Contact: David Wilson, ext 7407

1 Introduction

1.1 Attached as Appendix 1 is a note from Harvey Cole acting in his capacity as independent sounding board for the Panel.

1.2 Also attached at Appendix 2 are brief comments from the County Treasurer on the issues raised.

Recommendations

1 That the Panel ask the managers for their views on and implications for the Fund of the comments made in the paper.

Section 100 D - Local Government Act 1972 - background papers

The following documents disclose facts or matters on which this report, or an important part of it, is based and has been relied upon to a material extent in the preparation of this report.

NB the list excludes:

1. Published works.

2. Documents which disclose exempt or confidential information as defined in the Act.

TITLE FILE

Appendix 1

Questions and comments from Harvey Cole

1 Current concerns

1.1 Even with a stabilisation of markets looking more likely (but with the prospects for the economy less optimistic than some of the more sanguine forecasts suggest) there must be continuing concern over the medium-term outlook for the Fund.

1.2 The responsibility of Panel members (including those who are elected councillors) is presumably confined to ensuring that the legally prescribed benefits for employees and pensioners are delivered at minimal cost and maximum efficiency. In that case, they are presumably not required to try and hold a balance between the interests of beneficiaries and the council taxpayer.

1.3 It would also be useful to know in what form individual employees are notified each year as to the state of the Fund, and the position of their own contributions, amounts paid by Hampshire County Council and other employers and the projected value of their pension at retirement.

1.4 Will these be altered by new requirements to indicate to members the effect of expected inflation on the future real value of their stake, and, if so, does this have to be done in a particular statutorily prescribed form? How is the expected effect of future pay increases taken into account?

1.5 Although the next triennial valuation will relate to figures in March 2004, the results will presumably not be available until some time after that. It would be useful to have a range of possible outcomes for the Panel to consider, based on alternative projections of the course of markets over the next year.

1.6 I appreciate that a detailed assessment would be difficult and unnecessary, but it would be helpful, and I hope not a complicated exercise, to give a broad assessment for the Fund of the FTSE being at various levels, eg 3,500, 4,000, 4,500, 5,000, in March next year.

1.7 It may be of assistance to Panel members to have their attention drawn to a relevant selection of Press articles and other publications covering matters of direct interest to the work of the Panel. Without wishing in any way to overload the Panel, perhaps such items might be circulated roughly one a month. The choice could be made by the County Treasurer and myself. We already draw each other's attention to such material.

1.8 Attached as an Annex is an article written by John Shuttleworth (an actuary at Price Waterhouse Coopers) published in the Financial Times on 15 April 2003. His comments will be of interest in the current climate for the pensions industry.

1 Equity markets

1.1 Evidence grows that significant turning points may have occurred in the early part of this year.

1.2 The first of the charts in the Annex shows the completion (a rare event) of a so-called `head and shoulders' pattern in March. Not merely did an immediate bounce follow, but by the end of the month the FTSE-100 had finally broken through the long downward trend from near all-time peak levels in 2000, and also through the shorter-term resistance that had held since mid-2002. Short of some fresh international upset, it does now look as if we have seen the bottom.

1.3 The pace and durability of the recovery remains to be seen. The red line on the lower part of the main chart shows the inflation-adjusted trend of the index, which has held since the late 1970s.

1.4 While it would be imprudent to expect a very sharp recovery automatically to follow the unusually steep and prolonged fall, it is paradoxically true that if the long-term trend is to reassert itself, the index will have to rise at above the trend rate in the near and medium-term future. It would need to go from around 190 in March to nearly 260 by the end of 2008 - on an inflation-adjusted basis - to return to trend. Building in inflation at 2.5% a year, this implies the index reaching almost 5,000 in five years' time.

1.5 This does suggest that a policy of favouring equity investment should prove sound, as long as the market remains below or not far above the red line. The danger is, as always, that anticipation of improvement will lead to renewed exaggeration and yet another bubble. After all, if you have very good reason to think that the dollar is likely to rise in the second half of the year, you would not necessarily be wise to wait until 1 July to go out and buy the currency you are then going to need.

2 The world economy

2.1 The strongest reason to temper returning optimism over financial markets is the persisting pattern of imbalance in the world economy. Two countries, the US and, to a lesser extent, Britain, are providing nearly all the impetus in the industrialised world. But this is the other side of the coin of imbalances in their trading accounts, and emerging deficits in their internal finances.

2.2 Since 1995, the US has accounted for almost two thirds of the total growth in world Gross Domestic Product (GDP). This has been achieved largely by a sustained boom in consumer spending, predominantly financed by imports and therefore a growing foreign trade deficit. Something similar, on a lesser scale, has been happening in this country.

2.3 In turn this has led to a rising need for a capital inflow into the US to balance its accounts. (An alternative view is that the flood of foreign funds has itself necessitated the trade deficit since, by definition, the books have to balance). But in any event, any serious decline in the ability of the US to attract investment from abroad would soon lead to a weakening of the dollar - with an associated boost to American exports but also (every action in economics has an opposite - but not necessarily equal - reaction) a rise in internal inflation and a reduction in the level of consumption and imports.

2.4 In the past year or so there has been strengthening evidence that European investors in particular have been taking money out of America rather than adding to their holdings. But this has so far been balanced by a trend that has not been much remarked on, but which poses dangers of its own. Many of the major Asian economies, led by China which has a massive trade surplus with the US, are anxious to avoid any depreciation of the dollar which would weaken their exports. They have therefore been buying US Government securities on a large scale and thereby offsetting much of the `natural' flow of funds out of America. This is inflating the bubble to dangerous proportions, and, in any case, cannot continue to provide precarious stability to the world economy indefinitely.

2.5 While China and other Asian governments have been providing an appreciable proportion of the £1 billion a day plus, which is needed to support the dollar, the effect of the SARS epidemic in reducing industrial output and exports if only in the short term may make continuation of the policy more difficult. The other side of the coin is the massive undervaluation of the Chinese currency - put on the strangely reliable `Big Mac' index run by The Economist at over 50%. Certainly any reduction in US interest rates from the present 1.25% would make the opportunity cost of holding more and more US Treasury bonds very questionable.

3 The UK economy

3.1 All too often near unanimity among so-called experts is an indication that they are probably wrong. However, it is difficult to disagree with the consensus view that the growth projected for the British economy in this financial year and the next is seriously over-optimistic.

3.2 Of the four sectors of the economy (exports, investment, personal spending and public expenditure) only the last can be expected to show sustained growth. Exports are virtually certain to remain flat given the sluggish pattern of economic conditions in our main trading partners. In turn, this limits the likely recovery in private capital investment on which the Chancellor is relying for buoyancy further ahead. (Indeed, a sharp rise in investment could well take the edge off some of the recovery in revenue from corporate taxes on which the Chancellor is counting to avoid as sharp a rise in his borrowing requirement as many commentators forecast).

3.3 This leaves personal consumption. While still rising on a year-on-year basis of comparison, the growth is shrinking. Indeed as the chart in the Annex shows even the maintenance of last year's volume of consumption is dependent on a further rise in indebtedness. The Chancellor has pencilled in an increase of 2.75-3% for this year. That would require an additional borrowing of around 4% of personal income, or around £35m. Given that the first quarter saw about 40% of this figure - largely fuelled by a further jump in equity withdrawal on the back of higher but decelerating house prices - this is plausible. But the consequences and implications must be worrying.

3.4 In summary, things in the garden are looking better than for some time, but the climate suggests that the growing season may be shorter than hoped for, with some rather stunted plants likely to appear.

4 Further comments following the training session on 8 May 2003

4.1 A great deal of time and effort was concentrated on trying to assess future levels of earnings by the Fund. Even if a correct (ie a relatively successful) strategy is identified, actual performance must remain uncertain. While strategy for investment is obviously essential, I feel that giving this too much weight is putting the cart before the horse.

4.2 It is much easier to form a reasonably accurate idea of future liabilities which the Fund will have to meet. The numbers continuing to draw pensions, and starting to do so each year, is predictable with a high degree of accuracy. The only significant unknown in the rate of inflation, and that can be allowed for by making projections in terms of current prices.

4.3 Once the profile of future payments is established the funding requirement year by year can be calculated. That in turn will indicate the level of income that needs to be secured. At that stage a suitable strategy for investment and contributions will emerge more clearly, and it should become much simpler to arrive at policies which (a) will (or will not) meet the necessary targets and (b) are realistic.

4.4 Any actual pattern of asset selection will inevitably become less than optimal with the passage of time. An important aspect of whatever strategy is adopted should therefore be to build in a degree of flexibility so that the emphasis can shift with relative ease. Indeed, the longer the future view the more important potential flexibility should be rated as against more immediate matching of short-term market conditions.

Appendix 2

Commentary on Harvey Cole's paper on the Pension Fund

1 Introduction

1.1 Mr Cole raises a number of questions in the first section of his paper. Answers are set out below.

2 Responsibility of Panel members

2.1 Benefits under the Local Government Pension Scheme (LGPS) are guaranteed by law. There is therefore little the Panel can do directly to reduce employees' and pensioners' entitlements under the Scheme. There are some areas where employers have discretion, but these are of mostly little significance in terms of cost. Where there is a significant cost implication, for example granting early retirements for reasons other than ill health, employers have been paying an up-front contribution to the Fund since April 1998. Procedures for granting ill health retirements were tightened initially in July 1999 and again in April 2002. The decision on the exercise or otherwise of other current or future options by the County Council is the responsibility of the Executive Member for Personnel Matters, subject to ratification by the Cabinet, and not the responsibility of the Panel.

2.2 The Panel are aware that the Government's recent consultation exercises on the LGPS and Green Paper on pensions gave the Council and other employers in the Fund the opportunity to make their views on the Scheme and the Government's suggestions for change known. For example, the Council has taken the view that the employees' contribution rate should be increased from 6% to 7% of salary. This should reduce the level of employers' contributions, unless pay is increased to compensate.

2.3 The overall cost of the Scheme is dependent on the return on the Fund's investments. The Panel is responsible for ensuring that the Fund's investments are safe and well managed, and this can reduce the level of employers' contributions and hence demands on council taxpayers.

3 Information to employees

3.1 Each contributor and pensioner in the Fund receives an annual information leaflet. This summarises fund performance, the Fund's accounts, and its actuarial position. It also gives information on relevant contacts in the County Treasurer's Department.

3.2 Each employee also receives an annual benefits statement by the autumn of each year. The calculations shown are based on each employee's pay in the previous financial year. The content of the statements is summarised on the attached Annex. The current policy is not to estimate the effect of inflation on future benefit levels. LGPS benefits are currently index-linked, so it is considered unnecessary. It is better to give employees an indication of the real value of their accumulated benefits at current pay and price levels rather than make assumptions about inflation which could be incorrect and give a misleading indication of final benefit levels.

3.3 It is emphasised that there is no link between the state of the Fund and employee benefits which are guaranteed by statute.

4 Triennial actuarial valuation - possible outcomes

4.1 At its meeting on 29 November 2002, the Panel considered a sensitivity analysis which showed how the "unsmoothed" funding level would vary according to the level of the FTSE-100 index. Item 6 on this agenda revisits this analysis and gives indications of funding levels based on the FTSE-100 index at its current level, 4,500 and 5,000. It would be possible to go further and ask the actuary to carry out an exercise showing a range of possible outcomes following the March 2004 valuation. As well as the level of equity markets, there would be other variables, for example the amortisation period for the past service deficit (currently 40 years), the level of smoothing when valuing the Fund's investments, and the actuarial assumptions.

4.2 However, asking the actuary to carry out such a complex exercise now would amount to asking for interim valuation. The Panel considered this option at its November meeting and decided not to pursue it. In the meantime the County Treasurer will meet with the actuary to review the principles and assumptions underlining the next valuation. It is anticipated that some broad projections, at different levels of equity valuation, will be available in time for the AGM in September 2003 for presentation to employers. The November 2003 Panel meeting will consider more closely the assumptions and possible outcomes of the March 2004 valuation. However, it should be noted that any changes in employers' contributions will not come into effect until a year later in the 2005/06 budgets of employers.

5 Economic analysis

5.1 Harvey Cole's paper opens with trend analysis of the FTSE-100 index, and indicates that a partial but slow recovery in markets is probable. The analysis is interesting, but the Panel should keep in mind that trend analysis takes no account of destabilising events, either in the long and short term.

5.2 His analysis of the world and UK economy suggests, as last time, that, although prospects have improved, economic recovery may prove to be disappointing. The Panel may wish to raise some of his concerns with the managers.

5 Further comments following the training session on 8 May

5.1 As Mr Cole states, it is relatively easy to assess the Fund's future liabilities. The actuary assesses this at each triennial actuarial valuation based on data supplied by the County Treasurer on pensioner and contributor numbers, age profiles, and pension and salary levels, taking into account demographic factors, such as life expectancies. Such an assessment was also carried out as part of the asset/liability study in 1999, and this will be repeated when the next asset/liability study is carried out in 2005.

5.2 Assessing the future earnings of the Fund is more difficult, as Mr Cole points out. The actuary values the Fund on a market value basis, rather than estimating levels of future earnings. In effect, this means basing expected earnings on investments already made on the view taken by the markets, adjusted each year by the actuary to reflect the estimated extra income from investing the excess of the Fund's income over its expenditure.

5.3 Mr Cole is correct in saying that any recommended asset allocation will change with the passage of time. Life expectancy is likely to continue to increase. Employment patterns may change. Actuarial assumptions may prove to be incorrect. However, these changes will be relatively slow and, as the Myners Report emphasised, it is important to give the Fund's managers clear targets and investment parameters, and sufficient time to achieve them.

6 Article by John Shuttleworth - actuary at Price Waterhouse Coopers

6.1 John Shuttleworth has been putting forward the views expressed in this article for several months now in newsletters published by PWC, and it echoes some of the points made by Harvey Cole in the paper he presented to the meeting on 29 November 2002, in particular that funds generally have invested too much in equities and too little in property and bonds.

6.2 This can be raised with the actuary in early 2005 when the scheme-specific benchmark for the Fund is reviewed following the next actuarial valuation at 31 March 2004.

6.3 The adoption by the Panel of the scheme-specific benchmark in January 2002 has already resulted in a switch from equities to bonds. The benchmark was designed to match the Fund's investments to its liabilities. The Fund is not particularly `mature' in the sense that it has a relatively high ratio of contributors to pensioners. Bonds are the most appropriate match for liabilities arising from existing pensioners. But it is necessary to invest in equities to an extent to match liabilities in a final salary scheme for existing contributors whose pension expectations are likely to increase in line with economic growth generally rather than bond yields.