Navigating a pension scheme through these turbulent financial markets, while maintaining its course to full funding, is not for the faint of heart. Funding levels have dropped as falling bond yields and high inflation raise liabilities faster than investment returns raise the asset side of the balance sheet.
Sadly, nobody truly knows what will happen next in the Eurozone (EZ). Thankfully, there is a way to turn some of the ‘unknown unknowns’ into ‘unknown knowns’ via the power of ALM modelling.
At a recent trustee education event, Redington consultants provided an overview of the EZ crisis and tested the impact of various scenarios on two model portfolios:
- ‘Typical’ UK Pension Scheme
- ‘More Efficient Approach’
The key difference is a lower allocation to equities with extra cash being used to invest in assets with long-term, index-linked cashflows – such as social housing and secured leases – to better match scheme liabilities. To maintain expected return, a new allocation is made to diversified growth funds (DGFs) and macro hedge funds.
Redington has long been an advocate of robust risk management and Liability Driven Investment (LDI) - the results of these stress-tests highlight why we believe in this approach. The ‘More Efficient Approach’ brings:
- Slightly lower expected return, BUT...
- Much lower risk
- Much higher hedge ratios
That’s all well and good in a static environment but how would the portfolios perform if the Eurozone crisis spills over from Greece into Portugal, Spain, Italy etc? To test this we ran three scenarios, ranging from a disorderly default by Greece to a full break-up of the euro currency.
The results were pretty clear – the
funding level of the ‘More Efficient Approach’ portfolio was 9% to 14% better off than for the ‘Typical’ scheme (page 21).
To view the full presentation and stress-test results, please
click here.
[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]