With the Pension Regulator’s focus now on Long- Term Funding targets, Gerard Francis takes a look at the investment strategies that can help achieve them and considers why maintaining a higher return target over the near-term is likely to be the best option.
As schemes mature many are looking to become self-sufficient; reducing their reliance on a sponsor who may or may not be around in the future. Everyone has their own interpretation of what this means in practice, but it usually centres around reducing investment risk to avoid having to rely on the sponsor in all but the most extreme of circumstances.
The principle is sound enough, but a scheme can still find its liabilities increase independently from its assets. This might be caused by demographic risks, political interference, legal judgements or even trustee decisions, such as around discretionary benefits or actuarial factors. These risks cannot be readily hedged, and once investment risk has been reduced these ‘liability risks’ become the dominant influence on scheme funding. Trustees’ options at this point may be limited, but planning ahead and having the right investment strategy in place can provide greater flexibility should things go wrong in the future.
When deciding on how to achieve a long-term target trustees often prefer to target lower returns, and hence lower risk, in the expectation of a smoother journey (option B set out in the box). Whilst this may be true for assets it may actually make things worse when it comes to dealing with liability risks.
To illustrate why, let’s consider a scheme looking to achieve selfsufficiency within 15 years to see how targeting greater returns now can provide a better outcome.
When designing a journey plan, trustees have to make a fundamental decision:
A. Maintain a higher growth allocation in the short-term with the intention of reaching their long-term target in, say, 5 years before switching to a low risk ‘selfsufficiency’ portfolio, or
B. Have a lower initial allocation to growth assets but maintain this more consistently across the whole 15 year period.
Both are expected to achieve the self-sufficiency objective within 15 years but each takes a very different path to get there.
Option A targets a higher return in the early years of the journey. If things play out as expected then the scheme builds up assets more quickly and reaches its target earlier. This provides greater flexibility in how to secure benefits and gives a buffer against adverse asset and liability shocks. It also allows the scheme to move to its longterm, low risk portfolio sooner. This means lower risk exposure in the second half of the journey plan when there is both less certainty over covenant and less time to recover any losses.
That sounds like the ideal outcome, but of course a higher return target inevitably means accepting higher risk. To consider what this might mean for a scheme, let’s look at a few of the key scenarios which may arise:
- A negative shock may occur early in the journey, before growth has allowed assets to build up a buffer. In this scenario, the funding level is likely to fall below that under option B, all else being equal. Not an ideal outcome, but it occurs when there is the greatest certainty over covenant and the longest period of time to recover before the end of the journey plan.
- If a negative shock occurs after, say, two or three years of the journey then the situation is more nuanced. The scheme will have built up more assets than under option B before the shock occurs. This means, whilst the fall in funding level may be larger, it is starting from a higher point; so the minimum funding level may still remain above that of option B.
- If a negative shock occurs later in the journey, say in years seven or eight, then option A gives a much better outcome. Having already achieved full funding against the long-term target the scheme would have already switched into a lower risk, lower volatility, asset portfolio. The potential impact on funding level is both lower in magnitude and, with more assets already built up, far less likely to put the scheme back into a shortfall than under option B. This fits well alongside the much lower certainty surrounding the sponsor covenant that far into the future.
- After 15 years the scheme would expect to have achieved its long-term target under either option. Despite having de-risked the investment portfolio, liability risk remains and could still reduce funding significantly, potentially by 15% or more in a worst case scenario. For a scheme which thought it was self-sufficient with a low risk investment portfolio, this level of shock could be catastrophic. It may take 20 years or more to recover this level of loss unless the investment portfolio is re-risked – something most trustees are uncomfortable contemplating – and which may be completely impractical given the maturity profile of the scheme.
Again, option A softens the blow. Having achieved selfsufficiency ten years earlier, the scheme would be better funded – it has an extra ten years of returns from its selfsufficient portfolio in the bank – and will retain this margin indefinitely. This provides a buffer against all future shocks, whether to the assets or liabilities, shortening the period to recover the loss and reducing the chance of having to re-risk the portfolio.
A higher return target over the short-term is not a magic bullet. However, provided the covenant can support the level of risk being considered in the short-term then looking to achieve your long-term target more quickly provides more options should the unexpected happen. It could also bring forward the date when a scheme may ultimately have enough funds to buyout all of its liabilities by several years. It is why River and Mercantile believes this is the better option.
Director – River and Mercantile Solutions