Experts disagree on whether schemes understand the risks they are taking
Pension schemes believe they are smarter about risk than ever before – but some experts contend that some of the UK’s largest schemes are still taking too much of it.
UK pension schemes are becoming much savvier about planning for and managing risk, according to a survey of 220 UK defined benefit schemes by consultancy Aon Hewitt. An overwhelming 94% of schemes surveyed have a long-term objective (over and above becoming fully funded), compared with 70% in 2009.
Kevin Wesbroom, senior partner at Aon Hewitt, says: “Defined benefit pension schemes have undergone a wholesale transformation over the past decade and they are now much better equipped to identify and manage the risks they face. The credit crisis served as a wake-up call for sponsors and trustees, driving them to clarify long-term goals and put in place robust plans for achieving them.”
However, a separate new piece of research by covenant advisory firm Lincoln Pensions suggests that some big DB schemes are trying to invest their way towards full funding, without necessarily considering the associated risks.
Lincoln’s research team examined the risk profile of pension schemes in the FTSE 350. The team assessed the value of the underlying business which supports each pension scheme and cross-referenced this data against the level of investment risk the pension scheme is taking.
The results were surprising. On average, schemes with weaker sponsors are effectively doubling up by taking more investment risk in a bid to invest their way to full funding.
“This concept of trying to invest your way out of trouble using a risky investment strategy was not what we expected to see,” says Darren Redmayne, head of Lincoln Pensions and UK CEO of Lincoln International.
“The most critical issue is to actually get risk adjusted returns and not just to view risk as a strait-jacket.”
Redmayne describes how pension schemes can end up at the bottom of the priority list, whatever the prevailing economic climate, citing the Pensions Regulator’s sustainable growth objective as justification.
“Now that, generally speaking, companies are having an easier time of things, companies are saying to trustees, ‘We want to use this money within the company and look at the sustainable growth objective. We’re allowed to do that, so we’d rather do that than fund the scheme. We’d like you to continue to run on the investments. So yes we are more successful, yes we are more profitable, but we don’t want to put that into the fund. We want to use that for the company.’ They cite the sustainable growth objective as one of the reasons for doing that.
“The net result of that is that money doesn’t go into the scheme. That is evidenced by the fact that recovery plans are about three years longer.
“Then, when times get more difficult and you get back into a recessionary climate, the company then goes ‘I’d love to fund the deficit but I can’t.’ You can’t win. You’re not funded in the good times, you’re not funded in the bad times.”
A broad church
Several experts question whether it’s easy to come to any definitive conclusions by examining companies in the FTSE 350. Michael Clark, an independent trustee and director of Clark Benefit Consulting, points out that the FTSE 350 is a “very broad church” and that it only takes three or four pension schemes pursuing drastically different investment strategies to skew research findings.
Lynda Whitney, a partner at Aon Hewitt, suggests that increasing numbers of schemes are using liability-driven investment, which could also help to explain Lincoln’s findings.
Derivatives and other esoteric forms of investment often act as diversifiers within a pension scheme’s portfolio, so it could be possible for a scheme to appear to be taking substantial amounts of risk but actually to be well-diversified.
Whitney also points out that for schemes with long-term horizons, taking investment risk is not necessarily a bad thing. Stocks have performed strongly over the past few years, despite macroeconomic volatility.
It’s a point that Lincoln doesn’t dispute. The company’s managing director, Matthew Harrison, says: “[FTSE 350] schemes are large in the context of their employer. They have to deal with that scenario and so long as they are aware of the risks they are taking and are monitoring and staying on top of those risks, it doesn’t necessarily mean that it’s wrong. It means they ought to be knowingly accepting risk.”
Jean Keller, Argos Investment Managers’ chief executive, believes that pension funds ought to be relatively sanguine about long-term risk. “The more we constrain risk, the more we constrain returns. Ultimately the bigger hurdle pension funds have is to beat inflation,” he points out.
“Society should underwrite the risk of pensions going bankrupt”
He continues: “I am not suggesting for one minute that pension funds should invest 100% in equities. But using risk as a short-term measure of pension liability is not the right way to do it. If you tie it back to the Aon Hewitt research, the fact that 94% of schemes surveyed now look at long-term objectives really reassures me. I think that is really good news.
“The most critical issue is to actually get risk adjusted returns and not just to view risk as a strait-jacket. If you have a long-term objective, you are able to ride the volatility wave and invest in assets that will beat inflation.”
“It’s about rewarded risk,” agrees Clark. “Trustees are becoming savvier about rewarded risk. They’re also becoming savvier about unrewarded risk!”
Keller argues that if every scheme in the FTSE 350 were to take limited investment risk and receive limited investment upside in return, this constitutes a worse scenario for many more savers than a very small number of companies failing in an exceptional economic event, leaving the pension schemes stranded.
Keller says: “Society should underwrite the risk of pensions going bankrupt… If we have to save 5% of the employers, if we believe Lincoln’s report, that’s a much cheaper option than to having to provide a bridge income to retirees who haven’t had properly performing funds.”
He concludes: “You can’t plan pension benefits with the idea 2008 will come back every year. It simply will not. So because we completely killed risk in 2009, at the worst possible moment, we have missed out on fantastic returns in 2009, 2010, 2011. We should buy low and sell high and in fact we are doing the opposite.”