The triennial valuation is also a useful point for trustees to check out a scheme’s overall wellbeing, finds Matt Scott
1) MAKE SURE YOU KNOW THE ASSUMPTIONS THAT MATTER, AND THOSE THAT DON’T
PAN Trustees managing director and independent trustee Roger Mattingly says: “Having an understanding of which assumptions make a difference and which ones don’t is key for a trustee. The discount rate is pivotal and it would be rare that that’s not the main assumption. Future inflation affects schemes to varying degrees but often the future inflation assumption is also vitally important.
“In the past, the changes to life expectancy have been quite dramatic but mortality assumptions are no longer changing as much as they were a decade ago.”
2) DON’T FORGET THE LIABILITIES; IT’S NOT ALL ABOUT GROWING YOUR ASSETS
“With small schemes, there is a tendency to focus on the asset side of the question, and not really look at the liabilities,” says Nick Boyes, managing director of Able Governance and an independent trustee.
“You need to match the assets to the liabilities, and not worry about the asset values going down because the liability costs will go down as well. It’s the overall funding level that’s important, not the absolute level of the assets.”
3) HEDGING CAN BE COST-EFFECTIVE, EVEN FOR SMALLER SCHEMES
“There are cost implications for very small schemes, but there are solutions to at least allow them to approximate some of the hedging opportunities available for larger schemes,” says Alan Baker, Mercer’s UK head of defined benefit risk.
“For some of the smaller schemes we’ve seen an increase in the number that have moved to fiduciary management solutions to access pooled funds and delegate some of that hedging and day-to-day management.”
4) INTEREST RATES CAN GET LOWER
Many trustees, especially of smaller schemes, think hedging strategies are too costly, given the prevailing low interest rates dominating the UK pensions market.
But Boyes says lay trustees are often too focused on the retail market to understand the dangers of institutional investing.
“Lay trustees tend to think of the retail market instead of the institutional market where if interest rates are low they can’t go anywhere but up,” he says. “That means lay trustees often don’t want to buy interest rate protection because they think things can only get better – but it has been proven that it can get worse.
“You have negative interest rates in Japan and it is not out of the question that that could happen here.”
5) REMEMBER CONTINGENT ASSETS WHEN NEGOTIATING, THEY CAN PROVIDE A USEFUL SAFETY NET
Mattingly says that contingent assets can be used as a negotiation tool to open up extra options for the investment strategy, as well as protection for if the worse happens and funding levels bottom out.
“Whatever those contingent measures are, they provide peace of mind if all hell breaks loose,” he says. “They’re also able to accommodate a more open-minded attitude as far as the investment strategy is concerned when in discussions with the employer. It also means that the options in terms of investment strategy can be slightly wider than if no such safety net measures are in place.”
6) THE EMPLOYER COVENANT IS ‘ALL ABOUT CASH FLOW’
“The employer covenant is about cash as much as anything,” Mattingly says. “A lot of the employer covenant assessment and monitoring is about keeping a beady eye on the cash levels and what is being spent in terms of the capital expenditure. Is it to grow the business? Is it to make sure it’s competing in different markets? Or is it just trying to tread water or damage limitation?
“It’s about getting under the skin of how the company operates and the only way to do that is to work closely with it, but not take everything at face value.”
7) GAIN INSIGHTS BY LISTENING TO NEW TRUSTEES’ ‘INTELLIGENT NAIVETY’
Mattingly adds: “For new trustees, the big thing is to understand the picture of what is trying to be achieved, what the risks are and not to be afraid to ask questions. If they’ve got the guts to ask naïve questions and can say: ‘Hang on, why are we doing that? Why has this been proposed? What’s the outcome of that?’ The outcome to the rest of the trustee board may be very obvious, but it may be obvious based on traditional and outmoded thought processes.”
8) THE SCHEME ACTUARY DOESN’T KNOW EVERYTHING
Aon Hewitt partner and scheme actuary Lynda Whitney says trustees can often rely too much on what the scheme actuary says without thinking about the wider picture.
“Don’t get sucked in too much into the detail of what the scheme actuary is saying,” she says. “Instead, focus on what it means in terms of cash coming into the scheme if things go as expected, and what it means in terms of security if things go wrong.
“The areas to focus on are the rate of investment return you are expecting, or discount rate, and also what you are assuming about the mortality assumptions for the scheme.”