In a previous bulletin I highlighted how the experience of 2020 had shown what a flawed concept gilts-based exits from LGPS are. Recent experience has highlighted that even more!!
Early 2020 experience had promoted, and to some degree supported, the excessive prudence adopted by LGPS funds as they were viewing decisions against the backdrop of a pandemic, falling asset values and gilt yields. It was relatively easy to say that employers staying in Funds needed to be wholly protected against exiting employers. They were viewing these background circumstances as the new norm rather than some abnormal event outwith a more usual long-term trend.
Recent experience has totally highlighted that. We have had strong equity market recovery with some funds posting asset returns in excess of 25% from April 2020 to March 2021 with further upward growth subsequently. As inflation has started to rise we’re also for the first time in many years seeing an upward trend in gilt yields.
Both these factors would have materially improved exit terms. One client who had an exit debt in late 2019 of around £300,000 saw it balloon to nearly £600,000 in mid 2020 but has now seen it fall to low £10,000’s. Funds would quite happily have taken £600,000 in cash off that small charity with the fund effectively making all of that in ‘profit’ over a less than 12 month period. This highlights just how much of a lottery the existing exit basis is.
Unfortunately, some employers who ran out of active members over this period would have been forced by the Funds to pay exit debts at these inflated levels with many now locked-in to long-term repayment plans to meet debts which if revalued now would have been a fraction of what was agreed. What, to a great extent, has been every bit as bad has been that some funds moved employers to a 100% gilt Fund or a ‘notional’ gilt fund over this period which will have meant that they locked the employers in to a deficit at the worst possible time!
I have long accepted that there needed to be some form of ‘premium’ to protect remaining employers in Funds however the existing process just isn’t it. It is inequitable and does not create a fair balance between the departing employer and the Funds, especially when often it is in the interests of other Fund employers that these small covenant weak employers exit.
Funds invest in non-gilt assets primarily because there is an expectation that over the longer term they will out-perform gilts and the Funds are of a size that they can ride out market volatility. If Funds insist on persisting with this basis then at least provide some form of ‘run-off’ value over a fixed period of time where if market conditions move positively a part of the true return and any premium from member movements could be returned or offset against future or current payments.
As outlined in previous bulletins it is important to note that gilt yields do not reflect the actual cost of providing the benefits but purely a theoretical cost of ‘securing’ them at that point in time.
We are starting to see the first updated Funding Strategy Statements come through reflecting the 2020 updates to the LGPS regulations and the implementation of the Deferred Debt Arrangement (‘DDA’) flexibilities. DDA’s would resolve many of these issues although my experience to date is suggesting Funds are finding it difficult to move away from the gilts concept or are using the new Regulations as an opportunity to extract high levels of security. I can only hope that these are teething issues and more pragmatic solutions will be available going forward.