An OECD report has sounded alarm bells about scheme solvency in a low interest rate environment. Helen Morrissey takes a closer look.
- OECD report highlights risks of a low interest rate environment.
- UK schemes are increasingly moving into alternatives which may bring increased risk
- Schemes could be forced to purchase other fixed income assets with even lower yields
The current low interest rate environment has brought its fair share of challenges for pension schemes looking to plug deficits. Low bond yields have pushed liabilities higher while schemes remain wary about returning to the equity markets.
The need to generate returns in a low interest rate environment has proved cause for concern at the Organisation for Economic Co-operation and Development (OECD) which believes the current environment poses a significant risk for the long-term financial viability of pension funds as well as insurance companies.
Speaking at the launch of the inaugural Business and Finance Outlook, OECD secretary-general Angel Gurría outlined the problem: "The current low growth, low interest rate environment poses particular problems for pension funds and life insurers," he said.
I would say schemes are much more risk aware now than they ever used to be. I think this goes across the board with trustees, managers and advisers all talking much more about risk than they ever did
"These financial intermediaries, which offer long-term financial promises, rely on investment returns to honour their obligations. Today's Business and Finance Outlook identifies significant funding gaps as annuity promises based on existing mortality tables show shortfalls in many countries, both from rising longevity risk and from lower interest rates."
Should interest rates remain low over the long term the report highlights further problems for schemes. As significant investors in fixed income securities, schemes may find that once these securities mature they have to reinvest in securities offering even lower yields. The reduction in assets that this could bring about could leave schemes unable to meet the promises made to members.
The only potential solutions would be to increase duration of the assets so they are in line with their liabilities, renegotiate promises or increase contributions. However, the report highlights that such solutions are "far from being simple or equitable".
JLT Employee Benefits director Charles Cowling agrees that pension funds are in a difficult position.
"The OECD is right to point out that solvency levels for pension schemes are far lower than they ought to be and there are significant risks in our system with the possibility of significant financial fallout if things go badly wrong," he says. "It is possible the solvency deficit for UK private sector schemes is in excess of £1trn."
He continues: "This issue raises the fundamental question of how a pension ‘promise' should be presented to members if there is a clear risk of not being able to deliver on that promise (and that risk will be much greater for some pension schemes than others). There is an inherent dilemma here - if you make a lot of noise about risk and the possibility of defaulting on a pension promise, you could undermine confidence in the principal employer supporting the scheme and precipitate a crisis.
"Equally, at a macro level, if The Pensions Regulator responded to concerns from OECD on the poor level of funding of pension schemes and increased pressure on employers to take less risk and fund their pension schemes better, this could force some of the weaker employers into bankruptcy and put downward pressure on equity prices (as cash was diverted from shareholders to pension funds) and make matters worse - as deficits widen as a result."
Hunt for yield
According to Gurría, schemes chasing higher investment returns so they can fulfil their promises to scheme members are looking to "pursue higher-risk investment strategies that could ultimately undermine their solvency". Gurría adds: "This not only poses financial sector risks, but potentially jeopardises the secure retirement of our citizens".
The report highlights the shift in portfolio composition of pension funds over recent years where the dollar amount invested in assets described as "other" has increased steadily over the last decade.
However the report did state that this may be the result of larger total investment portfolios and said there was little evidence that this was happening on a wide scale except "perhaps" in the UK. Here it said there was a clear upward trend in the current value of investment in "other" assets such as private equity, derivatives and structured products. They also account for an increased proportion of total investment portfolios.
Gurría urged pension funds looking to allocate more assets to alternative assets to "remain vigilant" though he did say there was a role for assets such as infrastructure in portfolios.
"At the same time, promoting infrastructure and other long-term, productive investments by these institutions can help raise real returns on capital in advanced economies more generally, thereby improving structural conditions for business and the financial sector," he said.
However, Buck Consultants at Xerox senior investment consultant Celine Lee says that while the report makes valid points she feels pension schemes have a much better understanding of risk now.
"While I do agree that investors of all kinds are increasingly looking for yield if you look at defined benefit pension schemes I think overall they have adopted robust risk management frameworks that you would not have seen in the nineties for instance," she says. "I would say schemes are much more risk aware now than they ever used to be. I think this goes across the board with trustees, managers and advisers all talking much more about risk than they ever did."
She continues: "Even smaller schemes have improved risk frameworks and the use of things like modelling techniques to assess deficits is increasing. These are now embedded in pension scheme risk management processes. Things are much better than they used to be."
So while the OECD report is right to highlight the potential issues lurking in scheme portfolios it is also true to say that scheme understanding of investment risk has evolved markedly. The low interest rate environment looks set to persist for some time yet and schemes need to be aware of the risks this presents and look at how they can best be mitigated. For some schemes, taking a wider view of their investments and incorporating more alternative assets into their portfolio will be the right approach to remaining sustainable in the long term.
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