Redington welcome the PLSA DB Taskforce’s work and focus on the challenges facing DB schemes.
We have replied to the Taskforce’s Call for Evidence with our own views and experiences from working with schemes. Below is a summary of the key points from our response.
Schemes face many challenges in a volatile macro environment. Generating the returns and contributions to give members financial security in retirement will remain a challenge for at least the next decade. This is the challenge we have tackled with clients over the last 10 years. Continuing to do so is central to our ambitions as a business.
This problem is not intractable. We believe with the right mindset, collaboration and advice it is possible for schemes to navigate these challenges. There are several examples we can point to.
Data shows that, while the average financial position of pension schemes is challenged, there are many schemes with more favourable financial positions, having got there from a position of weakness. The tools and expertise pension schemes can use to place themselves on a more sustainable and stable footing have existed for years. Their application, however, is far from universal.
A key question must be, why is this the case?
As we put together our response to the call for evidence, there were three themes we felt were most important. They are:
The member benefit perspective
There are many competing objectives and stakeholders of DB schemes (as laid out in the Call for Evidence). We think it is important to remember the overriding goal of each DB scheme is to pay member benefits as they fall due. Prioritising this can help align stakeholders and make decision making more effective.
Look at the success stories
The Call for Evidence presents considerable challenges facing pension schemes. Yet the picture is more nuanced than presented. Some schemes have been able to move from positions of poor financial health to much stronger positions. A thorough analysis of what has created the conditions for this to happen is just as important as the broad picture facing all schemes.
Governance & regulation are key
Our experience suggests better governance is a key determinant of better outcomes among pension schemes, for a number of reasons. UK pension scheme governance has been documented several times over the last decade or more (including the Myners review of 2001). But decisive change has been elusive, and best practice is not universally applied.
Largely we didn’t disagree with the facts around the current DB pensions landscape as presented in the Call for Evidence document. However, we felt there were a couple of key additional considerations that needed to be kept in mind alongside those presented in the document, in order to gain a full picture.
Below we briefly outline the four most significant bits of context that we felt were important to add to the landscape described in the Call for Evidence.
1. The financial risks to member benefits are better understood and controlled than they were a decade or more ago
The primary goal of DB schemes is to have enough assets to pay the members’ benefits as they fall due. A significant development that has strengthened this is the launch of the PPF. Another is improved understanding of tools to manage the financial risks in DB pensions. However, while these tools exist, their application is not uniform across the industry.
The financial theory of defined benefit pension schemes was developed as a concept in the mid to late 1990’s. It extended commonly-accepted business principles regarding the valuation of cashflows in a business to a DB pension.It concluded that the liabilities of a DB pension scheme were bond-like, and risks could best be understood through an immunisation lens - similar to common practice in insurance.
The combination of these (and other) factors led to the development of what became known as Liability Driven Investing (“LDI”) and the immunisation of more and more of the liabilities of DB schemes against fluctuations in interest rates. According to research by KPMG, £746bn of liabilities were effectively immunised (or hedged) as of July 2016.
This is a significant development which has helped prevent DB schemes being in a worse financial position than they are currently. A key point is that we believe this trend has been driven by an understanding of how best to manage risks in a DB pension fund, and not by regulation per se (the regulatory landscape that applies to DB pension funds in the UK allows considerable scope of flexibility, in our experience). Alongside this, equity allocations have reduced. These two changes have substantially reduced the risk of large falls in the funded status of schemes (by our calculations the risk has roughly halved). This is a positive development in a volatile and adverse environment.
Alongside financial risks, the understanding of covenant risk has also advanced. This risk is important to member benefits, due to the size of contributions required from the sponsoring employer to close the deficit and having enough assets to pay benefits.
We believe a key goal and challenge of the industry should be integration of covenant and investment risks. Specifically, in a way that gives trustees useful, actionable information and helps them make better decisions.
Historically, fundamentally different approaches in these two areas and the “siloed” nature of how expertise has developed have hampered the development of a fully integrated solution.
2. Time horizon of pension schemes
The time horizon of pension schemes from an investment perspective is often described as long term. Today, this generalisation looks less and less relevant. Research from Hymans Robertson shows around half of DB schemes are in a position of negative cashflow (whereby they begin to pay out their assets in pension benefits over and above what they receive in contributions). Our analysis shows when this becomes significant, it is no longer accurate to describe these pension schemes' investment horizons as long term.
Further, schemes with weak sponsoring employers need to factor this into their investment horizon. Consequently, they may reasonably conclude they are no longer able to adopt a “long term” view.
Analysis of DB pension schemes needs to capture this nuance. Currently, there is sometimes a reliance on the simplifying assumption that all investment horizons can be described as long term.
3. Interaction with the real economy
We believe, from an investment perspective, the real economy needs to serve pension schemes, not the other way round. In the past, schemes held large equity allocations as their time horizons were then long term. Equities historically provided the returns needed to deliver salary increases in pension benefits. Today, most schemes still need to generate investment returns to have enough assets to pay benefits. In most cases, it is logical to invest assets by providing capital to productive enterprise in the real economy and earn an appropriate return. We believe that the need therefore exists for pensions schemes to invest in the real economy.
One thing that has changed over the last decade is the characteristics of preferable assets for pension schemes. Equities, with fluctuating market values and uncertain dividend payments have become generally less attractive. Assets that generate contractual cashflows have since become more attractive, one of the challenges when allocating to these asset classes can be excessive demand relative to the supply of assets.
In our experience working with schemes, governance is a key determinant of successful outcomes. Schemes that can organise themselves so the right decisions are made in a helpful and timely manner have fared better. For small schemes, the challenges of scale and accessing good trustees and advisors without creating disproportionate costs can be challenging. This suggests there is room for some consolidation at this end of the spectrum.
For mid or larger schemes, we observe a range of governance outcomes, depending on issues including:
expertise and background of decision makers and advisors,
levels of delegation
collaboration between stakeholders.
More guidance and standardisation of best practices across the industry could be beneficial.
Paul Myners set out several principles in his 2001 review of pension scheme governance. This review and associated principles form a notable part of the DB pension landscape. Many of the principles are just as relevant today as when they were written 15 years ago.
Suggestions for ways to resolve the challenges are:
A stronger regulatory environment which would give trustees, or the Pensions Regulator increased weight and proactivity in negotiations with the corporate sponsor
A clearer roadmap for working to offer alternative forms of security, or prioritise funding of the pension scheme in the event of corporate restructure.
A stronger framework for recognising and correcting substandard governance among pension schemes.
A better system for communicating a clear best practice in pension governance, risk management and investment strategy. Plus, sharing and socialising the industry’s success stories.
Recent newsworthy cases including BHS have raised the profile of some of these issues and provided some impetus and context for change.
We look forward to interacting with the DB Taskforce and contributing to their important work over the coming months.
You can download the Call for Evidence from the PLSA’s website by clicking here.