What next for LGPS equity allocations?
The Local Government Pension Scheme (LGPS) has been on an equity-driven rollercoaster ride over the last year. As we showed in our recent article, LGPS Valuations: Positioning for the New Cycle, by the end of May 2020 LGPS funding levels were almost back to where they were at the beginning of the year, having fallen by as much as 15% over the first quarter. As we move into the early stages of a new market cycle, we look at the challenges faced by local authority schemes as they try to manage portfolio risks, as well as the strategies that could help schemes to maintain long-term funding levels in a lower return environment.
To find out what returns local authorities can expect in the future, we took the return projections from our 2020 Long-Term Capital Market Assumptions and applied them to the average LGPS asset allocation*. You can take a look at our Long-Term Capital Market Assumptions here.
Based on conditions as they stood at the end of March, we found that local authorities could expect to generate annual returns of 5.4% per annum over the next 10 to 15 years. However, the subsequent equity market rebound means that return expectations had fallen to around 4.5% per annum by the end of May. These figures compare to long-term historical returns earned by the LGPS of around 8%.
We also found that LGPS returns continue to be driven by equities. Although schemes have taken many steps to diversify their portfolios over the last decade, equities still account for 80% of expected returns and more than 90% of portfolio risks.
Asset allocation, return and risk attribution: schemes rely on equities to provide most of their return
We believe equity markets remain fragile, having raced ahead of fundamentals, while measures of expected volatility in the marketplace remain elevated. Accordingly, investors should brace for further periods of volatility, such as the return to sizeable drawdowns that we’ve seen in the first half of June.
Lower and potentially more volatile future returns could have a detrimental impact on funding levels. While an expected annual return of 4.5% from current market conditions is in line with the 4.4% weighted average discount rate used in the LGPS 2019 valuations, there is clearly a significant chance that schemes could fall short. We estimate that schemes have around a one-in-three chance of underperforming their discount rate by more than one percentage point—an outcome that could create a funding shortfall in the order of £30 billion.
However, de-risking is tricky. Today’s ultra-low bond yields mean that the opportunity cost of moving into high quality bonds is significantly higher than in the past. Therefore, reducing risk by shifting allocations from equities to bonds may no longer be a viable option and may actually come into conflict with long-term funding goals. In this environment, with expected returns from high quality bonds currently so low, schemes will need to retain exposure to risk assets in order to generate the return they require.
For example, our analysis, based on our 2020 Long-Term Capital Market Assumptions, suggests that reducing risk by switching 10% of portfolios pro-rata from equities to bonds—even from end May equity valuation levels—could reduce the future return of schemes in the LGPS by around 40 basis points per annum, which is equivalent to around £12 billion in opportunity cost over 10 years.
Impact on LGPS of switching 10% from equity to bonds
New cycle, new opportunities
While the backdrop is challenging, the recent crisis marks the end of the previous market cycle, and the beginning of a new cycle. Local authority schemes do therefore have options that can help them to weather the current market volatility and also to take advantage of the opportunities that are now being created.
A critical step to retain exposure to long-term risk assets and ensure full participation in the new cycle is to regularly rebalance portfolios. Schemes may be tempted to suspend or abandon rebalancing policies in the current environment, but as our analysis in the May 2020 edition of Pension Pulse shows, regular rebalancing of portfolios and “buying on the dips” to maintain exposure to equities can help to preserve expected returns—even through periods of intense market volatility.
We acknowledge that liquidity conditions can be an obstacle to rebalancing in volatile markets, particularly for pension funds with negative cashflows. However, our research suggests that even partial rebalancing is better than none at all, with “halfway” rebalancing capturing most of the benefits of full rebalancing.
The new cycle also creates the opportunity for the LGPS to upgrade portfolios to a more sustainable approach, using investment strategies that ensure local authorities are positioned to take account of environmental, social and governance (ESG) risks. Such a repositioning can provide access to a broad and more diverse range of long-term investment opportunities
As the range of sustainable investment opportunities increase, there is growing evidence that a sustainable approach can have a positive impact on long-term pension portfolios. For example, our research into emerging market equities, ESG in Emerging Markets, finds that greater rewards can be achieved by prioritising duration over short-term outcomes.
Also, moving some equity allocations to credit using an ESG approach may help to boost portfolio diversification while maintaining returns. Our analysis of corporate bond portfolios, Does an ESG Tilt Improve Corporate Bond Portfolio Outcomes, finds that an ESG overlay in corporate bond credit research has historically reduced the intensity of drawdowns, dampened portfolio volatility and, in some cases, marginally increased risk-adjusted returns.
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.