Agenda item

MANAGING LIABILITIES - ADDITIONAL ANALYSIS

Minutes:

The Investments Manager introduced this item. She reminded members that at the previous meeting they had examined the concept of better matching the Fund’s asset base to its liabilities and thereby reducing volatility in the funding position. They had considered the use of index-linked gilts to help with the management of inflation risks throughout the portfolio. At the end of the discussion the Panel had asked for further work to be done, in particular on how the framework would impact on the Fund’s portfolios in terms of cash flow. Mercer’s had accordingly prepared another presentation, which had been circulated with the agenda. She said that if the decision was taken to adopt the proposal in principle, the implementation would be spread over a period of years and would be taken into account in the next valuation.

 

Mr Turner and Mr Giles commented on the Mercer document Risk management framework – further training and scenario analysis, which had been circulated with the agenda.

 

Mr Turner said the aim was to address the volatility in and growth of the deficit with a long-term plan to manage risk in an effective way. He reminded Members that since the last valuation the funding level had been as high as 87%, but had now come down to about 75%. Liabilities had increased. At the previous meeting the Panel had decided to implement the first step, which was to switch the Fund’s current holdings in fixed interest and overseas and overseas government bonds into index-linked gilts (to hedge 12% of the Fund). Mercer was in addition proposing that leveraging should be used to allow the Fund to match 36% of funded liabilities. The presentation gave details of the hedging instruments that could be employed. These were divided into physical instruments (fixed-interest gilts, corporate bonds, and index-linked gilts) and synthetic/derivative instruments (interest rate swaps, inflation swaps and gilt repos).

 

The report by Mercer was debated with significant discussion around the concept of leverage, the risks arising from leverage and how they would be managed including credit and counterparty risk and how the cash flows would be effectively hedged.

 

Responding to comments from the Independent Investment Adviser and from Members about the timing of investments, Mr Turner said timing was important, but there would never be a magic bullet to cope with short-term market changes; what was important was having a long-term plan to increase the level of protection. He did not think that interest rates would rise significantly in the near future. However, the deficit had risen, which would affect the valuation this year, and as the scheme is still open the liabilities will continue to grow.

 

The Chair asked Mr Turner about the supply of instruments to hedge the liabilities as supply might dry up as an increasing number of pension schemes invested in them, with the implication that the Fund should invest in them as soon as possible. Mr Turner thought that an increase in demand of a magnitude that would exhaust the supply was unrealistic, but a large volume of transactions would keep yields down. The Investments Manager said this needed to put in context, by, for example, comparison with how gilt yields had behaved over the past 10-20 years. Gilt yields are lower than they would be, because of pressure from pension funds to hedge their liabilities. But there were other factors, such as expectations for interest rates and inflation and the Government’s stated intention to have a budget surplus rather than a deficit, which made it difficult to predict the trend in gilt yields. Mr Turner said that there was reason not to delay hedging, and the Fund should be considering a three-year programme to increase its investment in hedging instruments.

 

Representatives from Insight Asset Management gave a presentation on how an investment manager would implement such a strategy and how they would manage the risks and cashflows.

Responding to a question from a Member, the Investments Manager said that hedging of liabilities could be done within a pooling arrangement of LGPS funds, or could be kept independent of the pooling arrangements.

 

Members had further questions about the complexity of the concept, the mechanics of implementation and the difficulty of assessing the risks involved. One said LGPS funds are reluctant to get involved in such investments, because their complexity is challenging. Mr Turner replied that LGPS funds now regularly invested in asset classes that had once seemed too complex.

 

A Member asked how many LGPS funds were currently using this kind of hedging strategy. Mr Turner said that there were about ten.

 

The Head of Business, Finance and Pensions referred to the court ruling some years ago that it was unlawful for local authorities to invest in interest rate swaps, which was made after some local authority treasury departments had been using them for about seven years. Local authorities were therefore still cautious about this type of instrument. A Member asked whether it was now lawful for LGPS funds to invest in them. The Investments Manager replied said the investment regulations were going to be reviewed, and when updated should allow funds to adopt an investment framework that would allow this. However, funds were currently able to invest via pooled funds.  It would take a long time to develop a liability hedging framework, which was why work on it had begun now.

 

RESOLVED:

 

  1. That, in principle, the Fund should put a framework in placed to more effectively use the investment assets to match the liabilities.

 

  1. To prepare a framework to be considered by the Panel for recommendation to the Committee. The proposal will bring together the work done to date and the proposed framework, including a 3 year plan to increase the level of matching and a longer term plan to reach a target level of matching when affordable.

 

After the discussion was concluded, the Head of Business, Finance and Pensions said that it was likely that Members still had questions about these issues. He suggested that it would unproductive if at the next meeting there was a rerun of today’s discussions, so he invited Members to email any questions or concerns to the Investments Manager. Officers would then prepare a response identifying the benefits that could be achieved from this proposal.

 

The Chair said that a great deal of information had been presented to Members, and that it was important not to let the details obscure the fundamental issues. He said that a future report should focus on the basic principles and on how and when the proposal might be implemented. The Investments Manager suggested that the framework and the timescale of implementation could not be discussed until the basis for the next valuation was known.

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