Pensions lose £14bn: Local Government Chronicle

Posted on June 26, 2009 · Posted in Local Government Chronicle

Local government pension funds have lost in excess of £14bn — up to 30% of their value — as a result of the global financial crisis, an exclusive analysis conducted by LGC reveals.

Responses to freedom of information (FoI) requests submitted by The Independent — and made available to LGC — also show that local government pension funds are exposed to potential losses of at least £26.8m in Icelandic banks and more than £20m in Lehman Bros bank.

Analysis of the funds’ returns shows a wide divergence. Somerset County Council’s fund showed the weakest returns of those that responded to the FoI request, and did so in a format that enabled analysis. This lost 28% in value between January 2007 and January 2009 — a monetary loss of £307m.

The largest loss in money terms was recorded by the Strathclyde fund, which lost £1.7bn in two years,representing 18% of its value at January 2007. Its valuation fell from £9.4bn in early 2007, to £7.7bn at the beginning of this year.

Worst-affected funds

31 January 2007: …………………………………was £1,093m
31 January 2009: ……………………………………was £786m
Loss in value: ………………………………….£307m / 28.09%
No exposure to Icelandic banks or Lehman Bros

2007: ………………………………………………………£406m
2009: ………………………………………………………£295m
Loss in value: ………………………………….£111m / 27.33%
No exposure to Icelandic banks or Lehman Bros

January 2007: ……………………………………………..£727m
January 2009 ………………………………………………£546m
Loss in value: ………………………………….£181m / 24.89%
No exposure to Icelandic banks or Lehman Bros

Note: some funds did not respond, or else responded in formats that could not be either analysed or compared

Harrow’s pension fund was the second worst performing among the respondents. Jennifer Hydari, Harrow’s divisional director finance and procurement, explains that the fund had 10% more invested in equities than the median for funds and that it hedged half its currency risk.

“On both these factors we expect recent rises in the market and strengthening of sterling to have helped,” she says.

But she adds: “Harrow’s [fund] managers have underperformed. We are in the process of a manager review andnew appointments will be proceeding. Overall our strategy is sound and is a long-term one.”

The trustee’s overall investment strategy is to maintain a long-term return similar to that expected from equities but with reduced risk and volatility

Sue Timbrell, independent chair of the Audit Commission Pension Scheme

The best performance reported came not from a local government fund, but from that of the Audit Commission — which will be a relief to the organisation after the widespread criticism it received for holding £10m in Icelandic investments.

It actually reported an increase in values in a period when stock prices and fund values were generally
dropping by between 20% and 40%. Its value increased by 4%, from £483m in December 2006 to £503m two years later.

Sue Timbrell, independent chair of the Audit Commission Pension Scheme, says: “Of course we are not immune from the challenges all pension schemes are facing in these uncertain times, but the much wider diversification we have been able to introduce has gone a long way to give us the stability in our investments that we intended.”

The fund’s increases were, she says, almost solely attributable to its use of investments to protect it against the impact of interest rate movements.

Returns on investments in ‘growth assets’ — those owned in the expectation of increased value, as opposed to income generation — were negative, but because the fund invested in a wide range of products those losses were much smaller than if they had been in equities alone.

“The trustee’s overall investment strategy is to maintain a long-term return similar to that expected from equities but with reduced risk and volatility, and it is clear the benefits of this approach are now really showing through,” she says.

The strategy, which served the commission’s fund very well during this period, was to move away from its ‘growth asset’ classes of equities and property, and it did so just before these fell substantially in value.

The fund then reduced its risks by diversifying its holdings and hedged against interest rate movements andliabilities inflation. New investments were made into three diversified growth funds, which invested in a mix of equities, private equity, commodities and infrastructure.

The best local government performance was by Orkney Islands Council’s fund, which reported a fund valuation of £101m in 2007 and the same in 2009.

A fund spokeswoman says: “Orkney Islands Council takes a long-term and conservative approach to the management of pension fund investments. The council is satisfied with the current performance of its appointed fund manager, which is measured over a rolling five-year period against an agreed benchmark.”

Least-affected funds

  • Hammersmith & Fulham

January 2007: ……………………………………………£448m
January 2009: ……………………………………………£426m
Loss in value: …………………………………..£22m / 4.91%
No exposure to Icelandic banks or Lehman Bros

  • Orkney

January 2007: ……………………………………………£101m
January 2009: ……………………………………………£101m
No loss in value
No exposure to Icelandic banks or Lehman Bros

  • Audit Commission

December 2006: ………………………………………..£483m
December 2008: ………………………………………..£503m
Increase in value: ………………………………..£20m / 4% +
No exposure to Icelandic banks
£88,000 exposure to Lehman Bros

Note: some funds did not respond, or else responded in formats that could not be either analysed or compared

Yet perhaps the most interesting question is probably how local government funds avoided falling more heavily in a period of steep economic decline and losses in value across a wide range of asset classes.

Research by Aon Consulting found that private sector employer schemes fell by 28% in the year from October 2007. And the FTSE100 index fell from about 6,500 to about 4,500 in the period analysed, around 30%, and by much more from peak to trough.

Commercial property values fell by more than a quarter in 2008 alone. Bond defaults rose substantially.

This led one pensions consultant — who did not wish to be named — to doubt the reliability of funds’ valuations.

However, even with these valuations, the level of pension fund deficits is now substantial — not least because more realistic assumptions about future liabilities have been adopted.

North Yorkshire’s pension fund says it now has a deficit equivalent to half its projected liabilities. Tom Morrison, principal accountant at North Yorkshire County Council, points out that between mid-2007 and late 2008 global
equity markets fell by more than half.

Actuaries’ assumptions about bond yields and inflation also changed, and contributed to an increase in the value of liabilities of more than 20% over the same period.

The combined effect of this and the markets’ decline over a relatively short period has had a very significant effect on the snapshot position of the fund as at 3 December 2008.

“The fund’s investment strategy includes a recovery plan, with 25 years remaining out of an initial 30, aimed at eliminating the deficit,” Mr Morrison says.

“This approach allows us to take a pragmatic long-term view of asset performance rather than be drawn into focusing on snapshot valuations distorted by an unprecedented level of market volatility.

“Our investment strategy is regularly reviewed and we remain confident that it appropriately addresses thecircumstances of the fund.”

The total fall in value of Hertfordshire County Council’s fund over the two years was 23.54%. A fund spokeswoman says that this should not be regarded as unusual.

She said the fund followed good practice by measuring itself against its own benchmark, rather than against the performance of other funds.

“Performance against benchmark varies and the county council’s investment committee monitor it closely and take action when necessary.

“Hertfordshire’s asset allocation is not out of step with other local authority pension funds,” she says.

It is interesting that councils’ pension funds have been much less affected by the collapse of Icelandic banks than have their sponsoring authorities.

The largest exposure in an Icelandic bank reported by a local government pension fund is at Kent County Council, where the fund’s exposure of £16m was included in the £50m reported by the county council.

But overall Kent had one of the stronger returns, having lost only 12% in the two-year period — underlining the point that the Icelandic exposures were relatively small compared with the funds’ total value.

There was, in fact, a wider exposure to potential losses from Lehman Bros — the failed US investment bank, whose collapse sparked the global financial meltdown. Several local government funds had invested in Lehman’s through bonds, while others held direct or indirect equity stakes.

Westminster lost £1.8m through its shareholding in the bank. Strathclyde stands to lose £2.9m on its Lehman bonds. And Lothian has £1.97m at risk, through exposure on foreign exchange contracts.

More surprising than the liabilities in Iceland and Lehman Bros is that local government funds have apparently not been affected much more severely by the global downturn.

But, as North Yorkshire revealed, when funds faced deficits anyway, any loss of value increases their problems in meeting liabilities. And that crisis is one that will not be resolved, even if and when the markets recover.

Local government pension funds adopt different investment strategies but they all have the common aim of raising enough money to keep paying their members’ pensions.

They cannot do that if their income is too low, but obligations to council offi cers past and present who belong to the schemes mean the pensions must be paid.

That imperative is likely to force consideration of some radical options.

What happens now?

The sharp decline in pension funds’ values increases their deficits. Normally this would lead to increases in employers’ contributions — as is being discussed in Northern Ireland.

But in England former local government minister John Healey recently insisted this was not necessary. Instead, he expected investment returns to recover sufficiently over the longer term to avoid any need for higher contributions.

But many commentators believe the local government pension scheme is not sustainable and some expect a future government to abandon a final salary scheme, replacing it with a defined contributions scheme — as has been widely done in the private sector.

It has also been suggested that the existing ‘funded’ scheme should be replaced by an ‘unfunded’ scheme similar to that of the civil service. This would mean that inyears ahead councils would meet the costs of retired workers’ pensions from their revenue budgets, rather than from a pension fund.

One way or another something will have to be done to address the overall deficit, which Pricewaterhouse Coopers estimated at 43% of potential liabilities as at the end of last year.

The alternative is a desperate hope that asset values, and incomes, will recover. Given the scale of the deficit, it is a hope that looks very optimistic.