Chasing Rainbows

It is becoming clearer and clearer that we need to find better ways to approach pension risk.

It is easy to blame Brexit for the woes afflicting UK pension schemes, but the sad truth is that it is only the latest in a series of reminders of the problems in the way our pension schemes are funded and invested.  Even before Brexit, the system was creaking.

For years, I’ve been talking to CFOs exasperated that the deficits in their schemes keep going up, despite the cash they have paid in.  Some I have helped to find better answers.

“The definition of insanity is doing the same thing over and over and expecting different results.”
Variously misattributed.

At the end of June 2016, after the referendum, the PPF 7800 index showed a deficit of over £380 billion. 

In the aftermath of the credit crunch, the PPF’s index only just touched £200 billion deficit in February 2009, even moving back into surplus by the end of that year.  Since November 2014, the PPF’s index has never shown a deficit less than £200 billion.

Some see the answer to be taking more investment risk: to spread more sails in the hopes of running before the storm.  That may prove to be a good course for some; I, for one, have doubts. 

Even if Brexit proves benign, we have all seen over recent years how unpredictable equity returns can be.  I also fear we may see years of disappointing returns as economic reality catches up with valuations plumped high by low interest rates and quantitative easing.  Can the employer – particularly now – really support a further increase in the deficit if that bet does not pay off?

“When you’ve lost your shirt, do you bet your trousers?”
A wise former colleague

Some are saying that we should change the measurement approach – that if we just close our eyes and pretend hard enough then the problem will go away.

Some accuse trustees of reckless prudence: that may be true of some, but I think the issue is more that prudence is not always looked at in the best way.  Some of the CFOs I talk to, burned by the experience of recent years, are more given to take a “prudent” approach than their trustees.

To see what a better approach might be, let us take a step back. 

For a defined benefit pension scheme, security of benefits at any point in time is determined, fundamentally, by three things:

• How much money the scheme holds;
• How confident the trustees are that they can get the rest of the money they need to secure benefits (i.e. contributions and covenant); and
• How likely it is that the investments underperform, increasing the amount of money needed

The funding target you set – the amount of money you hope to have – is only relevant insofar as it affects or reflects decisions taken on cash, covenant and investment.  Setting the bar higher does not increase security, unless it accompanies more cash, less investment risk or stronger covenant protections.

Sometimes, in a quest for “prudence,” I see stringent funding targets being set, but high levels of investment risk being taken in an attempt to square the circle.  Is that prudent?

Some are aiming to pass the benefits over to an insurance company as soon as possible.  That may be the right answer for some; however, the insurance market is only a drop in the DB ocean.  At £15 billion a year it will take many decades to deal with the £2 trillion of pension liabilities we have in the UK.

Trustees sometimes fixate on gilts as the “must-have” risk-free assets.  Yet even the gilt market may be too small for the task.  At the end of 2015, there only were £1.6 trillion of gilts in issue, of which £400 billion was held by the Bank of England.  According to Schroders, pension scheme demand for index-linked gilts is now five times the available supply.  There simply aren’t enough gilts to go round.

Where’s the harm, you might say?  You’ve got to have a dream.  After all, if you don’t have a dream, how are you going to have a dream come true? 

What if holding out for that dream creates a nightmare? 

What if pension schemes, addicted to gilts, become forced buyers, compulsively buying more and more gilts whenever they think they can? 

What if they become trapped in a vicious circle of rising gilt prices, falling yields and rising liabilities: the ultimate goal always remaining out of reach, because there aren’t enough gilts?

What if trustees, caught up in a headlong dash for a riskless nirvana, close their eyes to sensible steps that could reduce risk sooner? 

What if admirable goals become the source, not the solution, for risk as trustees try to fill the gap with equity returns, potentially putting benefits – and even the company – at risk?

What if that is already happening? 

Gilt yields – even after recent falls – remain higher than the yield on government debt in many other countries; yet Schroders believe they have already detected unusual movements in the market for index-linked gilts that they attribute to pension scheme demand.

Surely the prudent route – particularly where trustees have doubts about the company’s ability to make good on investment losses – is to take less risk now.

The CFOs I’ve been talking to crave stability.  They accept the need for deficit contributions, but they want to be able to build business plans with predictable levels of contributions; they want comfort that the deficit will come down.  The old approach has not delivered and they are keen to find a new one.

Before they leap into the arms of the insurance companies, pension schemes can learn a lesson from them.

If you transfer pension liabilities to an insurance company, they will build a portfolio of credit, property and other assets that produce income as close as practical to the benefits they need to pay out.  Gilts and LDI are used to smooth the bumps.

Pension schemes can do the same. 

Moreover, if the employer stands in for the insurer’s capital, expense and profit requirements then you would expect the cost to be less than the cost of paying an insurer to do it for you.  That lower cost means that, for the same cash contributions coming in, trustees need to achieve less investment return – and thus need less investment risk today.  Holding assets for income, rather than trading, means pension schemes can make the most of their ability to take a long term view.  The clear link between assets and benefits means that funding and investment strategies become closely aligned, removing much of the unnecessary noise.

Such a strategy may mean Trustees deferring their quest for a riskless nirvana; it may mean companies accepting the need to contribute for longer to support the scheme, but if it gives companies more certainty in their cashflow, trustees less volatility in their funding position and members better security over their benefits today – is that such a bad thing?