In what has been a turbulent year for pension funds, David Adams reveals what’s really going on with pension scheme funding

It’s not been a happy year for pension schemes and at the time of writing it’s getting unhappier all the time. At the start of October the Pension Protection Fund (PPF) announced that there had been another leap in the aggregate shortfall in UK corporate pension schemes: from £117.5 billion at the end of August to £196.4 billion a month later, closing in on the record level of £208.6 billion reached in March 2009. September had seen the FTSE All-Share Index fall by more than six per cent; and long term bond yields by an average of 0.5 per cent. The PPF has calculated that every 0.1 per cent fall in gilt yields raises pension scheme liabilities by two per cent.

Nor do these figures take into account the sharp falls in UK government gilts that have followed the latest round of quantitative easing (QE), during which the Bank of England will buy £75 billion of gilts before February 2012. The announcement of QE prompted the NAPF to call for an emergency meeting with The Pensions Regulator to discuss the negative consequences for scheme funding. David McCourt, senior policy advisor at the NAPF, told Pensions Age that the organisation and the regulator have been in phone contact and are trying to set a date for formal discussions.

Yet one could argue that many scheme trustees and employers should not be worrying so much about current market volatility. Pensions ought to be about the long term. “Clearly, if they have valuations coming up at the wrong time then their results are going to look a lot worse than they might have expected and that’s going to impact funding negotiations,” says Atkin & Co actuarial and consultancy firm managing director Chris Atkin. “But the thing is not to overreact to downward market movement.”

BlackRock managing director, UK institutional business, Mark Johnson says schemes’ strategies are broadly based on the strength of their covenant with the sponsoring employer. “Those with a strong covenant have been taking risk off the table, moving into fixed income assets, sometimes using LDI strategies and looking to diversify portfolios,” he says. “If you’ve got a strong sponsor you can take less risk. With a weak sponsor you’ve got to diversify. That’s why we’ve seen a significant growth in alternatives, from hedge funds to other asset classes.”

Of course, volatility can create investment opportunities too, but the most important questions are about the longer term. The trend towards de-risking continues, despite the financial turmoil and the effects of QE on gilts. Barnett Waddingham partner and actuary Paul Hamilton says he has seen more interest in ‘dynamic’ de-risking, a proactive approach involving close monitoring of assets and liabilities to enable actions to be taken at the best possible moment; and more use of absolute return strategies to manage growth assets.

There is also a growing tendency for schemes to consider the use of some kind of insurance option, whether through tools like longevity swaps, or a buyout. Actuary and consultancy firm HamishWilson managing director Hamish Wilson warns against schemes rushing down this line. First, he asks, “Is your sponsor strong enough to withstand the storm anyway? If he is then that insurance might be an unnecessary distraction and an inappropriate way to use scarce resources.

“The key thing is cashflow,” he continues. “With strong cashflow you can take your time, there’s no need to panic.”

But he acknowledges that in some cases the cost of running a scheme is becoming unbearable. “Smaller and medium-sized schemes are finding that the costs of managing the whole thing are just getting disproportionate,” he says. “So even though the costs of buyout are horrific, there will come a point where it is economical to do it.

“That’s at the smaller end. In the middle there’s a tendency to start planning for buyout in five, 10 or 15 years’ time, because if you don’t plan, you won’t make it. At the top end – and to some extent in the middle too – where they can’t afford a buyout, they’re tending to do a ‘DIY buyout’, where they’re doing what the insurance company would do: they move the assets into risk-free, or lower risk assets and they bolt down all the risks. You do need money to do that, but even without money you can still start planning.”

The ongoing funding crisis has done a great deal to change the way trustees work. “A lot of the schemes we deal with now have the investment making decisions delegated to a smaller group who meet more regularly and often include experts and independent trustees,” says Johnson. “We’re also seeing, for those schemes that don’t have a governance structure that enables speed of implementation, an increased interest in an outsourced solution, fiduciary management, appointing someone to manage the portfolio and take those decisions for the trustees.”

Beyond this recalibration of investment strategies and trustee decision-making, the funding crisis is also having a significant effect upon – and is then in turn influenced by – the relationship between the scheme and its sponsor. Hamish Wilson believes tensions have been exacerbated in some cases because of a wrong-headed approach to regulatory compliance.

“Often what happens is that people end up doing a tick box exercise, a bottom-up approach,” he explains. “There is a much more proportional way – which the regulator is promoting – a top-down approach, where you ask what’s the most efficient way to do this?

“If they take a top-down approach they will end up reducing their costs – and that would do wonders for the other part of the covenant: the willingness of the sponsor to pay. So I do think trustees and their advisers should be looking at being more proportionate.”

It’s also notable that more employers are considering the use of contingent assets to supplement funding, by passing on income from an asset, such as a property investment, to the scheme.

In the end, trustees must demonstrate a full understanding of the predicament in which many sponsors find themselves. “For a lot of sponsors, attention is concentrated on running a business that survives and makes profits,” points out Atkin. “Which is ultimately to the benefit of the pension scheme.”

Looking a little further into the future, is it possible for trustees, sponsors and scheme members to feel any optimism about the chances of the funding gap being closed? “There’s a greater recognition of the structural problems that we face and more people are doing things about it, so that’s good – but the problems are still significant,” says JLT Pension Capital Strategies managing director Charles Cowling. “I see more things to worry about than to be positive about.”

And yet, as McCourt emphasises again, trustees and employers should always be thinking about the long term. “Although it can be worrying to see bad numbers in each full valuation cycle,” – and as he points out, some schemes have now seen these for three such cycles in a row – “pension funding is a long game,” he says.

Still, schemes should be doing some forward planning for the shorter term, says Lane Clark Peacock senior partner Bob Scott.

“Schemes need to be prepared for different scenarios,” he says, “from a fast recovery to stagflation; and need to be asking, in each scenario, ‘is our funding strategy sufficiently robust?’ ‘Is there some action we can take that protects us against the worst downside but doesn’t give up too much of the upside if we have a fast recovery?’ I think it’s important not to just sit on your hands. There are things you can or should be doing or considering to improve your position.”

And perhaps trustees and sponsors alike should try to hold onto the idea that in this case at least, the chancellor’s slightly unconvincing mantra does hold true: they really are all in this together. “Use this experience to try and better understand dynamics and risks and to have a good dialogue with your sponsor,” advises Hamish Wilson. “A better dialogue is the best way to navigate the future.”

Written by David Adams, a freelance journalist

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