Today The Pensions Regulator has published new Investment Guidance for Defined Benefit Pensions Trustees.
They have set their guidance out in six sections:
2. Investing to fund defined benefits
3. Matching assets
4. Growth assets
In summary, the guidance is all very sensible and we are delighted to see a very strong alignment with the approach we have been using with our clients. Specifically, we would highlight the following key themes:
Risk. The most frequently mentioned word in the Regulator’s 2017 investment guidance, appearing over 400 times. This underlines the crucial focus on risk that is required to effectively manage a DB pension fund in today’s environment and deliver the best chance of good outcomes to members. It also re-enforces the modern trustee’s role as one of risk-manager as well as steward of the scheme’s assets.
Focus on the most important factors. Some DB schemes have successfully managed to buck the trend of falling funding ratios and widening deficits of recent years. In our experience, this has been driven by a relentless focus on a small number of really key factors that are the most influential on scheme outcomes: risk, hedging, long-term objectives, time period. We are therefore encouraged that TPR’s guidance focuses the minds of all trustees on this key point.
Begin with the end in mind. In our experience the single most significant factor in aligning the stakeholders of a DB pension fund, and enabling the trustees to take the right decisions, is alignment around a single common long term objective - hence we are very happy to see this feature prominently in TPR’s guidance. This focus works best when it looks beyond the regulatory “Technical Provisions” (TP) basis toward the desired end-point for the scheme, and works back to establish a journey-plan, and associated evolution of the TP basis to get there.
To bring the guidance to life, and to help trustees to test their current investment strategy against the new guidance, we have identified eight questions trustees should ask:
Eight Questions Trustees should ask following the Regulator’s Investment Guidance
Word Cloud from TPR DB Investment Guidance
1. Do you know the risk capacity of your sponsor, the risk budget of your scheme, and what the difference is?
Risk is a recurring theme in the Investment Guidance paper (the word appears around 400 times) which underscores the key role that risk management plays in generating good outcomes for pension schemes. Understanding the risk-bearing capacity of the sponsor and how this should affect the risk budget the trustees set is fundamental to setting the right investment strategy for the scheme, and maximising the security of members benefits. TPR’s guidance is clear that the risk budget is one of the most important scheme metrics - do you know what yours is, and are you clear in which situations this would increase, and when it would decrease?
2. Are your assets working as efficiently as they can for your scheme?
The second most frequently occurring word in the guidance is “assets”. Not surprising, given that investing to grow the asset base in order to have enough to meet liabilities is a key challenge for many DB pension schemes. Today’s investment landscape puts a great variety of asset classes and strategies at the disposal of trustees. Are you using the full range of diversifying strategies, including illiquid assets?
3. Do you know what you need to pay, and how this affects the scheme’s risk?
DB pension funds exist to pay the benefits to members as they fall due. Around £3 trillion of benefit payments are due to members of schemes over the coming decades; as the bulk of these paid schemes will turn “cashflow negative” when they start to pay out more benefits in each year than they receive in investment income from their assets. Our own in-house analysis supports the Regulator’s statements on this. High levels of net cashflow out of a scheme leave the scheme more vulnerable to underperformance, as it can change the effect asset volatility has on a scheme. Even if your scheme is not materially cashflow negative today, advance planning can identify thresholds and tipping points which can inform your Integrated Risk Management (IRM) planning conversations.
4. Are you clear on your beliefs?
It is worth getting clear (documented) agreement on your beliefs as a trustee board - such as what risks are rewarded, your attitude to liquidity, active management etc. - so you don’t have to repeat the conversation again and again. Investment beliefs are an important starting point for strategy and we are very encouraged to see the prominence given to them by TPR.
5. Can you get everything you really need to know about your scheme on a single page?
In our experience, better pensions scheme outcomes have been associated with a relentless focus on a small number of the most important scheme metrics. These can be delivered really effectively in a dashboard, as TPR suggest in the guidance. The challenge is focusing on a small enough number of metrics to have a really firm grasp of them - TPR mention many metrics that could be included. Our challenge to scheme trustees would be to try and get everything they need to know about their scheme on a single page.
6. Are you clear what actions you should take in response to changes of the key scheme metrics?
Having a dashboard is a great start. Reviewing the outputs it generates regularly (we would suggest quarterly) is even better, but what really matters for good decision making is knowing exactly what actions you will take as a trustee if particular metrics decline or increase. As a trustee, are you clear on what levers you have at your disposal if the scheme’s position deteriorates, or gets better? After all, knee-jerk decision making is rarely optimal - but neither is doing nothing.
7. Do you have the right metrics to get a handle on risk?
Taking investment risk goes hand in hand with the need to grow assets to meet liabilities. Risk management is about ensuring that journey is as smooth as possible, and trying to establish how severe any bumps in the road might be. There are a number of different “lenses” that can help trustees get a handle on risk. No single measure gives the perfect answer in all situations. What matters are measures that help inform better decision making, and give trustees a better handle of the chance of ultimately paying the benefits due. Are you getting what you need from your risk measures? A second opinion on these is never far away.
8. Do you know what implicit assumptions are embedded in the models used to calculate your risk?
As TPR notes, risk is often best understood with the help of an Asset Liability Management (ALM) model. Models, by definition, will always be a simplification of reality, with inherent limitations. But they can still be very helpful for decision-making. As TPR points out though, there can be inherent assumptions which are “baked in” to the structure of some ALM models. It’s very important that trustees understand what these are, as they represent risks that aren’t being explicitly measured. For example, as TPR outline, if an ALM model assumes mean-reversion of interest rates, the scheme could be exposed to the risk that rates fall (or remain the same), without this being explicitly highlighted by the model.