Natasha Browne explores the issues scheme trustees face on their journey to self-sufficiency and beyond.
Defined benefit (DB) pension scheme trustees face a major challenge trying to juggle their investment risks and returns. Failure to get this right can lead to under or over-funding at a crucial time in the life of the scheme.
Last year's Global Pension Risk Survey from Aon Hewitt found 64% of schemes had a long-term strategy for self-sufficiency, with one in five looking to complete buyouts. The consultancy has since published its Pensions Stability white paper, which warned schemes were failing to get the right balance on self-sufficiency. A scheme was defined as self-sufficient if the probability of it having a funding deficit at the end of any of the next 20 years was less than 1%.
The report raised concern that trustees may go into over-funding if they underestimate their investment returns and demand high contributions from their sponsor at the initial outlay. Once schemes have wrapped that cash up in the fund they can no longer return it to a sponsor who has overpaid.
Aon Hewitt partner Paul McGlone advises trustees to think hard about their funding level target and what they hope to achieve. He says: "It's about asking what that funding level really means. When you say you've got enough assets, what do you mean? Enough assets to do what?"
Trustees should have a clear idea of the actions they plan to take when they hit full funding. McGlone understands that this can be challenging, however. He says: "While you're a long way from that target it doesn't really matter exactly what it is. It's a bit like saying you're headed for Scotland. The first thing you need to do is go north. It doesn't really matter precisely how you get there as long as you're going north. But as you start to get closer to your target, it does matter.
"First of all, you might not end up being quite where you expected to be, you might not get agreement from everybody, and having got there, you might find that it wasn't the right place. You would need to start making some changes, which might be to your investment strategy. As schemes' funding positions are starting to improve, which they are, and as schemes are starting to get more mature, what we're saying is you need to be thinking more seriously about what that target is and what it really looks like."
P-Solve director of asset solutions Barbara Saunders points out that most pension schemes are still underfunded relative to technical provisions. She says: "Many have plans to be self-sufficient in 15 to 20 years' time but, arguably, putting a detailed plan together for that is irrelevant when you're still underfunded on a technical provisions basis. Although most of the plans are for best endeavours, the level of detail that they can achieve at this stage is very woolly in our view. If they are too precise this far away, it is likely the plan will have to be changed many times along the way."
To de-risk or to not de-risk
Although 20% of schemes want to complete buyouts, the white paper suggested considering whether sponsors would prefer to delay locking into annuity rates until the scheme is smaller or the membership is older. On the other hand, a failure to lockdown good investment returns would leave the fund open to losses as it continues to ride the equity and gilt markets. The paper showed a funding level of around 122% would be required for a buyout. This reflects market conditions in spring 2014 on a gilts plus 0.5% p.a. basis. This level would be 112% in 20 years' time as the membership matured under the same conditions.
Hymans Robertson partner James Mullins thinks it is a good idea to take risk off the table when good market conditions have generated better-than-expected returns. "That's just an opportunity to reduce risk sooner than you might have done otherwise," he says. Mullins argues that trustees can avoid over-funding by gradually removing risk throughout the lifetime of the fund. He adds: "If you keep doing that kind of cycle then you're not going to have trapped surplus. What you are going to have is this well-funded scheme invested in a very low risk way. The chances of things getting better or worse in the future become very low because you've grabbed the opportunities to reduce risk as market conditions improve. The only time you're going to get a trapped surplus is if market conditions improve and if you don't take any action". He adds: "It helps frame decision making and ultimately helps trustees and companies grab opportunities they might otherwise have been unsure of whether it made sense or not."
However, Saunders warned against schemes de-risking too soon and not targeting enough return now. She adds: "Unless they are very fortunate to be in a very low risk basis already and well-funded on that, most pension schemes need return just to pay their benefits. De-risking too early can be one of the biggest risks they face.
"We want to ensure that return is targeted in a risk controlled way, for example by using liability hedging through LDI and good active management around the diversification of the assets and not just relying on equities. But actually reducing risk too early could cause you to fail to meet any of your objectives, let alone your self-sufficiency targets."
Saunders explains that de-risking does not change how much return schemes need, but rather, when they target that return. She says: "What it does mean is you have to stay invested for a longer period but at a lower level rather than essentially getting to where you need to sooner. Arguably, targeting return now when you have more certainty about where your sponsor covenant is will be a better idea than necessarily waiting to target that in ten or 15 years' time."
Mullins is increasingly seeing two types of triggers used by trustees to balance their objectives. The first is around the decision to move from growth assets into bonds. He says: "Many schemes now have triggers in place which predetermine when those moves are going to be made. That's an important first step." The second trigger sees them move to LDI products, buy-ins or buyouts. Mullins adds: "The first trigger helps reduce overall volatility and that's important. The second trigger then helps refine the level of matching and to really make it very specific to your scheme and your membership. I think that's where more and more schemes are heading right now."
Defining funding levels
Mercer principal Le Roy van Zyl points out that there are varying views on the meaning of self-sufficiency. He believes trustees and sponsors need to discuss this to ensure they are on the same page. He says: "Frequently we find that the corporate's view of being over-funded would be different to what the trustees view as over-funded.
"You really need to talk to one another to try get to a common view because if you don't have that it's very difficult to act appropriately. Otherwise you get stuck in endless debates between the trustees and the sponsor, and you can miss market opportunities. It's about asking what the target is; whether that's buyout or something less conservative. Then you tailor your suit accordingly."
Pan Governance chief executive Steve Delo expects some reluctance from employers to over-fund schemes, but he does not think this creates too much tension between the trustees and the sponsor. He says: "Even if it's on technical provisions that you get to full funding, it's a nice problem to have because we've all been wrestling with such horrible deficits in the last few years.
"If you explore it properly it tends to open up all sorts of debates about the risks people are willing to take, and how you want to protect against the downside because it's all very well being fully-funded on any particular measure but if you've still got some risk in there it means you could find yourself not fully-funded."
Delo has seen many schemes approach full-funding on a technical provisions basis. He believes they should be driving towards over-funding to reach self-sufficiency, however. He says: "I'm aware of a couple of employers who are quite keen to make sure that once they're at technical provisions funding they don't fund beyond that. It is a bit of an issue, certainly with gilt yields having improved a bit and risk assets having done well over the last year, schemes are in a better position.
"Once you get to full funding on technical provisions you should be looking at the range between there and getting to full self-sufficiency funding. Try to develop a happy medium strategy or exit plan with the employer to get to that point. Employers shouldn't be told that's the point at which you turn the tap off; it's the point at which once one problem is gone away, you start working on the second layer of the problem."
Nearly every trustee is confident of the next stage in their scheme’s strategy, despite almost an equal number being forced to consider replacing plans within the prior 12 months, according to research by Barnett Waddingham.
The government will set up an infrastructure bank to support investment and to co-invest alongside investors including pension funds.
The Retail Prices Index (RPI) will be reformed and aligned with the housing cost-based version of the Consumer Prices Index, known as CPIH, by 2030, the Treasury has confirmed.
Companies could be overstating their pension liabilities by up to £60bn due to their life expectancy assumptions, according to XPS Pensions Group.
Estatee agent denies a shareholder’s absence from voting is an issue, finds Minerva Analytics.