Middle-age and the LGPS – is your fund running out of cash?
26 May 2017 - Estimated reading time: 3 minutes
On the face of it, this sounds like a daft question. How can a multi-million pound pension fund possibly be short of a few bob?
The question makes more sense if we think about one word - cash. LGPS funds have lots of assets, but they don’t hold lots of cash. There are good reasons for this - funds generally invest for the longer term, and holding too much cash leads to lost opportunities on other assets that offer higher expected returns. Funds are therefore constantly trying to balance the need to hold enough cash to meet all benefit payments versus the need to invest in return seeking assets. This balancing act is usually called “liquidity” or “cash buffer” management.
The responsibilities of middle-age
In days of yore, getting the balance right between cash and other assets was pretty straightforward. Youthful LGPS funds were strongly cash flow positive with income (from contributions) far exceeding expenditure (from benefit payments). The only problem was how to quickly and efficiently invest all of that extra income in other assets.
LGPS funds have now reached middle-age in cash flow terms. The simple and care-free days of youth are behind them, and it’s now time to be responsible and plan ahead for the inevitable onset of old age.
If this all sounds a bit depressing, the good news is that you have time on your side to do the planning. The latest annual report1 from the Scheme Advisory Board suggests that the LGPS in England and Wales is slightly cash flow negative, by £279m over 2015/16 (income of £9.8bn vs expenditure of £10.1bn). However funds are likely to have more than enough investment income to cover any shortfall in the short to medium term at least, although some thought may be needed about how best to ‘unlock’ the income if it is mainly reinvested automatically.
Plan ahead for old age
Doing some forward planning now to manage cash flow risk is time well spent. We suggest the following steps:
- Agree objectives & constraints – establish your fund’s appetite and tolerance for the risk.
- Obtain cash flow projections – having a clear picture of future cash obligations, and sensitivities around these, will underpin better decision making.
- Integrate funding and investment strategy – consider what, if any, changes need to be made to funding and investment strategies to ensure your fund always has the cash it needs to pay benefits.
- Monitor progress – keep an eye on the risk via advance warnings and updated projections.
- Pat yourself on the back – your fund has not been forced to sell assets at an inopportune time to pay benefits, and has not appeared on the front page of a newspaper for failing to pay pensions!
If you are an English or Welsh fund, your actuary will have a wealth of fresh data available from the 2016 valuation and can provide a fresh outlook of your projected cash flow position. Sensitivity testing is recommended e.g. on assumptions such as inflation, or on events that affect contributions and benefit payments such as workforce reductions.
The chart above shows cash flow projections for a sample fund based on 2016 data and assumptions. Early indications suggest that the “tipping point” at which cash flow turns from positive to negative is much nearer for LGPS funds than it was previously, and some funds will already be in negative territory.