A sponsored article by Hannah Simons, Schroders
According to the Pension Protection Fund (PPF)*, the average defined benefit pension scheme has experienced a “lost decade” – 10 years when funding levels have not improved despite significant payments from employers
And the uncertainties look set to continue this year. Whether it is the newly inaugurated Donald Trump as US president or elections in the Netherlands, France, Germany and possibly Italy, few are sanguine about the prospects for political stability in 2017. The result is that market volatility is back and likely to be with us for some time.
But every cloud has a silver lining and volatility also means opportunity. While liabilities may be difficult to pin down in this climate, growth assets can do well at such times. Whether it be managing erratic funding ratios or exploiting investment opportunities, it will be more important than ever for pension schemes to be both prepared and nimble.
Widen the search for matching assets
Schemes can prepare in a number of ways. Many already use liability-driven investment (LDI) approaches which should come into their own in these conditions. By locking in liabilities to matching assets, trustees can sleep that bit easier at night. However, while growth assets remain available for those able to accept the risks, the bigger problem has been finding bonds that are attractively priced for matching purposes. Government bonds (gilts) are particularly problematical right now, given that real yields on most are negative. This means liabilities – and therefore provisions – remain high, increasing the pain for the growing number of schemes whose contributions from the sponsor and members are insufficient to cover the pensions they pay out. In the absence of help from contributions, such schemes need to make their assets work harder.
One possible option for trustees in this situation is to seek an affordable solution by adopting “cashflow-driven investing” (CDI). Instead of a traditional growth portfolio using gilts, CDI uses corporate bonds and other credit assets which can provide both low-risk growth and the ability to match liabilities. Although it can be implemented on its own, CDI can achieve an even closer cashflow match between assets and liabilities if it is combined with a traditional LDI portfolio. The higher expected return of CDI assets relative to a gilt portfolio means a scheme
can achieve a close match with liabilities while maintaining the outperformance assumed in the technical provisions. For those trustees looking to manage their pension scheme on a long-term basis there are also potential cost benefits when compared to buyout pricing. Furthermore, CDI portfolios can often represent a “set and forget” approach, making them low maintenance for trustees.
Outsource the effort
If indeed we do see heightened volatility this year, it will be more important than ever that growth assets are managed flexibly, decisively and speedily. In other words, investors will have to be nimble if they are to climb the ladders and avoid the snakes. Unfortunately, that is inherently difficult for trustees who may meet only once a month or even once a quarter and who do not have the time and resources necessary to run investment portfolios effectively. In these circumstances, it will make increasing sense to sub-contract the management of all the growth assets.
This delegation can take a number of forms, but it need not be radical. A few larger schemes may be able to recruit their own investment experts to do the work. For others it may simply be a question of handing management responsibility to a small subcommittee that combines expertise with expedition. For a much larger number of arrangements, however, it is likely to be more cost-effective to let outside professionals take over the day-today management of not just the scheme’s growth assets, but also the liability-matching portfolio as well.
Apart from the gains in flexibility and speed, this should allow greater specialisation and more accountability. Trustees can discuss and agree both their objectives and favoured strategy for achieving them directly with the manager. Suitable financial incentives can be agreed to ensure that both manager and client are pulling in the same direction. That manager can then implement the decisions directly and be directly responsible for the results.
Move to manage risk
Of course, being nimble in volatile markets may not be enough. However good they are, active managers may not be able to take avoiding action if markets dive. Schemes that want greater protection may need to have at their disposal more systematic approaches. This could involve taking out “loss insurance” in the form of downside risk protection using, say, put options. Such insurance can be expensive, however, it could be combined with – or replaced by – strategies that systematically control equity volatility.
These approaches will be more effective if the same manager also manages the liability-matching portfolio and provides asset allocation advice. In what could be a difficult investment environment, such unity of advice could be invaluable. While the scheme may have a long-term de-risking plan, it is important that it retains the flexibility to deviate from that strategy from time to time. Having a manager on call should allow changes of tactics to be undertaken nimbly as circumstances change.
A single manager totally aligned to the objectives of the trustees with an overarching view of the whole portfolio is much better placed to advise on the scheme’s strategy. A single manager with all-round vision can much more easily decide the tactics to adopt and the risks to avoid. Any such manager should clearly have access to, and knowledge of, a wide range of investment tools and approaches in a selection of investment vehicles to suit different risk tolerances and budgets. Moreover, by having a single manager with access to a rich palette of investment approaches, both the growth and liability portfolios can be better tailored to the needs of the individual scheme. The result should be better and more timely decisions, which should in turn feed through into better results for scheme members.
