DB pension schemes need to increase certainty about potential outcomes to help them reach their chosen goal, says Jos Vermeulen of Insight Investment
Defined benefit (DB) pension schemes are at a watershed, with more than 80% effectively closed to new members and 40% also closed to future accrual.1 Many trustees and sponsors would like to move to an ‘endgame' that secures all their scheme's obligations, such as a full buy-out of pension obligations by an insurance company or self sufficiency with little dependency on their sponsor.
Problem: Most schemes don't yet have enough assets to fund all their liabilities. So how can schemes plot a sure path from where they are now towards their goal?
Finding the path
The first step, says Jos Vermeulen of Insight Investment, is to identify your preferred goal - such as a buy-out in ten years - so that you can explore a range of possible paths towards it.2 He says that schemes usually find that paths employing traditional ‘return seeking' strategies result in uncertainty. These strategies offer too wide a range of potential outcomes because of investment and other risks including inflation and longevity risk.
Insight argues that like an individual employee approaching retirement - moving from asset accumulation to decumulation - pension schemes moving towards endgames must shift their focus from return generation to outcome certainty. "Cash-flow negative schemes have shortening time horizons that leave much less time to recover from unforeseen shocks," Vermeulen explains.
Schemes have had to deal with the unexpected many times over the last decade including market volatility after the global financial crisis, prolonged low interest rates, the Brexit vote, and accelerated cash outflows after George Osborne's 2015 pension freedoms.
"So the key goal is to narrow the range of potential future outcomes", he says, using the wider toolkit now available in the pension scheme armoury. Insight suggests following three steps:
• Lock down outcomes by hedging liability risks including interest rates, inflation and longevity, often perceived as the most difficult risk to handle
• Solve the uncertainty problem by investing in contractual assets such as bonds to generate the cashflows and returns needed to meet obligations
• Manage liquidity to ensure the scheme can cover its outflows and avoid being a forced seller in difficult markets
The Insight team recognises that no solution can be 100% perfect, so schemes should create buffers by stress testing any residual risks such as reinvestment risk or the risk of default in their bond portfolios. They should also construct portfolios that preserve flexibility to help deal with any setbacks.
- Source: The Pensions Regulator, November 2018.
- Over half FTSE 100 schemes might be in a position to move to insurer buy-out within 10 years. See K. Kaveh, How Close Are DB Schemes to the Endgame?, Professional Pensions, 11 July 2019, pp.14-15.
Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
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Where the portfolio holds over 35% of its net asset value in securities of one governmental issuer, the value of the portfolio may be profoundly affected if one or more of these issuers fails to meet its obligations or suffers a ratings downgrade.
A credit default swap (CDS) provides a measure of protection against defaults of debt issuers but there is no assurance their use will be effective or will have the desired result.
The issuer of a debt security may not pay income or repay capital to the bondholder when due.
Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise.
Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.
Where high yield instruments are held, their low credit rating indicates a greater risk of default, which would affect the value of the portfolio.
The investment manager may invest in instruments which can be difficult to sell when markets are stressed.
Where leverage is used as part of the management of the portfolio through the use of swaps and other derivative instruments, this can increase the overall volatility. While leverage presents opportunities for increasing total returns, it has the effect of potentially increasing losses as well. Any event that adversely affects the value of an investment would be magnified to the extent that leverage is employed by the portfolio. Any losses would therefore be greater than if leverage were not employed.
This document is a financial promotion and is not investment advice. Unless otherwise attributed the views and opinions expressed are those of Insight Investment at the time of publication and are subject to change. This document may not be used for the purposes of an offer or solicitation to anyone in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it is unlawful to make such offer or solicitation. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment.
Issued by Insight Investment Management (Global) Limited. Registered office 160 Queen Victoria Street, London EC4V 4LA. Registered in England and Wales. Registered number 00827982. Authorised and regulated by the Financial Conduct Authority. FCA Firm reference number 119308.
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