Why LPFA is contrarian
As one of the largest providers of the Local Government Pensions Scheme (LGPS) in the UK, the LPFA fund provides defined benefit (DB) pensions for the employees of over 220 organisations in the non-profit sector, as well as delivering administration services to eight London boroughs amongst other organisations – giving a total of 190,000 members.
For a pension fund that creates an asset allocation model and sticks to it, there is an element of contrarian investing. LPFA believes over recent years that it has been the most contrarian of all public sector pension funds and probably all UK pension funds. Some 35% (£1bn) of the whole fund, is invested in index-linked gilts.
Up until 1994, the fund comprised a single mixed group of more than 240 employers, each having reached different stages of maturity. Some employers had mainly retired pensioners whilst others had a majority of active contributors to the fund. LPFA decided to split both employer groups and pension fund assets into two distinct parts. This allowed pensioner- skewed employers to attach to a pensioner sub-fund and employers with an active contributor bias to attach to an active sub-fund. The active sub-fund is made up of 56% in active contributors and the pensioner sub-fund now has over 93% in pensioners and deferred beneficiaries.
The active sub-fund has a typical liability profile in terms of contributor proportions and can enjoy the benefit of a conventional investment policy and consistent actuarial assumptions. The weighting of the fund’s £1bn assets is heavily equities-biased, running at above 80%. The portfolio is constructed of two multi-asset mandates, together with an equities tracker.
The pensioner sub-fund has just 7% contributors, and is quite swamped by the number of pensioners and deferred beneficiaries. The objective for this sub-fund is to dampen volatility from employer contributions and minimise risk of cross-subsidisation and the possibility of forced asset sales in adverse market conditions to raise cash. This sub-fund has an extreme and unconventional asset structure. It has been developed with the emphasis on maintaining solvency levels rather than obtaining the highest returns. The £1.4bn in assets are substantially weighted in index-linked gilts (£1bn) and bonds (£0.2bn) which represents 84% of the portfolio.
By isolating the different risk profiles of the combined pension fund by splitting it into two notional parts, the investment strategy for each of the sub-funds becomes demonstrably transparent.
LPFA’s trustees consider asset allocation to be their most important investment decision. While asset allocation has important implications for investment performance, the trustees view it as a risk decision relative to the liabilities, rather than an expected return decision. Asset allocation isn’t taken as an investment decision at all. It is a risk decision which the trustees have determined by reference to the uniquely different maturity structure of the sub-funds and anticipated liability cashflows.
For the pensioner sub-fund, the extreme liabilities have been ring-fenced to achieve as near a risk free asset structure as possible to guarantee that pensions are paid when they fall due.
There is a strong herd instinct amongst trustees, who inevitably take comfort from doing as others do and there are strong incentives for them to herd. It took an act of courage for the LPFA to depart from conventional wisdom on asset allocation and make an early pledge to a progressive investment strategy based on maturity and cash profiles.
Some seven years ago the index-linked gilt commitment was seen as radical, even now that allegiance is occasionally tested. But the strategy is steadfast and supported by moves in other quarters. WM are now developing different universes based on liabilities and funding criteria. LPFA can now be measured against peer groups based on similar liability profiles. It will then be possible to ask why strategic asset allocation differs if the liability profiles are the same. The contribution from investment performance can be aligned with fund objectives.
Equally, in 2000 and for the first time, the introduction of tailored benchmarks has overtaken the use of peer benchmarks, according to CAPS.
Stockmarkets are celebrated for their ability to look forward rather than back. But recently, markets have not played their part. Whether the change is structural or cyclical is much debated but for LPFA the ponderous forecasts are not the subject of too much musing. The investment strategy is robust and others are now catching up.