Pension schemes are realising the unpredictability of financial markets and looking for ways to manage its volatility while meeting their return requirements. Is there a way out?
Here’s the story of a small pension scheme which has managed this exceedingly well by following a disciplined and robust approach, delivering an impressive performance as a result.
Turning back to the summer of 2008, the Scheme (then with less than £100m in assets) is close to being fully funded on a buyout basis, but still with over 90% of its assets invested in equities and less than 5% in bonds. This might seem shocking now but many of you will know that it was not very unusual for those days!
By the time the trustees knew about the Scheme’s excellent position, it was too late. It’s September 2008; the financial markets had collapsed, the Scheme suffered a sharp deterioration in its funding position and a buy-out was out of reach.
The trustees became determined to take control of the situation and set up a framework to ensure this didn’t happen to them again. The first step was to set clear and realistic funding and risk objectives for the Scheme, then using this, to design a simple yet efficient investment strategy to achieve those objectives. The trustees adopted the use of derivative instruments to achieve efficiency and simultaneously put in place a dynamic de-risking programme to monitor the funding level on a daily basis. They would move from risky assets (e.g. equity exposure) to matching assets (e.g. gilts) as their funding level improved based on pre-set trigger and action points. They also had a plan to consider re-risking if things were to go bad.
The initial set-up required time and effort but the whole Trustee Board (yes, the whole Board and not an Investment Committee!) was more than willing to engage and work with the Sponsor and Investment Consultant to set up the framework and become comfortable with the dynamic process. Later on, the de-risking programme was automated and outsourced to their LDI manager.
After one and a half years of implementing this approach, the Scheme is now close to 90% funded on a self-sufficiency basis (more than 10% better funded than if it had not implemented this approach, with a funding level which is also now fully protected against interest rate and inflation movements. It has also reduced its equity exposure from more than 90% to less than 10%. All this has been achieved without impacting its recovery plan and in perhaps one of the most volatile periods of financial markets.
The conditions this Scheme faced are the same as any other. Some may say the Scheme had simply been lucky when making certain timely de-risking and re-risking decisions. Maybe that was the case; however, I myself believe that the key to their success is a combination of setting out to define clear and realistic goals and then adopting a disciplined approach when implementing the strategy. The decision to re-risk or de-risk was not based on “market sentiments” but a well-defined metric we call “required return to full funding”.
In recognition of its work, the Scheme has received three well-deserved pension awards during this period. I have had the pleasure to work with the Scheme as it has moved forward successfully on this path and the day the Scheme was fully hedged was perhaps one of the proudest moments of my professional life.