PAPER D2

For Noting

REPORT TO THE EXECUTIVE

Date: 17 DECEMBER 2002

Title: ISSUES RAISED AT EXECUTIVE ON 10 SEPTEMBER 2002

REPORT OF THE DEPUTY LEADER

1. When the annual accounts were put to the Executive on 10^th September one member raised a series of issues and as a result the Panel was asked to consider the specific concerns raised and to report back to a future meeting of the Executive. The concerns were:-

2. - action taken to protect the Pension Fund from the vagaries of the stock market

- the fall in value of the fund

- the performance of some of the fund’s largest holdings

- the amount of holdings in the fund manager’s own in-house unit trusts

3. By way of general background in common with all local government pension funds, the Isle of Wight Pension Fund has seen the market value of its investments fall as the stock market has fallen.

4. However, the Pension Fund has a positive cash flow as the total of investment income plus employers’ and employees’ contributions exceeded the total of pensions paid. Therefore there is no need for the forced sale of investments at current prices.

5. Pension investment is a long term undertaking, for instance the fund could be paying the pension of someone joining the scheme today as far in the future as the year 2082. It could therefore afford, and indeed needs, to take a long term view.

6. Over the long term equities (company shares) have proved to be the best class of investment. A recent asset/liability study carried out by the Fund’s investment advisers was considered and acted upon by the Pension Fund Investment Panel. This has led to the setting of a specific benchmark for asset allocation which reflected the fact that the Fund was less mature (ie people receiving pensions formed less than half the membership) than many Local Authority and other peer group funds.

7. Therefore, the Fund could appropriately choose that a small increase in its total equity holdings was an appropriate long term balance between risk and reward.

8. The local government pension scheme is a final salary scheme and employees’ pensions are secured by statute and regulation rather than contract. The financial risk falls therefore on the employer. Employees pay a fixed contribution with the employers paying whatever contribution is required to balance the long term costs of pensions. These in turn are determined by a valuation of the fund every 3 years, the next of which takes effect in 2005. If current conditions persist, there will be an increase in the longer term cost of pensions.

Dealing with the specific points raised in turn.

Action to protect the fund

9. The best long-term protection for the fund is to have a strong position in the asset class most likely to produce the best long term returns at a risk level acceptable to members and consistent with the asset/liability profile of the fund.

10. This was in fact the action taken following the asset/liability study carried out by the fund’s independent advisers, which set a scheme specific benchmark for asset allocation consistent with the fund’s maturity profile.

11. Action has therefore been taken to protect the long-term value of the fund.

The fall in value of the fund

12. Any snapshot in time is likely to produce a transient result. Since 31^st March the fund’s value has fallen further and at 31^st October was £140.3 million, compared with £170.1 million at 31^st March.

13. Because the fund is not a forced seller the value at a point in time is not particularly relevant. What actually matters is how anticipated future investment returns impact on the employer’s contribution rates in the future. There is no doubt that if present projections are fulfilled the employer’s contribution rates will have to rise again in the future although there are some offsetting factors.

14. Short of having taken a heroic gamble to sell equity holdings at the height of the market and being out of equities (a wholly unreasonable and imprudent risk to have taken) it is difficult to see how the effects of the market fall could have been avoided. A large turnover of stock also brings its own costs in brokerage and stamp duty in addition to the risks described above.

Individual Stock Holdings

15. The largest 10 holdings at 31^st March 2002 are set out below together with their performance compared with the stock market index over the previous 12 months.

Holdings	Return %	Index Return %
Schroder Instl. International Bond Fund	0.2	0.3
Schroder Exempt Property Fund	4.4	7.2
BP	10.6	-3.2
GlaxoSmithkline	-8.0	-3.2
Schroder Instl. Pacific Fund	6.6	6.0
Vodafone Group	-32.2	-3.2
Schroder Instl UK Smaller Cos Fund	2.3	-3.2
HSBC Holdings	0.7	-3.2
Shell Transport & Trading Company	-1.0	-3.2
AstraZeneca Group	5.4	-3.2

16. The fund managers are expected to produce performance that has a relatively low level of volatility relative to the benchmark. As a result they have a number of risk controls designed to ensure that performance in each area of the portfolio does not diverge too far from the relevant stock market index. It would be deemed too risky not to hold any stock in the largest companies in the market as this could result in unduly volatile performance. For example, the negative return produced by Vodafone during the year clearly impacted on the Fund’s value. However, the fund managers’ position in Vodafone was a smaller proportion than its neutral index weight and was held throughout the year for the purposes of risk control. Therefore, the fact that Vodafone underperformed the All Share index meant that this underweight position added value relative to the benchmark.

Holdings in Schroder Unit Trusts

17. At 31^st March 21.6% of the fund was held in Unit Trusts managed by Schroders. The entire fund is delegated to Schroders to manage and therefore stock selection is a matter for the fund managers in the absence of any specific instruction to the contrary. Unit trusts are used to invest in particular stockmarket sectors where the fund might be unable to obtain reasonable sized individual holdings economically.

18. The use of in-house Unit Trusts has the following advantages:-

- the spread of risks by the unit trust itself investing in a much wider spread of individual holdings than the fund could achieve on its own

- consistency of approach from the same fund manager

- no additional costs as in-house management fees are rebated

The relative performance of the funds over the past 3 years is as follows:-

Unit Trust	Return % pa	Index Return % pa
Pacific Inc	10.4	7.2
UK Smaller Co	8.9	-1.7
Recovery	12.7	-1.7
EUR SM CO	8.9	0.5
JAP SM CO	4.9	4.8
Emerging Markets	2.1	8.2
Developing Markets*	19.7	20.6
International Bond *	0.2	0.3
Exempt Prop	10.3	10.5

*12 months data for these unit trusts as these funds were launched within the last 3 years

19. Of the Funds with a three year track record, only the Emerging Markets Fund and the Exempt Property Fund have produced returns below the relevant benchmark.

20. Finally, the fund managers’ performance is kept under quarterly review and in the ultimate is terminable without notice. Over the 10 complete years the managers have held office the annualised return has been 11.0% p.a. compared with the average local authority fund’s 10.9%. The adoption of a customised benchmark has further clarified responsibilities and sharpened the measurement of their performance.

21. Members are asked to note the report and indicate whether they wish to make any additional response to the Executive.

RECOMMENDATION

22. THAT the report be noted.

BACKGROUND PAPERS

None

J PULSFORD Strategic Director Finance and Information

P HARRIS Deputy Leader