Different types of investments can provide a bit of a bumpy ride for local authority pension funds - which is why they should keep up to date with investment trends, says Nathan Elvery 2006/07 saw local authority pension funds deliver their fourth consecutive year of positive returns this decade with an average return of 7%. Despite this level of performance, local government still faces the on-going challenges of our growing liabilities-and the recent market turbulence does nothing to settle one's soul. The financial markets look set to go through a very difficult few months, partly as a consequence of the losses in the United States in the sub-prime mortgage lending market and the consequential turmoil this has created in the world's financial markets. This further emphasises the point that fund managers need to constantly review the market and their asset allocations to ensure they are fit for purpose if we are to achieve the same performance levels. Historically UK pension funds have focused on investing in equities and bonds as primary asset classes; in 2006/07 86.2% of our total allocation. Indeed Croydon's fund has been heavily dominated by equities for many years. Most pension funds have been dependent on equities to provide them with the excess return to fund increasing liabilities, and to a lesser extent the contribution received from active management, whilst bonds, whether fixed interest or index-linked, government or corporate, have typically been held to reduce risks relative to a pension fund's liabilities. A simple but effective formula? However, as witnessed in recent years, equities have the potential for large variations. The WM annual review shows UK equities produce negative returns in the years ending 31 March, of -8.8% in 2001, -2.1% in 2002 and -30.3% in 2003, whilst producing positive returns of +32.2% in 2004, +15.6% in 2005, +27% in 2006 and +10.7% in 2007: somewhat of a rollercoaster ride. During this period the average local authority pension fund had between 37.8% and 49.7% of their assets invested in UK equities and therefore the implications on the 2004 actuarial valuation reflecting a more stomach churning low than an exhilarated high, with many authorities under funded. As a consequence, pension fund managers are increasingly seeking other investment opportunities more directly aligned with their liabilities and are examining alternative asset classes, such as hedge funds, property, private equity, emerging market debt, high yield debt, commodities and infrastructure including PFI, active currency management, and tactical asset allocation to name but a few. Despite these opportunities it is very clear from recent surveys, such as WM returns and CREATE Research, that most Pension Funds do not use these alternative asset classes. Over the 10 year period investments in alternative investment/absolute returns remain low and have only increased from 1% of total funds in 1998 to 2.3% in 2007. If alternative investments can enhance the risk/return trade off within a pension fund then are they not worth consideration? The chart above details the historic performance of alternative asset classes and demonstrates over the 10 year period, with the exception of high yield debt, that the alternatives shown have outperformed long dated gilts. It is also interesting to note equities have underperformed gilts. It is clear that many local authority pension funds continue to ignore alternative assets although they can assist pension funds to control risks. The question must, therefore, be asked whether the benefits/risks from these investments are fully understood by managers of the funds and our members who ultimately decide asset allocation. Property, for example, has enjoyed a fantastic run outperforming equities by over 6% per annum over the last 10 years. Despite this the WM Returns show that the average local authority fund held as at the end of 1998 was 4.1% in property and that this had only increased to 8% at the end of 2006/07. Most importantly, over the 10 year period to 2007 property returns had never fallen below 9%, although during the same period equity returns had produced negative returns( in 2002/03 of over 30% in both UK and overseas equities). This has even tempted Croydon to move into property! Local authority pension funds and their advisors have a duty to examine alternative investments and to ensure that the benefits/risks from them are recognised by the Members of the Funds who take decisions regarding the asset allocation. Food for thought? But think very hard before you get on the rollercoaster Nathan Elvery is director of finance and resources at Croydon LBC.
