Defined benefit schemes need to change the way they look at long-term risk, find new frameworks and learn to say no to ensure a good future for their members, according to industry leaders.
Legal & General head of portfolio solutions Graham Moles and Electrolux group pensions manager Chris Clifton discussed the current risk environment for DB schemes at the Pensions and Lifetime Savings Association (PLSA) annual conference with PLSA head of DB, LGPS, CG and standards Joe Dabrowski.
Of all the issues DB schemes face, Moles said the current quantitative framework, in particular, is flawed, while too much of the investment strategy focus is on the short-term risk.
“It looks at the asset risk and at liability risk, it might be volatility, it might be value of risk or it might be funding levels. But what we really need to see in my view is an increase in focus on some of those longer-term risks as schemes continue to de-risk. Things like demographic risks and covenant risks,” he said.
One solution to the flawed framework is Proportions of Benefits Met (BPM), the sum of pensions paid divided by the sum of pensions promised.
Moles explained: “We look at the range of different scenarios and within each scenario, how successful has that asset strategy been in meeting all of the pension payments.”
The Legal & General framework also shows that if you have a bad rating, with about 20 years until the sponsor goes bust, taking on more equity risk in the short term is more beneficial than choosing a low-risk route which will guarantee failure.
Clifton, who is in the middle of changing the investment strategy of the Electrolux final salary fund, said risk is good, in the right context and for the right scheme: “Risk is a measure of uncertainty, not outcomes. I think we forget that a lot as an industry.”
The Electrolux strategy shift has come after Clifton calculated a worst-case scenario and found that it would still be cheaper than a buy-out.
He said: “We have been led by the same advice for years and years and years and the trustees have just said yes. To the trustees in the room: learn to say no, learn to argue. Start a fight. Too much of the pensions industry, I believe, is led by the big three, by the big four, we just follow them. Stop doing it.”
Clifton was also sceptical to the frequent use of calculated funding. “Deficits and surpluses on any one day are just an educated guess of future values and liabilities based on arbitrary investment returns at that specific day.”