Pension schemes have had a difficult few years. Triennial valuations of pension schemes have shown a jump in the deficit position as lower real rates have significantly increased the value of liabilities and assets have not been generating the returns expected.
As can be seen from Figure 1, the Pension Protection Fund (PPF) 7800 Index shows the extent of the volatility within pension schemes funding positions and the fact that they are now fully funded on a s.179 basis.
Source: Insight Investment
This valuation method measures the liabilities on the basis upon which the PPF would make pension payments, which is lower than the full scheme benefits that a pension scheme is required to make. Thus pension schemes remain largely in deficit, although the size of the funding gap is likely to have reduced over the past 12 months or so.
As part of triennial valuation processes followed by UK pension schemes, a statement of funding principles is required to be submitted by a pension scheme to The Pensions Regulator. Where there is a funding deficit, this statement must contain a schedule of additional contributions from the sponsoring employer to ensure that the scheme is funded to at least the level of its technical provisions over an appropriate period. To eliminate any deficit, there will need to be a balance between the level of risk taken within the investment strategy of the pension scheme and the level of additional contributions paid by the sponsoring employer. Trustees have the right to demand these additional contributions. This is backed up by The Pensions Regulator, which has the ability to act where they believe that a sponsoring employer is deliberately attempting to avoid their pension obligations.
There is also an increasing awareness by the equity markets and ratings agencies of the impact of increased pension deficits on sponsoring employers. An increase in deficit repair contributions to eliminate an increased deficit will need to be met by diverting cashflow from elsewhere, to the likely detriment of the efficiency and operation of the sponsoring employer.
Changes in Pension Scheme Investment Strategies
Over the past few years, pension scheme trustees have become increasingly aware of the significant impact that changing liability values have on their pension scheme’s net funding position. The volatility within the liabilities can far exceed that of the assets and yet the main focus of attention for trustees has historically been on asset allocation and the performance of their investment managers. A pension scheme’s liability value is volatile due to the impact of changes in interest rates, inflation expectations and longevity assumptions.
As a result of this significant volatility, trustees have sought to better match assets to liabilities. Bonds have been regarded as a match to the liabilities and we have seen an increase in bond asset allocations as a consequence. However, this only has a limited effect in increasing the liability matching, demonstrated by the continuing volatility within funding levels. A typical defined benefit (DB) pension scheme will have an average duration of liabilities of around 20 years. However, bond portfolios will have a significantly shorter duration. For example, the long dated over 15 year UK government bond index has a modified duration of only 15 years and a decision to invest solely in a portfolio of bonds benchmarked against this index to better match a pension scheme’s liabilities takes no account of the relative value of bonds along the yield curve. Where there is an investment in corporate bonds, the average duration of such a portfolio will be even shorter – typically, under 10 years.
The other key risk with such a strategy is yield curve risk. Where there is a significant allocation at one point, or a very small number of points, on the yield curve in an attempt to duration match the liabilities, a change in the shape of the yield curve will potentially result in the liability matching portfolio providing less of a liability hedge and therefore require rebalancing. This can lead to increased transaction costs as certain maturity bonds will need to be sold and different maturity bonds bought to rebalance the liability matching portfolio.
Matching liabilities through an allocation to physical bonds will also reduce the capital available to invest in growth assets and therefore risks raising contribution rates and the long-term funding costs of a scheme.
Managing the Risks
The limited additional benefit of managing liability risks through bond duration extension strategies has led to an increasing desire by trustees to seek alternative solutions to better manage these risks and thereby mitigate the downside financial risk. This has been behind the increased use of liability driven investment strategies as well as buy-out or buy-in solutions. We have also seen the use of longevity hedging directly by pension schemes with several high profile transactions reported over the past few years.
Buy-outs and buy-ins undertaken by insurance companies have been predominantly for the pensioner cohort only and need to be on a fully-funded basis, typically using a discount rate at which they expect to fund, bearing in mind the regulatory capital implications of holding non-matching assets. For most DB pension schemes, this is not achievable unless the sponsoring employer injects the requisite funding to bring the pensioner cohort of the pension scheme to a fully-funded position. Even where a buy-out or buy-in has been undertaken, the liability risks in respect of the active and deferred members of the pension scheme will remain.
A liability driven investment strategy is put in place over the existing investment strategy of a pension scheme. As a result, the existing asset allocation, particularly the allocation to return seeking assets, does not necessarily need to be disturbed. The scheme therefore retains the potential benefit of outperformance returns generated from the return seeking assets in order to eliminate any deficit position.
A liability driven investment strategy can be employed to remove risks even where a pension scheme is not fully funded. In certain instances, a liability driven investment strategy is used as a precursor to a buy-out or buy-in once a fully-funded position has been reached. In the meantime, the volatility within the liabilities, and therefore the funding position, is significantly reduced.
The Evolution of Governance Structures
The variety and complexity of asset classes now available to pension schemes continues to increase. The clear benefit is that pension schemes can manage risk much more effectively by adding greater diversification to investment strategies, but there are higher governance costs involved for trustees. The Pensions Regulator is putting increased emphasis on trustee education, but the complexity of the financial markets means that not all trustees are well-versed in the detail.
Traditional governance structures have meant that trustees tend to meet on a quarterly basis and it is quite easy to envisage a scenario where it could take nine to twelve months for a trustee board to undertake sufficient due diligence to reach a level of comfort to invest in a new asset class or adopt a revised investment strategy. Within this timeframe, potential investment opportunities that may have arisen due to market dislocation could well have disappeared as the market fully exploits them.
As a result, many trustee boards have started to form sub-committees to focus on key issues including their investment strategy. These bring together a smaller group of trustees that have delegated authority and a better knowledge of specific issues. This smaller group can dedicate more time to understanding the financial markets, and meet more frequently to discuss current market developments. The treasury function is increasingly seen as an ideal source of knowledge that can provide advice in the best interests of the trustees. As a result, treasurers are now, more than ever, being asked to become trustees, sit on investment sub-committees, or are involved in negotiations with their pension scheme.
Another governance structure we are beginning to see is a joint working group established between the sponsor company and a subset of the trustees. This provides a forum for the sponsor company to make the trustees aware of their views, given that the sponsor has no legal right to direct the investment strategy of the pension scheme.
Potential conflicts of interest need to be recognised by both the pension scheme and the corporate sponsor, and this may result in treasurers not being formally appointed as trustees. However, as managers of financial risk within a company, treasurers need to understand the dynamics of their DB pension schemes and the potential impact, negative or positive, that they can have on the financial condition of the sponsor company.
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