The belief that maturing DB schemes should automatically move into bonds and gilts is being increasingly challenged. Kristian Brunt-Seymour explores alternatives to the traditional de-risking model.
At a glance:
- Schemes with stronger sponsors could tolerate more growth assets
- But weaker sponsors should avoid investing in more volatile assets
- Schemes could lower de-risking triggers and invest in illiquid assets
Deciding on the correct level of investment risk for defined benefit (DB) schemes has been long debated in the industry.
There has been a common belief that mature schemes should automatically de-risk into bonds and gilts. This commonly includes reducing the level of growth assets and switching to risk-free assets as schemes mature, which means they become more defensive in nature.
Punter Southall has warned this ‘double de-risking' strategy could be adding up to 15% to the assessed value of liabilities and places too much strain on sponsor contributions to fill the gap.
Its principal and head of employer consulting Craig Wootton believes there is a danger of schemes focusing less on the right level of risk for their particular schemes. This includes trustees assuming their scheme would be 100% invested in gilts in the future.
Instead, he argues moderate to stronger sponsors should challenge this herd instinct by holding more growth assets to pay for DB benefits.
"My view on investment strategy is it should be set relative to the level of volatility the sponsor can tolerate rather than the maturity of the pension scheme," says Wootton. "Where you've got an implicit allocation of growth assets as the scheme gets more mature you're going to get times in the market where those growth assets don't move the same way as your liabilities. As a result you're going to get some short-term volatility by holding those growth assets.
"However, over time these assets should out-perform and employers are rewarded for holding those rather than gilts and bonds. These are theoretically the best way to pay for DB member's benefits because you're balancing sponsor contributions with investment return."
Hymans Robertson head of corporate DB Jon Hatchett does not believe schemes should take more risk as they mature, stressing the fundamental importance for sponsors to pay members' benefits.
He points out the risks maturing schemes run is magnified if they invest in more volatile assets. As a result mature schemes with weaker employers should avoid investing in these assets.
"Many corporate sponsors are generally uncomfortable running risk," says Hatchett. "You could expect growth assets like equities to outperform bonds, but there's no guarantee they will. As a result, schemes should take account of the risk in their investment strategies and not just what they expect to happen."
Instead Hatchett believes illiquid assets are an alternative option for maturing schemes as they offer higher yield.
"Assets which are illiquid offer higher yields because investors tend to favour liquid assets," Hatchett says. "Given DB schemes have a very long-time horizon and generally know when they need cash flows, if sponsors invest in illiquid assets which pay out funds for 20 to 30 years that's good for them provided they've got some balance of liquid assets as well."
Sponsors are increasingly looking at the investment strategy rather than letting the trustees drive it because the employer is ultimately responsible, according to Barnett Waddingham partner Rod Goodyer. As part of this, the assumption that schemes should automatically de-risk into bonds is being challenged.
Given many DB schemes are presently underfunded they are looking for more creative ways to de-risk, he says. This includes looking at middle ground assets which give stability and inflation protection but also offer upside on returns. Schemes need to focus on their situation such as the covenant and funding basis along with what they can realistically afford in terms of investment.
In scenarios where the sponsor is weak, Goodyer advises schemes to lower their triggers for de-risking, and taking more risk off if good progress is made.
"I would challenge clients on the level of their de-risking and whether it makes sense if they are a long way off buyout," he says. "If a scheme's covenant is weak then worrying about where it is in 15 years' time may be less of a concern than where the scheme is in 12 months' time. In these circumstances it might make more sense to have a plan to de-risk more quickly.
"However, if your employer is strong you can run those risks and take a longer-term view because you can always go back to the employer and discuss further funding.
"If you have a stronger employer you often find trustees and sponsors are working in partnership on a flight path on a jointly agreed long-term goal."
Schemes are encouraged to challenge the 'double de-risking' herd mentality and choose a strategy that suits their own situation. This includes looking at the strength of the covenant, the amount of risk the sponsoring employer can tolerate and how much of the scheme is already de-risked. Depending on their specific needs, schemes could hold onto more growth assets for longer, lower their de-risking triggers or invest in illiquid assets.
GLIL Infrastructure has agreed to acquire a 30% equity stake Agility Trains East (ATE) for a rolling stock fleet of 65 new UK intercity trains from Tokyo-headquartered Hitachi Rail.
Defined benefit (DB) schemes that provide GMPs must revisit and, where necessary, top-up historic cash equivalent transfer values (CETVs) that have been calculated on an unequal basis, a landmark court judgment says today.
Regulators must act now to impose some "proper regulation" to stop another defined benefit (DB) transfer advice disaster, saysTim Sargisson.
In this live blog, Professional Pensions' sister title Investment Week collates all the breaking market news, analysis and opinion on equity, bond and currency movements as well as the impact of trade wars, tightening monetary policy and the Brexit negotiations....