Iain Campbell, senior investment consultant at Hymans Robertson, reflects on robust LGPS valuations for 2022 and looks ahead to the next edition in 2025.
For LGPS funds, actuarial valuations provide an important opportunity to reassess investment strategies’ suitability. It’s a time when funds are able to ask key questions such as ‘do we still need this level of return?’, or ‘are we comfortable with the amount of risk we’re taking?’.
It’s a statutory requirement that these valuations take place every three years. And the 2022 valuations – the most recent – for England and Wales showed that LGPS funds were in robust health. Despite a global pandemic and the first large-scale war in Europe since 1945, the preceding three-year period ended with strong returns on assets and improving funding levels.
Subject to possible changes in employer contribution rates, this offered any funds that were considering lowering their targeted returns a chance to do just that. Meanwhile, any funds asking questions about their risk levels also had the opportunity to bank profits and divest from riskier assets.
When it comes to de-risking an investment strategy, there are two main approaches: buying lower-risk assets, or increasing diversification by investing in assets that are less correlated with each other. And when we talk about lower-risk assets, we typically mean bonds. In most LGPS funds, these are UK investment-grade corporate bonds and gilts. But at the time of the analysis for the 2022 valuation, these looked incredibly unattractive, with very low yields on offer. This made putting money into something with such low returns difficult to justify for investors who aim to pay pensions in 100 years’ time, whilst keeping contribution rates stable and affordable.
Therefore, the preferred de-risking option on this occasion was to increase diversification. Normally, this involves taking money from LGPS funds’ traditionally large equity portfolios and moving it into alternative assets like property, infrastructure, and private debt. These assets are still expected to produce strong levels of return over the long term, but they’re less correlated to the wider investment strategy, thereby reducing overall portfolio volatility.
What themes do we expect in 2025?
Now that the actuarial valuations and investment strategy reviews have been signed off for 2022, LGPS funds’ attention naturally turns to the next valuation, in 2025. However, market conditions today are very different from a year ago, with inflation and bond yields notably higher. Ultimately, it’s impossible to know what markets’ position will be next week, never mind in 2025. But if market conditions remain broadly similar, we expect to see a number of key themes emerging from the next review.
The first of these is more investment in bonds. At yields’ current levels, bonds don’t pose the same challenges for long-term investors like the LGPS. However, if bonds offer higher expected returns, then riskier assets will too. That means it’ll be important to test both affordability and any potential impact on contribution rates before making a significant move into bonds.
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The second is cash-flow generation. Rising inflation has quickly matured the cash-flow position of the LGPS, with many of its funds facing benefit payments higher than the levels of cash they receive from contributions. This can have a material impact on an optimal investment strategy. Funds will have to consider how to efficiently meet benefit payments without running a greater risk of having to sell assets at market lows.
Another theme is smarter inflation protection. High inflation is an important consideration for the LGPS, and finding affordable inflation protection is difficult in the current market conditions. Funds will have to be more strategic about how they achieve exposure to the beneficiaries of inflationary environments to boost their returns.
The last of the themes we expect is increasing investment in alternative assets. Although there’s a natural floor to how low an LGPS fund’s equity allocation should go, alternatives offer the opportunity to earn strong returns along with diversification benefits. They can also help funds to meet other strategic goals in line with local, impact, and climate investment themes.
Conclusion
It’s important to note that all these predictions aren’t restricted to a hypothetical future: their effects are already being felt. So, while the next LGPS valuation may be in 2025, that doesn’t mean funds should wait until then to address them. We think LGPS funds should systematically review all their funding risks over the next two years.
Meanwhile, we’re already factoring these themes into our analysis, advice, and education programmes. And we’ve already tested some of our clients’ investment strategies for more optimal solutions. Given the changes in markets since 2022, and the levels of uncertainty involved, we want to ensure our clients are thinking about the future as early as possible.
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