lending allows them to do so.

Liquid assets’ potential

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Time to reconsider the bond

the first time they’d taken on a large amount of external debt and therefore the implications, costs and benefits need to be carefully considered.

However, the strong credit profile of the local authority sector, together with UK investor appetite for bonds, means that at the appropriate time local authorities willing and able to diversify their sources of funding can expect to find the bond markets offering a very credible pool of liquidity.

This could be on an own-named basis or as part of a pooled club of issuers. In time, the UK retail bond

market may also be a source of liquidity that local authorities can access at competitive rates.

All this means local authorities have plenty to consider and evaluate in relation to their potential sources of funding. Pricing and relative cost of any non-PWLB option will be the key first hurdle, but the timing and size of any fundraising, the appropriate market to choose, target investors, potential cost of carry issues, and the pros and cons of approaching the credit rating agencies should also be on the agenda.

The simple message for local authorities is to stay focused on funding flexibility. Reviewing the full range of potential funding options is a worthwhile investment in that future flexibility. ● Chris Hearn is head of local authority and education at Barclays Corporate

‘‘ At the appropriate time local authorities willing and able to diversify their sources of funding can expect to fi nd the bond markets offering a very credible pool of liquidity

LGC

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LGC139 Advertorial 1 20/02/2012 15:45