Current economic and market conditions make it challenging for Local Government Pension Scheme (LGPS) trustees and their advisers to protect their members’ portfolios.
Low bond yields and rising inflation have put pressure on central banks to rein in quantitative easing and raise interest rates, causing sell-offs in equity and bond markets alike. The biggest problem for trustees and advisers trying to safeguard portfolios is that bonds and equities aren't balancing each other out. High correlations between equity and bond returns is limiting the diversification benefits of bonds, so constructing well-balanced portfolios has become difficult.
In all of this there's one way of defending the value of members' investments that trustees and their advisers ought to accord more prominence as a long-term strategy: equity protection. Equity protection, at its most basic, is using a customised set of options (the right to buy or sell an asset at a given price) to hedge against market risk and it can work better than strategies like moving into bonds or private markets. To understand this, we need to look at the specific challenges LGPS schemes face.
Overall LGPS schemes are in very strong funding positions currently - partly because many have significant equity allocations. However, this also means there is significant risk in their portfolios. Logic might suggest reducing equity allocations or decreasing pension contribution rates but there are big drawbacks in doing so.
Open final salary pension schemes need strong long-term growth. Decreasing risks, particularly by moving into bonds, might seriously compromise their ability to generate compelling returns. On the other hand, a move to alternative asset classes such as private debt or private equity doesn't serve to decrease risk. It also raises the question whether the illiquidity premium (the greater returns that can be enjoyed in private markets) after fees is high enough to justify such a move. Trustees also need to bear in mind that private markets have a high correlation with their respective liquid counterparts, particularly in times of market stress, so they don't protect portfolios against risk. Finally, just reducing contribution rates can have very damaging long-term implications.
Fortunately, there is the third option of equity protection. Equity protection offers investors the chance to participate in equity market upside while being protected from drawdowns. Deploying the right combination of put and call options can protect an equity portfolio against crashes. Even with the added cost of protection, potential returns are still greater than bonds and protected equities provide a much stronger moat against sudden shocks compared to equities.
The advantages to LGPS are clear: solid funding positions can be sheltered while schemes stay invested in equities. This gives them decent long-term growth potential in times when lower risk assets like bonds are not looking particularly attractive. However, the true power of a protected equity strategy is not found in this alpha generation, but rather in the significant reduction in the variability of returns (future possible outcomes) which increases the probability of pension funds to achieving a desired return and their desired funding level. In addition, equity protection can be easily applied to equity portfolios that integrate commonly accepted or customised ESG and climate approaches.
Trustees are sometimes put off by equity protection because it is seen as too complex. However, increasingly it is designed transparently and cost effectively. A protected equity solution can also be customised to the particular needs of each investor. For example, a customised protected equity solution could use only exchange listed index options to provide protection. The exclusive use of such options guarantees very high liquidity, low transaction costs and transparency. Individual customisation can also focus on anything between eliminating tail risks (loss of capital due to a rare market event) while preserving equity returns, to providing higher levels of protection for more conservative investments that have similar risk profiles as bonds.
For an LGPS, protected equity can be an option well worth considering especially in the current market context. This is because it gives schemes the ability to continue to enjoy the strong returns of the equity markets, while also lowering risk and increasing the probability of achieving a desired funding level by reducing the range of possible future outcomes. Depending on the circumstances, neither bond markets nor private markets may provide this as effectively.
Philipp Loehrhoff is head of protected equity solutions at Berenberg Wealth Asset Management