Richard Batty, fund manager within the multi- asset team at Invesco Perpetual, says: “Many schemes historically underestimated their liabilities due to life expectancy, so there is a continual need for a return vehicle to ensure they remain fully funded – a growth element to cover unexpected liabilities and risks.”
Wage inflation
Batty points to another, largely unhedged risk – wage inflation.
For defined benefit schemes which link benefits to final salaries and still have an active member contingent, the prospect of wage inflation is another real risk. After nearly six years of falling real wages, the tables have finally turned, according to data issued by the Office for National Statistics (ONS) in April. Weekly wages, including bonuses, rose 17% in the year to February while inflation, as measured by the Consumer Prices Index (CPI) was also 1.7% in February, but fell to 1.6% in March.
Although pension scheme liabilities are linked to the higher inflation measure of the RPI, the direction of the relationship between wages and inflation should not be ignored as the margin will likely continue to decrease with wages eventually exceeding RPI too.
“Skills shortages in an increasing number of sectors could lead to higher wage inflation in the future,” Batty points out.
Building a return engine
In consideration of factors such as swapbased, longevity and wage inflation risks, few schemes (even where fully funded) can afford an entirely LDI strategy. “They need growth assets, termed ‘alternative matching’, to provide the scope for growth to create a long-term link to liability risks,” SSgA’s Kearns says.
Aon Hewitt’s Giles believes: “Having a contingency margin by putting around 10% of assets into a return engine to hedge against unhedgeable risks would be sensible.”
Importantly, however, those assets cannot be purely return-generating. They must also offer a degree of capital preservation and should spread risk across a range of different market risk factors in order to avoid bubbles.
“Make sure the investment return vehicle is fit for purpose,” Batty warns. “Valuations issues can make some single asset class funds problematic. It is important not to pigeonhole an investment vehicle into a single asset class that may periodically be expensive, as market timing asset classes can be notoriously difficult. Any investment vehicle used has to have capital preservation qualities as well as the prospect of earning a reasonable return in order to work for underfunded schemes. For fully-funded schemes the low risk attributes of an investment vehicle will also be vital.”
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