LGPS valuations: Positioning for the new cycle
The Local Government Pension Scheme (LGPS) valuations for 31 March 2019 are now all publicly available. As we previously expected, the LGPS saw substantial improvement in funding since the 2016 valuation cycle. However, with the Covid-19 crisis reversing some of some of these gains, schemes now need to ensure that their portfolios are positioned to rebuild funding levels as we enter a new market cycle.
Improved funding levels for the 2019 cycle
LGPS valuations as of 31 March 2019 confirm what we previously expected—a substantial improvement in funding levels since the March 2016 valuation cycle. On average, funding levels were 13% higher than when they were last measured three years earlier, with gains driven almost entirely by higher-than-expected investment returns.
In fact, if schemes had relied on investment returns alone, funding levels would—on average—have been 18% higher. Other factors conspired to pull the overall average funding level gain down to 13%.
The impact of Covid-19
Such strong returns mean that many local authority schemes would have had full funding in sight as the end of 2019 approached. Since then, funding levels have been on a roller coaster ride. The sharp falls in global markets in response to the Covid-19 pandemic drove funding levels down by 15% on average over the first three months of 2020, but the strong rally in equity markets during April and May has almost entirely reversed that effect. Overall we estimate that funding levels have fallen by only about 3% since the beginning of the year, and in fact higher than they were a year ago.
Concerns remain however that, with equity markets running so far ahead of fundamentals, the recovery is fragile and risk levels remain elevated – we may be in for a bumpy ride yet.
Our research suggests that if current equity valuations are sustained, the LGPS can be expected to recover any residual losses within a few years. However, if equity valuations fall back to end March levels, it could take 8 years for the LGPS to recover to the funding levels enjoyed at the end of 2019. To get back to end of December 2019 funding levels from the end March, the average scheme would require a 6.5% annualised return over the next five years, versus just 4.6% from current valuation levels. Based on our Long-Term Capital Market Assumptions-which we have updated to the end of March 2020 to account for the market movements resulting from the COVID-19 disruption —we expect the aggregate LGPS annualised return to be 4.6% - 5.5% over the next 10 years, depending on what happens to equity valuations in the short term - and the potential fragility of the recent equity recovery warrants us to be cautious about our expectation from this point forward.
What would it take to return LGPS pensions to end Dec funding levels?
High hurdle returns rates make for stretch goal, even over longer horizons, if no additional contributions
New cycle, new starting point
Without doubt, Covid-19 marks the end of the last market cycle. But with new market cycles come new opportunities. There are four actions that local authority schemes can take to ensure that they are well positioned to rebuild funding levels as the new cycle unfolds:
- Rebalance regularly: The first critical step to ensure full participation in the new cycle is to regularly rebalance portfolios to retain exposure to long-term risk assets. Our recent Pension Pulse analysis suggests that regular rebalancing of portfolios consistently leads to superior results compared to allowing portfolio allocations to drift-even through periods of intense market volatility2.
- Aim for sustainability: The new cycle creates the opportunity not just to rebalance allocations, but to upgrade portfolios to a more sustainable approach, using investment strategies that ensure schemes are positioned to take account of emerging environmental, social and governance risks.
- Diversify for long-term value: Market weakness provides an opportunity to add diversification to portfolios and add exposure to assets that now look more attractive. Credit markets, for example, previously looked rich but following recent spread widening offer fertile ground for active research-based strategies to identify mis-valued securities. Also, real assets will offer attractive opportunities as the cycle unfolds for schemes that can tolerate lower liquidity.
- Add portfolio ballast: Ensuring portfolios contain sufficient ballast to withstand further bouts of market volatility will be essential. Traditional safe haven assets, such as sovereign bonds, no longer provide value given current ultra-low yields and the increased potential for medium-term inflation. As we discuss in our recent thematic paper, Rethinking Safe Havens, local authorities will need to look towards a wider range of assets to provide the ballast they require in the future.
While 2020 has so far been a very challenging environment for the LGPS to navigate, the dawning of a new market cycle provides a new starting point-with a range of asset classes and strategies now offering more attractive long-term value. Gaining exposure to these new opportunities, while also managing risk through the cycle, will be key.
If you would like to discuss the points raised above in more detail, please don’t hesitate to contact your usual J.P. Morgan Asset Management representative.
1 For more details, see J.P. Morgan Asset Management Long-Term Capital Market Assumptions Mark-to-Market, Executive Summary, 30 April 2020.
2For more details, see “Stay the course: Rebalancing policies are crucial, particularly at times of market stress” by Sorca Kelly-Scholte and Jerry Song (J.P. Morgan Asset Management Pension Pulse May 2020).