23 April 2020
The typical UK pension scheme has suffered significant funding level falls (estimated to be around 5-10%) in the first quarter of 2020. The Covid-19 crisis resulted in 20%+ falls in global equity markets and even lower risk diversified or credit mandates often fell 10% or more. In addition, gilt yields both fell materially (leading to increased deficits for under-hedged schemes) and experienced huge volatility (leading to issues for leveraged investors) over the same period.
Following this large deterioration, many trustees have been asking what actions they should take. However, unfortunately for most, it’s too late, the horse has already left the stable. The right time for action was before the virus was known about, when markets were flying high. Those schemes that reduced risk prior to this have generally had very stable funding levels, often only having funding level declines of 1-2%..
But having a resilient investment strategy is not just about liability hedging and diversification, it’s also targeting an appropriate level of return for the long term objectives of the Scheme. I believe that the way that most actuarial valuations and journey plans are designed, results in many schemes targeting too high an investment return in the short term and thus being overly exposed to investment risk.
With the majority of schemes now in run-off having closed to new members and future accrual, trustees (and the Pension Regulator) approach has rightly moved to focussing on achieving a low-risk low-dependency position (e.g. fully funded on, say, gilts + 0.25% to 0.5%). However, actuarial discount rates are typically set by having a mix of a high discount rate pre-retirement and a low discount rate post-retirement. This means that the required return of a scheme’s investment strategy starts out high and then declines as members gradually retire until by the time most members have retired, the required return is broadly in line with the low dependency requirement. Where this is not the case, it’s common to have “linear de-risking” approaches that results in a similar outcome.
This approach is generally justified for two reasons: a) if the scheme is relatively immature (lots of member pre-retirement) then it has a longer time horizon and can afford to take more risk and b) the strength of the sponsor covenant is clearer in the short term so taking risk now is appropriate since it is more likely the sponsor can afford to make good any deficit.
However, there are a number of significant problems with this approach:
- Relying on the sponsor covenant concentrates the risk mitigation within one entity. We have seen plenty of unexpected situations where the sponsor strength deteriorates very quickly and is then unable to underwrite the risk (Covid-19 being, unfortunately, a good example).
- In addition, poor investment outcomes often come at the same time as the sponsor covenant is weakened and therefore less able (and willing) to support the scheme with extra deficit contributions.
- Pre Covid-19, there was no particular reason to expect the next 1-3 years as a particularly attractive time to take extra risk compared with the 3-7 years following that. Recent events have clearly shown that to be the case.
- Volatility of funding position and hence volatility of deficit contributions is, in my opinion, unattractive for both trustees and sponsor (in my experience sponsors are increasingly focussed on stable cash contributions rather than taking risk to aim for lower contributions)
- As time progresses, the size of the scheme will gradually decline as the scheme matures. So taking extra risk now means taking more risk on a bigger amount of assets and thus exposing the scheme and sponsor to bigger £ amount risks.
- Taking more risk now means that there is less “dry powder” to exploit opportunities if they emerge. Often investment opportunities emerge at times of market stress and a low risk investment strategy is generally more liquid and less leveraged and therefore in a better position to target attractive assets.
The alternative approach I generally recommend for my clients is to take a “level” return approach to achieving its long term low dependency position. This means that materially lower risk is taken in the short term. In practice, I have found this approach means that the overall risk levels can be broadly halved today compared to the standard linear or member status de-risking approaches. The funding approach is then made consistent with this level return/risk investment strategy with no or little impact on ongoing cash contribution amounts. Over the past 3 years, most of my clients have already positioned their investment strategy for this lower level risk approach and coupled with appropriate high liability hedging ratios and asset diversification, this has meant that their funding positions have remained remarkably stable through the Covid-19 crisis.
Opponents to this approach often claim that it leads to little ability to de-risk over time or “cliff-edges”. However, clearly markets don’t move in straight lines and opportunities will no doubt emerge (as well as the scheme being better prepared for threats).
As a result, my clients are able to focus on the key job of ensuring their businesses are running appropriately in these difficult times, without having the added distraction of a much weakened pension position to also deal with. The investment discussions I am having with them are about using “dry powder” to exploit the newly emerged investment opportunities rather than panicking about what to do now to stop a bad situation getting worse. To me, it’s clear that many UK pension schemes had too much risk at the start of this year and unfortunately are now in very challenging positions as a result.