How to Manage Long-Term Liability Risks through Increased Portfolio Returns

Nearly all local governments manage significant infrastructure assets including buildings, drainage works and long-term liabilities related to maintenance and renewal of these assets.  With interest rates currently very low, some councils may be facing future budget gaps with their investment portfolios not providing the necessary returns to offset longer term risks. Councils may therefore need to utilise more effective asset-liability management approaches. 

Longer term liabilities can best be managed better by hedging them with growth assets as over the longer term growth assets are expected to provide better returns than lower risk cash assets; although short-term volatility is almost certainly going to be greater.  For example, simple maths shows over a thirty year time horizon over four times as much money needs to be set aside to defease a future liability if it is assumed a 1% return is made on invested funds as opposed to a 6% return.

Under prevailing investment legislation, the only access NSW councils have to growth orientated assets within their investment portfolios is via the NSW Treasury Corp (TCorp) IM Funds investment facilities.  Within these selection of funds, the most growth orientated one is the Long Term Growth Fund (LTGF) as it contains the largest proportion of capital growth assets (the Medium Term Growth Fund also contains growth assets but at a lower percentage and therefore is less efficient as a source of growth assets). 

Amicus has worked with and advised several NSW councils to utilise the LTGF to defease some of their long-term liabilities.  Typically, a hedging strategy involves the complex task of matching the current value of the long-term liability with the growth assets, then adjusting the hedge within defined parameters each year depending on the movement in value of both asset and liability.

The largest danger is volatility in returns over the defeasance period, therefore robust processes and procedures must be put in place to manage these risks and to ensure management and councillors understand the issues and are committed to the strategy on a long-term basis. Research and analysis undertaken by Amicus on the LTGF has been documented to provide a compelling case as to why investing in growth assets is a demonstration of councils acting “prudently” rather than engaging in “speculation” in search of higher returns.

Please contact Amicus if these hedging strategies may be of interest to you as we can provide guidance and advise on implementing procedures and protocols that have worked for other NSW councils.

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