Local Government Pension Scheme (LGPS) funds are being urged to prioritise cashflow management as investors are challenged to find income in traditional fixed income and property markets.
Investment advisory firm Linchpin has predicted that the scheme will fall into aggregate negative cashflow - even when including stated investment income - within the next few years.
It comes as data from the Ministry of Housing, Communities and Local Government released last year revealed some 34 individual funds already had negative cashflow after including investment income in the year to 31 March 2020 - noting that, in aggregate, there was a deficit of 1.2% of contributions over expenditure, which was plugged by 1.6% of income. The LGPS had a 0.9% surplus when transfers into scheme were taken into account.
Linchpin founder William Bourne predicted that 2024 would likely be the year where the LGPS would go to cash neutral or negative.
"The private sector went negative cashflow some time ago and the LGPS is clearly going in the same direction. The downward trend is absolutely clear but the exact speed is a little less clear. It has taken longer to get to where we are than many people expected," said Bourne.
This is because income from equities has been rather higher than expected, as well as people leaving local authorities and lots of new employers coming into the LGPS, particularly academies.
"More and more funds will start to become net cashflow negative, or will have to make greater use of the income on their assets to meet those cashflow requirements," said Hymans Robertson's head of LGPS investment David Walker.
All LGPS funds should do cashflow planning even if they have positive cashflow, said Bourne. He suggested looking at short-term cashflows over the next three to five years, and then a longer term looking at 20 years into the future.
Income focused investment
Investment consultants have been advising funds to start building a greater component of income focused investment strategies with an overall asset allocation. Pension funds traditionally looked to the bond markets for income, but with yields still at historical levels, they are forced to look further across the income spectrum.
"Traditional sources of income like index linked bonds and investment grade bonds still have a role to play but certainly the prospective returns on those asset classes are looking a lot lower than they have been in previous years," said Walker.
For example, investment grade debt offers hardly any premium over government gilts, even at the lower end BBB credit ratings.
Instead, income-seeking investors have looked at real assets such as property but this has come under pressure during Covid-19.
Equity is one area that the LGPS is looking for income, said Bourne: "Funds have been buying equities because they can't really think of anything else to buy at the moment, and at least equities are still delivering income. In the absence of [income from] bonds, investment grade credit and real estate, it makes sense to buy equities."
Walker added: "The recent volatility or recovery that we've seen in equity markets has given the opportunity to trim some positions where the values have risen substantially, and naturally make use of those assets to meet ongoing cashflow requirements as well."
There is now a broader range of assets that funds are looking at in order to receive a more predictable income stream, such as private credit.
"That might counter some of the uncertainty over some asset classes like private equity where funds have focused on more yielding income focused allocations as part of their portfolios," said Walker.
With private equity, funds are almost certain to get something for cash flow planning but it is it uncertain exactly when they will get it, added Bourne.
