The Cumbria County Council Pension Fund has joined the ranks of local authorities hedging their equity downside with an equity protection strategy. Nearly £1.1bn of the fund’s equities will be covered by the arrangement.
Local government pension schemes have begun to take advantage of equity protection strategies since the introduction of legislation in 2016 that permitted investment in derivatives.
The £2.6bn Cumbria fund will apply equity protection to £1,075m of UK, US and European equities against falls in values from 5 per cent to 30 per cent.
It will cap gains at 18.7 per cent over the life of the protection, and will purchase a tapered product after protection ends.
You’ve also got to think about a market fall in the round
Mark Davies, River and Mercantile
Legal & General Investment Management is sourcing and managing the strategy on behalf of the fund.
Alison Clark, senior manager, pensions and financial services at Cumbria County Council, identified a fall in equity markets as the biggest risk currently facing the scheme’s funding level.
An equity market collapse could be “large enough not only to eliminate the gains already made, but also to reduce the 2019 funding level below the actuarial assumptions factored into the deficit recovery calculations made in the 2016 valuation”, she said.
The protection will last until March 31 2020, to tie in with the date at which the 2019 triennial valuation will be formally signed off.
Fifteen years to reach full funding
Investors use equity protection strategies to keep exposure to return-generating assets while managing downside risks.
A pensions committee document states that the fund’s investment subgroup had “been advised that the current estimate of the premium payable was £3.5m, providing protection until March 31 2020”.
It adds that “this cost could potentially vary on a daily basis until purchased” and that the committee “agreed a premium of up to £10m could be accepted”.
The fund decided to implement the equity protection strategy as a way of reducing the need for increased employer contributions following the 2019 valuation, Clark said.
The scheme’s investment strategy has been designed with the aim of achieving the investment performance needed to meet its aim of deficit recovery by 2033, she added.
The scheme is ready for an equity market fall
The Cumbria fund is following in the footsteps of other local government schemes looking to take advantage of relatively new access to derivatives, in a bid to hedge against equity market falls.
Last year, the London Borough of Islington Pension Fund began assessing three equity protection strategies as part of its investment strategy review.
Nikesh Patel, head of investment strategy at asset manager Kempen Capital Management, identified a fall in the cost of equity protection owing to years of strong equity market returns.
With the strategy, the scheme will be able to pay out its benefits without having to crystallise any losses and sell its equities in response to a market fall, he said.
“Let’s say there was a crash in 2019, or just before the contract expires in 2020, of 20 per cent, which has happened several times over the past decade,” he said.
“That would be a £200m hit to their portfolio. But doing this, they can effectively protect themselves against almost all of it, and suffer only [about] a £50m hit to their portfolio,” he added.
Think about the full market cycle
The South Yorkshire Pension Fund agreed an equity protection strategy for its 50 per cent equity allocation last year.
LGPS funds have only been allowed access to equity protection strategies for just under two years.
Mark Davies, managing director at River and Mercantile Derivatives, said he believes that equity protection strategies are on the horizons of most LGPS funds.
He identified the deregulation, and the comparatively high allocation to growth assets across LGPS, as largely responsible for the uptick in interest.
Islington weighs up equity protection strategies
The London Borough of Islington Pension Fund is assessing three equity protection strategies as part of its ongoing investment strategy update.
Davies urged schemes considering the strategy to think about the full market cycle. He has witnessed schemes using structured equity to capture market gains once markets have fallen.
“You’ve also got to think about a market fall in the round and say, ‘If this market fall happens and this protection kicks in, we’re still going to underperform our return objective, so what are we going to do once that market fall happens?’,” he said.
