Over history, equities have generated returns that have saved local governments billions of pounds in pension contribution payments, enabling these savings to be directed into much-needed public services.
It is recognised that in the long run returns from equities will likely make the cost of funding schemes more affordable for employers. However, employers also want stability of contributions for budget planning purposes and, as taxpayers, we want the costs to be equitable for all generations. While schemes have clearly benefited from equity returns over the long term, the path to get there has been anything but smooth.
Downside protection on the bumpy road to prosperity
It took over 10 years for markets to recover from the dotcom bubble that burst in 2000. It took less than eight months for markets to hit new highs following the Covid-19 crash. The difference was the rapid and unprecedented fiscal and monetary policy response from the world’s governments and central banks that provided the shot in the arm (pun intended) for the sharp reversal of the equity market falls. Markets reached new all-time highs a mere eight months on from the previous high
It is too difficult to predict what might cause the next major repricing in equity markets, when this will happen and how long it will take for them to recover. There are clear risks: persistent inflation, rising interest rates, supply chain disruption, tapering of quantitative easing programs and fears of a new Covid-19 variant all pose the most obvious threats.
No one can say what will trigger it, but if history teaches us anything, it is a matter of when rather than if equity markets will tumble. The next time, governments may not be able to afford to pump trillions into economies to prop up equity markets, and we may enter another “lost decade” following the next sudden correction. If equity markets fell 30% and it took over a decade for markets to recover, how would this impact the affordability and stability of employer contributions for your fund?
Fix the roof while the sun is shining to protect your investments
This is a key concern of many LGPS clients who generally recognise that, despite associated volatility, equities must remain a part of long-term portfolios to keep costs affordable, but don’t want to burden employers with nasty hikes in contribution rates if there is a material and sustained shock to markets. This is where investment protection comes in.
At Mercer, we believe an equity protection strategy can play a key role in helping your LGPS fund on its journey.
These strategies maintain a fund’s exposure to equities but provide downside protection in the event of a severe market fall. These strategies enable funds to tailor their risk and return profile to equities with the aim of providing employers with increased certainty over their future contribution requirements.
An equity protection strategy can be characterised as either “static” or “dynamic” in their implementation, with both approaches summarised in the table below.
|Summary||Similar to an insurance policy to protect your investments against losses exceeding a certain amount over a fixed time period||Similar to a static strategy but traded little and often so investment protection levels adapt continuously over time|
|Objective||Preserve value over a defined period — for example, until the upcoming actuarial valuation||A longer-term approach to reducing equity market volatility over time|
|Term||Fixed — decision required to renew at expiry||Evergreen but can be switched off at any time|
|Outcome||Largely known for a given equity market move at expiry||Less certain given no defined expiry and evolving nature of strategy|
|Protection level||Fixed for the given term — risk is therefore increasing in rising markets||Evolves with markets over time|
|Governance requirements||Higher ongoing requirements due to periodic renewal or restructure||Lower ongoing governance requirements as downside protection strategy renews and adapts with markets|
LGPS funds we have worked with typically opt for a static option when they first implement an equity protection strategy with the main aim of ensuring the portfolio preserves value heading into an upcoming actuarial valuation.
With equity markets at all-time highs and the 2022 valuation cycle about to start, this would be an opportune time to consider adopting an equity protection strategy to reduce the impact of a material market fall and provide increased certainty for employers during this period.
As the concepts of the strategy become more familiar, and when the static strategy reaches maturity, we are seeing more clients then switch to a dynamic strategy.
A dynamic equity protection strategy is a cutting-edge implementation solution that can reduce significantly the governance burden on funds compared to static strategies. Mercer has helped implement dynamic strategies for LGPS funds totalling more than £10 billion in assets.
While not completely a set and forget approach, dynamic equity protection strategies automatically evolve with markets over time. This means less time is required from officers and committees in the ongoing management of the strategy.
With a dynamic strategy to protect your investments, there is no requirement for the fund to continually reaffirm whether to renew the protection after each expiry unlike with a static approach. The evergreen nature of a dynamic strategy means that protection continually renews until the fund decides otherwise. Crucially, the protection evolves with market conditions, meaning if markets rise, the protection levels will rise over time also. This isn’t the case with a static strategy, where the protection can only be increased upon implementation of a new static structure. The dynamic approach is therefore designed to reduce the fund’s governance burden by ensuring the strategy adapts to market conditions gradually over time without the need for periodic renewal or specific restructuring exercises.
This key benefit of a dynamic equity protection strategy is illustrated in chart 2. The strong rise in equities since the Covid-19 crash would have meant that a static strategy protecting a fund from more than a 10% fall relative to market levels on 31 October 2018 would only protect a fund from more than an 80% fall three years later. However, the protection level under a dynamic strategy automatically evolves with increases in markets, reducing risk in a low governance way.
De-stress, don’t distress
Many LGPS funds are grappling with the challenge of providing manageable (and lower!) costs that are sustainable for employers in the face of all-time equity market highs and uncertain market risks. At Mercer we believe making an equity protection strategy part of the strategic armoury can help funds tailor their risk and return profile to their specific needs in an objective and transparent way, providing increased certainty for stakeholders and avoiding nasty surprises.
If your LGPS fund is yet to implement an equity protection strategy, or has a structure that is nearing expiry, we would welcome the opportunity to discuss the different approaches available to help you manage the affordability and stability of contributions for your employers through these uncertain times.
Specialising in risk management strategies for LGPS
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