The end game

In recent months a number of press articles have suggested the funding levels of many pension schemes have improved, as a result of strong equity market returns coupled with rising bond yields. In addition, many companies have been making significant contributions towards their scheme deficits.

While any improvement in funding levels is welcome, the funding position at any point in time is merely a snapshot. For both trustees and companies, the key question remains: how are they going to be able to deliver the promised benefits, in full, to members as they fall due?

Most schemes are not currently in a position to achieve this objective without a significant cash injection, but trustees, employers and advisers can work together now to put a plan in place that looks to meet this bigger objective over an appropriate time horizon.

Fundamentally, there are two reasons why schemes cannot guarantee benefits in full today. Firstly, the value of the investments isn’t large enough, and, secondly, the cost of immediate and deferred annuities are too high.

There is therefore a simple solution: increase the value of scheme assets through a more focused investment strategy with company support, and at the same time be in a position to benefit should long-term yields rise sufficiently and annuities become cheaper.

A move to investment strategies which apparently reduce risk, traditionally through the use of gilts and bonds, can be contrary to this solution.

Gilts and bonds are expected to produce lower investment returns over the medium to longer term. Gilts and bonds may provide the best match for known future cashflows, but do not include margins against factors important in the cost of annuities, such as improving mortality rates. Gilts and bonds will not benefit, relative to annuity costs, should long-term yields rise. Therefore, a move to gilts and bonds does not help meet the bigger objective.

Investment strategies that focus on producing absolute levels of returns, coupled with a greater level of diversification to reduce volatility in those returns, can provide part of the solution. If investment managers have an objective which is focused on maintaining capital value, rather than outperforming a particular index, then schemes may benefit at some time in the future from rising yields.

In recent years, reactive legislation and accounting standards have caused a lot of focus on short-term issues.

Investment solutions have been developed to remove the “interest rate risk” primarily as a result of the new accounting standards. It is time for trustees and companies to ignore short-term pressures wherever possible and look at the bigger picture. By taking a longer term view, schemes can look to add interest rate risk, not remove it. This may be particularly true at current yields.

As part of the overall management of scheme risk, the way to remove the risk of people living longer is to buy out members’ benefits through deferred and immediate annuities, and pass the risk on to an insurance company.

While increased longevity is good news for us all, pension schemes are left to deal with pension promises made when the expected lifespan was lower. Actuaries have always made an allowance for future mortality improvements in their valuations, but actual improvements have outstripped this allowance and there is every possibility that life expectancy will improve beyond current projections in the future.

While the increased competition in the annuity market is welcomed, it is not having any immediate significant impact on the cost of buying out benefits. The new companies are, however, introducing greater flexibility into the marketplace by introducing features such as buying out small parts of the liabilities through an agreed programme over time, as and when the investment returns come through.

Historically many schemes have adopted strategies which invest in return-seeking assets, predominantly equities, for liabilities prior to retirement, and switch to lower volatile assets as and when people retire. With the change in priorities on wind-up, where pensioners no longer get first call on the assets, coupled with the introduction of the Pension Protection Fund, this may no longer represent the most appropriate approach.

One way forward is to adopt a strategy which looks at the scheme investments as a whole and looks to produce positive absolute returns, but also includes a strategy of buying out benefits over time, when either the investments perform and/or annuity prices reduce.

Finally, one of the more positive pension items that this government has introduced is the PPF. The cost of supporting it, as demonstrated by the recent hikes in levies, “so employers have certainty” is, however, high.

As a general principle, if you are paying for an insurance policy against, say, your home being burnt down, you do not then also self insure by reserving the cost of having to rebuild it in the unlikely event of a fire. The PPF is not guaranteed and benefits are not protected in full, but if schemes are paying a premium for this “insurance”, then this should give them some freedom when determining their investment strategy.

If nothing else, schemes may look to at least generate the extra returns needed to actually pay the levy! Businesses are not run on the basis that they are going to fold tomorrow. Pension schemes should be no different.

Going forward, trustees, together with their advisers, should consider regularly monitoring funding levels and putting in place triggers to secure benefits over time as and when there is favourable investment experience and/or annuity prices move.

With appropriate company support and suitable funding, and investment and exit plans in place, this should ensure that contributions are focused on the big objective of delivering benefits in full, rather than being invested in low-return assets for many years and, even worse, being used to subsidise the pension benefits promised by failing competitors.

Iain Fitzgerald is an investment consultant at Garvins