Sir Merrick Cockell | The MJ | 15 july 2016
This article was first published in The MJ
Former Chinese Premier, Zhou Enlai, is reputed to have said, when asked his view on the impact of the French Revolution, ‘it’s too early to say’.
The impact of the recent Brexit vote may not take quite so long to assess, but Zhou’s epithet certainly holds true for the foreseeable future. Political and economic uncertainties are unlikely to be resolved for some time.
However, one immediate result of the outcome of the referendum has been further falls in the yields on government and corporate bonds, and an increased likelihood that the low interest rate environment that has persisted since the 2008 crisis, will stay with us for longer.
This has profound implications for the UK’s Defined Benefit (DB) pension funds, including the Local Government Pension Scheme (LGPS).
Lower gilt yields over the past eight years have contributed, along with increasing longevity, to a significant widening of pension scheme deficits, and the further erosion of yields post-Brexit, described by one commentator as ‘pure poison’ for DB pension funds, can only exacerbate this problem.
This challenging scenario is one faced not only by pension fund trustees and their members, but also by their sponsoring employers.
In the corporate sector, companies may face pressure to find more money to help plug scheme deficits – cash which could otherwise have been used to invest in growing their businesses, or paying dividends to shareholders (including pension funds).
As readers of The MJ will be all too aware, LGPS employers face slightly different, but no less acute cost pressures.
Given these tough conditions, how can LGPS schemes develop investment strategies that help to address the threat posed by the continuing low rate environment?
Assets that produce higher yields at a time of ultra-low interest rates, sluggish growth and ongoing uncertainty are a vital part of the answer. Infrastructure is one such asset.
It provides inflation protection since infrastructure investment often includes an inflation linkage and the scarcity of good quality assets and active management means it also offers capital appreciation.
Equally important, it produces consistent, stable cash flows over a long time horizon. If the investment is informed by a detailed understanding of liabilities and when they fall due, this means investors can seek a liquidity premium safe in the knowledge that they are investing amounts that they do not need to access for some time.
Of course there are many schools of thought that believe infrastructure is too risky an asset class and funds should remain focussed on the more traditional gilts and bonds, funds of funds and passive investment.
Yet, even before the current challenging environment, it was clear that pension funds could not simply rely on contributions and sluggish investment returns as benefit payments continue to increase. They need income-generating investments in order to meet their liabilities on time.
We should also recognise that most of us are in the same boat, which is why partnerships and collaboration – with each other and with the private sector – are important.
LPFA’s infrastructure joint venture with the Greater Manchester Pension Fund was established a year ago for this very purpose, and it is delivering.
Days ago, I returned from helping to open a biogas plant in North Yorkshire which was built using funds delivered from LGPS investors.
Not only will the investment earn the level of returns we are looking for, it will contribute to the energy targets set by the Government for 2020, as it will be the largest of its kind in the UK.
The involvement of the Merseyside and Strathclyde Pension Funds in the project, alongside LPFA and GMPF demonstrates that by approaching opportunities collaboratively, we can increase our exposure to infrastructure and deliver long-term returns that match our liabilities, as well as shelter us somewhat from continued low interest rates.
It also provides the opportunity for much needed investment in major UK infrastructure projects, which may sorely be needed if rumours of large projects being delayed or scrapped post-Brexit are to be believed.
Sir Merrick Cockell is a senior adviser at PA Consulting Group and chairman of London Pensions Fund Authority