Executive summary
What is each day, but a series of conflicts between the easy way and the right way? An immeasurable number of potential courses of action fan out ahead of us, each promising the path of least resistance and mixed potential for success. With pension deficits being reflected on corporate balance sheets, equity markets close to record highs, government bond yields close to historic lows and the promise of the first UK interest rate rise in close to a decade just around the corner, never has making a decision (let alone the correct one) been more of an issue for pension trustees. This poses the daunting question, “what are pension trustees to do”? In order to answer this question, we need to unlearn the classic “asset-only” approach to managing pension schemes (setting aside “conventional wisdom”) and formulate a dynamic framework for managing pension funding risk.
At Quantum Advisory, we believe a dynamic strategy that focuses on managing pension schemes’ funding level should be sought; while remaining responsive in order to capitalise on favourable financial market conditions as and when they arise.
Unlearning conventional wisdom
A pension scheme’s funding level is the result of the continuous interaction between assets and liabilities. Why then, historically, has the management of pension scheme assets been the sole realm of investment advisers and scheme liabilities the remit of actuaries? Pension trustees are increasingly realising that a clear understanding of the relationship between pension scheme assets and liabilities is required; migrating from managing assets and liabilities in isolation to holistically managing the pension scheme funding level. This holistic approach will allow trustees and sponsoring employers to meet their two key objectives:
(I) To achieve full funding on an agreed funding basis; and
(II) Minimise the cost of failure (i.e. a low expectation of significant, unbudgeted contributions).
Dynamically managing pension funding risk
If the recent financial crisis taught investors anything, it is that risk is dynamic and ever present; threatening to derail pension scheme recovery plans and corrode corporate balance sheets. Why then, do pension schemes adhere to static investment strategies that fail to adjust for the dynamism of financial markets? Against this ever changing backdrop pension trustees are increasingly recognising the requirement for a “dynamic de-risking” strategy i.e. a framework that establishes the end destination of the pension scheme and a “flight-path” (or plan) for getting there.
A dynamic de-risking strategy allows pension trustees to react to market conditions; assisting in meeting/adhering to the pre-determined flight-path. Specifically, trustees may wish to de-risk pension scheme assets as the funding level improves above that previously expected under the flight-path; with excess exposure to riskier assets (e.g. equities) being transferred to assets that exhibit scheme specific liability matching characteristics (e.g. Gilts or swaps). The idea is simple, pension trustees adopt those risks necessary to achieve the end goal; nothing more and nothing less.
Pension schemes that match their liabilities will see a negative/positive investment return as Gilt yields rise/fall (remember, as Gilt yields rise/fall, the value of Gilts fall/rise). If this matches the decrease/increase in the value of liabilities (remember as Gilt yields rise/fall, liability values fall/rise), the funding level would be protected. Therefore, pension trustees have embarked on a strategy for reducing funding level volatility. This raises the difficult question, “what proportion of liabilities should be “protected”?” Unfortunately, this question underlines the traditional static approach to investing pension scheme assets. The level of liability protection varies with changes in market conditions and pension scheme and sponsoring employer circumstances; the specific triggers for de-risking are the result of an iterative process involving the pension schemes trustees, sponsoring employer and investment adviser. Increased protection is typically purchased as: (i) the pension scheme funding level improves; (ii) interest rates rise; and (iii) risk appetite wanes.
The attraction of dynamically managing scheme assets is clear. Those pension schemes following such a strategy over the past two years will have benefited from rising Gilt yields (and thus an improving funding position), while mitigating the extent the scheme funding level fell as Gilt yields began to fall.
Conclusion
The greatest dynamic de-risking strategy in the world is of little use without the necessary supporting infrastructure. It is not sufficient for pension schemes to simply identify opportunities to de-risk; they need to be poised to act on such opportunities before a potential reversal. Timing is everything! At Quantum Advisory we have developed tailored trigger based de-risking strategies for many of our clients. The key is to develop a de-risking strategy that allows schemes to de-risk quickly and efficiently without hindering their ability to achieve funding level targets.
Scott Edmunds – Investment Consultant