The local authority pension fund recently bought protection for its £2.6bn equity portfolio ahead of its 2019 valuation. Stephanie Baxter looks at how the strategy works
In March, the £8bn South Yorkshire Pensions Authority (SYPA) implemented an equity risk management strategy for £2.6bn of developed equities to protect against a significant market downfall.
It is one of several local government funds that have bought bespoke strategies to shield improved funding levels from potential market falls ahead of their 2019 triennial valuations.
During the middle to back end of last year, the fund had achieved significant gains in its value, mostly due to big rises in the equity markets. That is likely to bring the fund close to or at the fully funded level by the next valuation in 2019; its funding level was 86% in 2016. However, there are concerns the cycle will soon come to a close, and wipe out gains.
George Graham, who joined the SYPA as fund director in February, says the scheme wants to avoid going backwards. "A sudden political event could suddenly knock a big hole in the valuation. Looking at the flight path the actuary gives at each valuation, we're clearly well ahead in terms of investment returns."
Protecting funding levels
The strategy, which was developed by Schroders and advised on by Mercer, protects against losses of between 5% and 30% in the value of active non-emerging market equities, which account for 46.5% of the scheme's total asset allocation. It has 3.5% in emerging markets, bringing its total equity allocation to 50%. All of the fund's equities are managed actively and in-house.
The protection was put on in early March, after which there was an immediate significant drop in the equity markets. "We saw the benefits of the strategy almost straightaway. When trying to explain it to people that don't have day-to-day involvement in financial markets, being able to prove what it says on the tin has been helpful," says Graham.
In addition to maximising downside protection, the equity risk management strategy is also designed to keep as much upside potential as possible for SYPA. To pay for the protection, the fund has given up upside of above 14.25%.
"If I got that in any year I would be very happy, and given that one of the reasons for putting this insurance on is that we are at or close to full funding, the driver for capital growth of significant levels above 15% isn't there to the degree it was in the past," says Graham. "For us, that's reasonable. We would take the hit on the first 5% downside, but that's manageable within the dynamics of the fund. It's when it gets beyond that that we feel we'll get into a hole again and struggle to get back from it."
For Schroders this is the first LGPS fund for which it has created an equity protection strategy, but it has previously implemented these for other private sector pension funds, including its own pension fund a couple of valuations ago.
"As each pension fund's equity exposure will be different, the level and kind of protection they want will be different," says head of portfolio solutions group Andrew Connell. "The cost implications are mainly around how much they will pay in terms of the protection, as well as in terms of transaction costs. Then there's a whole conversation around what the pension fund's experience will be like under different scenarios, and how this will interact with the equity portfolio itself."
Connell says putting equity protection strategies on such a big portfolio requires meticulous implementation, and you need to be very careful about how you mitigate the market impact.
He adds that using pooled rather than segregated accounts enabled speed of implementation.
Connell explains: "Within a month to a month and a half of the manager being hired, the pooled fund can be up and running with the derivatives ready to go in. Whereas a segregated account approach would take longer because it involves writing derivatives in the pension fund's own name. Speed of implementation is important when pension funds are heavily exposed to the kind of gyrations, including relatively substantial falls in equities, we've seen a couple of times this year."
The bigger picture
However, some consultants have argued that LGPS funds can take a longer-term perspective and consider other ways to change their investment strategy instead, such as diversification or de-risking.
"There are other ways to manage equity risk, but a pension fund that relies on a large allocation to assets from which you expect equity-like returns until the valuation cycle is complete - these strategies enable you to have strong visibility over the amount of loss that could be incurred over the cycle," says Connell.
Also, the strategy can ensure that the retained upside potential from equities can still sustain the return requirements as assumed by the actuary. "The cap on equity participation will be at least equal to the assumed returns - so you're giving away excess above that but not the excess return the actuary assumes for valuation purposes."
For South Yorkshire, the equity protection strategy is just part of a bigger picture. At the same time, the fund has reduced its equity exposure and increased allocation to alternative investments. In the year to March 31 2017, SYPF generated a 22.6% return on its assets, driven mostly by its 60% equity allocation. Following a review, the fund's investment committee recommended lowering that exposure to 50%.
The fund is holding more cash now than it would ordinarily, having cashed in £500m in profits from equities to protect against volatility in equity markets. Graham says this has had a positive effect.
Meanwhile, the scheme has committed another 5-6% to alternatives, and invested £200m into private equity, infrastructure and real assets in the last 12 months.
The equity strategy has been put on for three years until contributions rates from the 2019 valuation come into force, after which SYPA will do a strategy review. "We may alter the amount allocated to equities, and may look to significantly change allocation in direction of lower volatility assets, but we're only just beginning the thinking of the work on this," says Graham.
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