The 2022 LGPS valuations are on the horizon. Peter MacRae looks at the role climate change risks will play.
Predicting the future isn’t easy, but when we look back at history’s infamous blunders some are more forgivable than others. The record label that turned down the Beatles because “guitar groups are on the way out”, or the twelve(!) publishers who rejected Harry Potter because they thought kids weren’t into wizards? Both very costly mistakes, but rational ones that you’d probably call unlucky rather than stupid. The architects of the ill-fated European Super League, on the other hand, shouldn’t have been surprised by the reaction to their plan or its collapse after just 48 hours. Someone clearly hadn’t considered all the risks!
Why does this matter for the LGPS? Because both setting your employer contributions and deciding on an investment strategy involves thinking about the future and considering risks.
14 July 2021
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We need to decide what to do today, based on what could happen to life expectancy, inflation, and investment returns in years to come. Actuaries may claim to be more scientific than the A&R division at Decca, but we still don’t expect to get everything right.
What’s important is not just whether an assumption turns out to be right or wrong, but how it was made. You could be way off the mark but unless your logic was ropey or your data was incomplete, your assumption might have been perfectly justified.
Dim view
Future generations of actuaries, LGPS officers and members will understand that things don’t always turn out as we assumed, but they will take a much dimmer view if we don’t do enough to tackle major risks. Climate change is perhaps the most obvious—and most important—example of this.
No one would argue that we should ignore a material risk, and I hope everyone reading this would agree that climate change falls into that category.
Judging by the number of industry events featuring climate change and responsible investment there is certainly an enormous appetite to discuss it. With climate risk disclosures expected to be mandatory in the LGPS by 2023 there will soon be a regulatory requirement too.
But for me the more important question is what LGPS funds should actually do differently in response to climate risk—not just what they should analyse, discuss or disclose.
There are only really two levers we can pull: employer contributions and, or, investment strategy. The challenge is deciding whether one, both or neither of these needs to change.
Discussion starter
At the last round of LGPS valuations we carried out basic climate risk analysis for several LGPS funds, illustrating what the high-level funding impact could be under three scenarios. One fund used these results as part of deciding the level of prudence in the funding plan, but in general it was more of a discussion-starter than a decision-maker.
In 2019 or 2020, doing this analysis probably put you ahead of the curve as far as considering climate risk in the funding strategy was concerned. Soon I think it’ll be regarded as inadequate.
We’re celebrating our 100th birthday this year (as are many LGPS funds) and as part of this we’ve pledged to make climate risk an integral part of our advice. Nowhere is this more important than in the LGPS where open-ended time horizons mean that the potential impact of climate change is more significant than for a closed private sector scheme.
Stress test
Starting later this year in the run-up to the 2022 valuations, we’ll be able to “stress test” modelling results under climate scenarios and (crucially) build the results into decision-making.
For example, the core results might tell you that a particular strategy will be successful in 70% of outcomes. But if that number fell to 60% in one of the climate scenarios would it still be acceptable?
Or, perhaps, you’re choosing between two options which both meet your core criteria. As a tiebreaker you could see which one is more resilient to climate risk.
In both cases you might not end up doing anything differently, but at least you could justify that decision, and at least you would have a sense of how much extra risk is involved.
I’m not saying that actuarial modelling will solve the problem of climate risk—and it certainly won’t save the planet. But if we want the LGPS to thrive for another 100 years we need to understand if the decisions we make today have a good chance of hitting the mark in future.
When your distant successor looks back at the 2022 valuation, you don’t want them to shake their head and wonder why climate risk was still just an entry on the risk register.
Peter MacRae is an actuary at Hymans Robertson.
Image (cropped) by Jody Davis from Pixabay
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