Every year in late October or early November MHLUC releases SF3 statistics on the LGPS’s finances and membership from the preceding March. In 2021 fund values have risen sharply compared to 2020, but investment income is down by an aggregate 16.5%.
We write annually about the SF3 data, and admit we sound rather like a broken record: the inexorable trend towards negative cashflow from operations continues, and the need to use investment income to plug the gap grows. Last year we pointed out that in aggregate expenditure exceeded contributions by a net 1.2% of the fund’s AUM, and that over 30 individual funds had negative cashflow even after including investment income.
Since then, a lot has happened. The aggregate AUM has risen by some 23% from the March 2020 lows, while investment income fell by 16.5%. The consequence of the fall in the numerator and the rise in the denominator is that investment income only reached 1.1% of AUM (1.6% in 2020). Expenditure other than that paid out as pension benefits rose by 12%. On the more positive side, contributions were 26% higher as many employers chose to pre-pay three years’ contributions, and in 2021 just about equalled expenditure.
These data come with numerous caveats: two London boroughs failed to provide data before publication; mergers over the past five years (most recently Tyne and Wear and Northumberland), and inconsistent treatment of the resultant transfers of assets and liabilities, mean that historic comparisons are not completely accurate; and treatment of investment income can vary substantially from fund to fund. We have excluded transfer payments from our analysis of expenditure and income.
However, there are clear trends. Over five years, costs have gone up by 60%. The lion’s share of this is investment costs, up by 66%. This reflects both the 28.5% rise in total AUM and also the shift from low-cost fixed income to higher cost alternative investments. It may also reflect a growing emphasis on ESG considerations, and the additional costs which they imply. Administration and governance costs, perhaps to do with pooling, are up 25% and 34% over the same five years.
The second trend we point to is the fall in investment income. The bulk of the fall was in income from listed bonds (-36%) and equities (-24% year on year). It is tempting to ascribe this to COVID, but income from real estate, supposedly the worst hit asset class, only fell by 15%. We suggest the real explanation has more to do with pooling and the move away from directly held investments to holding accumulation units in pool sub-funds which often do not directly pay out income.
Even despite the contribution pre-payments, 42 of the 85 funds experienced negative cashflow in 2021, and 14 even after adding investment income back in. The latter number compares to 34 funds in 2020. The obvious question is how many will find themselves in this position when contributions fall back in 2022. On the rough estimate that 2022 contributions fall 20%, we would estimate that about 30 will be cash negative even after taking investment income into account. This is a matter of serious concern.
The third is the substantial rise in costs. Pooling has now been in place for five years, and it is no secret that most pools have yet to deliver substantial real savings. They have been incurring the costs of establishment and in many cases do not yet have sufficient scale to reap the benefits. More complex governance has incurred, will incur, and should incur higher costs too. That all said, most pools are now close to ‘normal’ operation, and it is reasonable to expect significant investment cost savings over the next five years.
The final trend is probably the most controversial. MHLUC’s covering note on this statistical release starts with some detail on the three mergers which have taken place over the past five years. The total number of funds in England and Wales has now fallen to 85 from 88 five years ago and 89 ten years ago. Will that number fall further in the next five years, and how much by?
Further out, of course, the cash-flow maths gets worse as the LGPS gradually mature. If as per our estimate, something like 30 funds are going to find themselves cash negative in 2022 even after taking their existing investment income, this problem is now close to the centre of the stage.
The good news is that there are solutions. As a first step, funds can take more income from their existing investments, though some care needs to be taken with the actuarial modelling here. For example, if the income stream from equities is withdrawn rather than reinvested in some form, whether back into equities or elsewhere, the long-term returns will be lower.
A second step is to tilt the investment mix towards more income-oriented assets. Today, because yields and spreads on investment grade bonds have compressed, it implies either taking more risk (e.g. emerging equities) or more illiquidity (e.g. real estate) or more complexity (e.g. private credit). But, given the inflation outlook, there is some hope that at some point in the future fixed income will resume its normal income-generating position in the firmament of the investment universe.
We will look forward to the 2022 SF3 data in a year’s time with interest, but in the meantime please feel free to contact us if you want to know more.
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