At Redington we read with great interest the pension regulator’s DB funding statement 2016. I thought the four key takeaways from an investment perspective were:
1. Acknowledge the importance of negative cashflow, and plan for it.
“As schemes mature, liquidity planning is becoming an important consideration, especially where the cash flow requirements represent a significant proportion of the scheme assets. Market developments may mean that schemes are forced to sell assets at lower than expected prices in order to meet cash flow demands. This could put increased pressure on the scheme’s funding plans and on the sponsor for higher contributions over a shorter period than anticipated, affecting their plans for sustainable growth.”
Our recent work with clients really supports the need to plan in this way. In particular, it shows that schemes paying out a significant percentage of their asset base each year are in quite a different position, from a risk and ALM perspective, than those with low levels of net outflows. While this is an entirely expected (and intended) development as schemes mature and pay out the benefits from the asset pool, it does result in a significantly increased risk exposure to path dependency which necessitates using a different set of risk lenses from conventional measures such as volatility and VaR to evaluate. This will allow trustees to understand risk (and possible mitigations) and make more informed decisions, including implementing investment strategies that better take into account the scheme’s position.
We believe this is an important issue for UK pension schemes to be aware of. TPR placing increased emphasis on this is very helpful in bringing this to the mind of pension schemes, trustees and their advisors. The questions we hear most often from schemes are “at what level of cashflow should we start really looking at this?” and “what metrics should we track?”. I think these are questions that advisors, the industry generally and possibly TPR should look to answer and provide guidance on over coming years. Ultimately, we believe these considerations should be captured in a scheme’s IRM.
We look forward to contributing to advancing this important issue for the industry - keep an eye out for some imminent research that we’ll be releasing on this topic.
2. Longevity & life expectancy - Live Long & Prosper?
“The 2015 version of the Continuous Mortality Investigation model (CMI2015) produces life expectancies that are lower than the 2014 version. “
Contrary to longer-term trends, experience in the last 5 years has implied a lower level of life expectancy. While this may be “good” news for many schemes, in a financial sense, this has particular implications for schemes who have enacted longevity swaps in recent years, as they may need to adjust their strategic asset allocation to allow for the collateral that needs to be posted if and when the contract takes on a negative value.
The timing of this change means that many of the longevity swaps that have been executed to date (ie, since 2009) currently have significantly negative value to pension schemes. One thing that some of these contracts allow for is a provision for either party to request a review of the mortality assumptions underlying the fixed leg of the swap valuation. This is something that trustees in that situation should consider.
It also provides an interesting perspective to debates around longevity risk and the cost of hedging - while longevity hedging may be appropriate for some schemes recent experience reminds us that this isn’t a “one-way” risk.
3. Control the controllables - know your risks and be ready to adjust if appropriate
“As part of their IRM approach, trustees should decide how much and when to hedge against risks. Trustees should be aware of the degree of risk which remains un-hedged, including any tail risks.”
TPR has long advocated an integrated risk-driven framework for pension schemes, an approach we fully agree with. Indeed, we see a high correlation between schemes that have implemented such frameworks in recent years and those that find themselves better funded with less exposure to sudden market movements.
Pension schemes are complex and face a great many event risks that they cannot directly control - such as the result of the EU referendum, the possibility of a China hard landing, decline in the oil price or unexpected Fed hike. What schemes can control are the investment risks they are exposed to directly, these can be understood by in-depth asset-liability modelling (ALM), the aim of which should be to inform trustees such that they can make informed choices as to the risks they do, and don’t want to run (the controllables).
Many pension schemes will need to run some level of investment risk, in order to generate the returns they need to be fully funded. What schemes can choose are the risk exposures they wish to take, and that they believe are rewarded.
Another issue that has historically plagued many UK pension schemes is the inability to adjust to incorporate new information (such as unexpectedly bad or good news) in a timely way- we welcome the focus that TPR is bringing to the need to be dynamic in adjusting strategy as we believe doing this can lead to materially better outcomes for pension schemes (and their corporate sponsors) over the longer term. However, it does require schemes to put the necessary governance and delegations in place up front to achieve this (look out for more thinking from us on this important topic shortly).
“This can include considering the risk/rewards of their current strategy against alternative approaches and being in a position to identify opportunities to adjust the strategy in a timely manner, as appropriate.”
4. Mind Your Mean Reversion
“Trustees who continue to assume that gilt yields would revert to a higher level and/or sooner than implied by the markets (‘yield reversion’) should reconsider their assumptions in light of market developments. This should include whether it would be more appropriate to assume reversion over a longer time period and to lower levels than before.”
We understand that many schemes and advisors build mean-reversion of long dated interest rates into their assumptions for the future. Whilst that isn’t an approach we advocate, I can acknowledge some of the arguments often put forward in favour of it. What recent history shows us is that mean reversion is not guaranteed, and indeed interest rates can move substantially in the opposite direction to what is expected, for long periods of time.
We believe it is very appropriate and timely for TPR to ask schemes to reconsider their assumptions around mean reversion, and that scheme trustees should continue to ask themselves whether it is appropriate to build long term projections around an expectation of this happening. As mentioned above, schemes do indeed need to take investment risk in order to reach full funding, but historically this has been a particularly poorly rewarded trade, to which schemes have had outsized exposures.
We acknowledge that many schemes will want to incorporate strong views on interest rates into their future plans, we encourage them to right-size that risk relative to other risks in the portfolio.