Growing market volatility could adversely affect defined benefit (DB) schemes nearing buyout over the next five years, Barnett Waddingham says.
The consultant's research found over a quarter (27%) of FTSE 350 DB pension schemes approaching buyout in the next five years are exposed to unnecessary risk and could be over-exposed to growth assets and illiquid investments.
As schemes move towards buyout, they are generally improving volatility management within the growth portfolio by reducing equity allocations in favour of greater diversification.
The report said that, on average, at least 27% of FTSE 350 DB pension scheme assets are invested in growth assets, including 11% in equities. It said a further 12% is in diversified growth funds that offer smoother returns but are exposed to equity market volatility.
The gradual decline in equity market exposure within growth asset portfolios picked up in 2018, with a six percentage point reduction in equity allocations - noting that the reduced reliance on equity markets may reflect the level of returns above actuarial assumptions in recent years; the availability of alternative sources of additional return; maturing scheme profiles; and schemes looking to lock-in some of the recent gains.
The vast majority (90%) of schemes are now cashflow negative with one in eight FTSE 350 schemes suffering from a cashflow burden above 5% of total assets. The research found the cashflow burden is steadily rising, with annual payments to members now equivalent to an average of 3% of FTSE 350 DB scheme assets.
Generally, outflows above 5% are likely to be problematic if not managed correctly, particularly for poorly funded schemes or those not conservatively invested, the report cautions. This is already the case for one in 10 FTSE 350 companies with a combined growth and liability-driven allocation of more than 50%.
Barnett Waddingham said firms over-exposed to growth or illiquid assets may find themselves in a difficult situation when it comes to managing cashflow. Indeed, it said some 75% of FTSE 350 DB schemes with durations of 15-20 years have DB schemes that are already cashflow negative.
If cashflow is not adequately managed, schemes may be forced to sell down assets to meet liabilities at a time when asset valuations are falling. Forced sellers are likely to move further from their endgame and need to ensure the cashflow burden is factored into investment strategy as early as possible.
"As schemes have matured a general de-risking has been inevitable but corporates need to seriously consider whether they have gone far enough," commented Barnett Waddingham partner and head of corporate consulting Nick Griggs.
"For those close to the endgame, being proactive with your strategy is crucial in ensuring the level of investment risk matches the agreed objective, whether that's an insurance company buyout or a run-off," he added.
The firm said that illiquid assets may be a particular problem for some schemes looking for a buyout in the next five years - noting that, on average, 4% of assets are in property investments and are unlikely to be accepted by insurers as part of a premium payment for buyout.
The report says schemes expecting to transact in the next five to 10 years should also consider how they will shape the portfolio towards one that better reflects insurer pricing.
Barnett Waddingham said the funding positions of schemes are also threatened by low and falling interest rates over the long term - noting that schemes can do more to neutralise the impact of this and reduce the volatility of funding levels.
"Diversification in assets can protect schemes from the increasing cashflow burden but the key ingredient is a firm plan for the scheme's endgame," noted Griggs. Engaging with trustees on a long-term objective and a reasonable timeframe together with a risk management strategy is vital, he notes, adding that the investment strategy should support such a goal.
The Tate & Lyle Pension Scheme has completed a £930m full buy-in with Legal & General (L&G), insuring benefits for around 4,800 members.
There have now been a total of around 50 buy-in and buyout deals of over £500m announced since 2007. The full list, provided courtesy of LCP, is as follows...
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