Gilt markets can be as volatile as EM debt
Any defined benefit trustee board that found itself running short on collateral to cover the fund's LDI portfolio can take comfort in the idea that the circumstances could not have been anticipated. But as the saying goes, 'Fool me once, shame on you; fool me twice, shame on me' – we must be prepared to face such a challenge again.
So our first challenge (for defined benefit schemes) is to balance capital efficiency with collateral prudence. The need for higher levels of prudence may mean other things have to give – some schemes will have the choice of lower levels of growth assets (pushing out the expected date that self-sufficiency, or buyout, will be achieved), or accept lower hedge ratios, making that funding journey more volatile. Many schemes cut their hedge ratios while the Bank of England was offering support to the gilt markets, in the two weeks post the crisis, not knowing how markets might behave when that support was withdrawn, and now boards must decide whether those hedges should be re-established or there is a new hedge strategy and if so, for how long.
The gilts crisis had implications for defined contribution schemes too. Trustees with significant allocations to gilts in their near retirement default strategy need to challenge themselves on whether this is appropriate, particularly where experience shows members have been taking cash or drawdown solutions at retirement, rather than the annuities that gilt strategies are designed to hedge.
But then coming out of gilt strategies now might be slamming the door after the horse has bolted – drawdown became popular because of just how little income an annuity bought you. Higher gilt yields could mean a revival in at-retirement annuities.
Do we need to rerisk?
The funding of many schemes will have suffered as a result of the gilts crisis. This is particularly the case for those that got whipsawed. Some LDI managers unilaterally sold hedges in the crisis at the peak of gilt yields, but re-established the positions as soon as there was adequate collateral to do so (ie when gilt yields had fallen substantially).
Many trustee board then realised that in this new world they had insufficient collateral, so they then sold part of their hedge again, while other schemes were doing the same, putting new upward pressure on gilt yields. This was a sell low, buy high and sell low again strategy that didn’t do funding any favours at all. As a result, they may need to reallocate to growth assets to keep their funding plan on track.
Or can we buy out?
Schemes with low hedge ratios have, for valuation after valuation, been asking their sponsors for more funding as falling yields have increased deficits.
However, these are the schemes that may have suddenly found themselves well funded. The asset falls on their portfolio will have been outstripped by the fall in the value of their liabilities as rates rose. On paper it may appear that they can buy out, and many will likely wish to do so.
But there are challenges here too – preparatory work is needed, now more than ever, when insurance companies can pick and choose who they quote for. Schemes with poor member data quality or without rigorous specifications of benefits by section (and generation) may find the insurance industry turns its nose up at them. So the 2023 challenge is maintaining solvency funding levels while getting their houses in order.
The case for illiquids
Pressure is mounting on DC schemes to consider allocations to illiquids. Statements of investment principles will soon need to justify why DC schemes don’t hold illiquids, if they don’t hold illiquids. Many DC boards really haven’t given this area much thought at all, so 2023 is the time to tackle this question, and if they find the answer is that illiquids diversify and offer attractive returns, then they will need to start facing the challenge of managing their illiquid allocation. Or alternatively, recognise they cannot and consider whether they can still offer value for money or should consolidate.
Of course, DB schemes have been investing in illiquids for many years, so they may have the opposite challenge. With falling asset values, and increased collateral requirements, they might find they have too much in illiquids. In a perfect world, these illiquids might transition from the DB portfolios to the DC portfolios, matching buyers and sellers, but as we well know, sales pressure from DB schemes can most certainly distort markets, so managing down illiquid allocations will be a challenge.
This of course leads to a whole other subject of trying not to go with the herd – one lesson learned is that if UK pension funds are crowding a space and the most significant investor in it, it might be an idea to try and do something different – hard when we all have the same advisers though!
Should we discount liabilities with gilt yields?
For DB schemes, the question of actuarial valuation methodology has to come out of all of the considerations around investment strategy. If we do not want to buy out in the foreseeable future and can build a portfolio of cashflows to match our liabilities using secure income (even if in illiquid form) why should this look like it creates very significant funding volatility? Regardless of gilt yields, we might still have exactly the right cash to pay our benefits at the right time. In 2023 we should be putting this challenge to our advisers.
While policymakers might like us to believe 2023 will see the end of the inflation spike, that is far from certain. We are already in a cost-of-living crisis, and for the pensions industry, focussed on financial welfare in retirement, this is a real challenge. As trustees, we need to understand what discretion we have to pay additional benefits, and if we have any discretion, whether and how we should exercise it. Whether the discretion sits with us or the company, any capped or fixed pension increases are likely to see member dissatisfaction as the cost-of-living crisis continues.
Then of course, where we are trying to hedge inflation risks, we have other challenges. In 2022, many schemes benefitted as inflation pushed up their hedge assets while their liability increases were capped, but if inflation falls, we have the opposite problem. And we must be prepared to act quickly if we are suddenly hit with deflation, else our hedges could really hurt.
But if inflation is here to stay, and back on the subject of DC, how can we offer long-term real returns to pension savers in that environment, particularly if it is stagflation? Again that takes us back to needing a long and hard look at our default investment strategies.
And the challenge of where to get real returns is faced by DB trustees too. With all the economic challenges we face, many growth assets have been remarkably resilient – so are there falls still to come?
We are hurtling towards a climate disaster, but is it our place to stop it?
Is there any point in providing a pension if there is no hospitable world to retire into?
Undoubtedly a global top priority should be reducing carbon emissions and honouring our Paris alignment commitments. But in 2022 it was the stocks and sectors excluded from ESG portfolios that typically outperformed. The energy crisis has caused a shift in priority away from greening our energy supply to increasing support for fossil fuel infrastructure. It is a big challenge for trustees to navigate the web of carbon risks and opportunities, fiduciary responsibilities and moral obligations.
Schemes that have started reporting against the Task Force on Climate-related Financial Disclosures and set paths to net zero will likely be seeing their carbon footprint going in the wrong direction when they publish their 2023 report.
But of course carbon planning is only a small part of ESG. A challenge for trustees in 2023 will be considering how to tackle biodiversity challenges in their portfolio (the Taskforce on Nature-related Financial Disclosures reporting standard is coming), as well as social considerations – we might expect to hear from Guy Opperman’s new taskforce on social factors this year and will need to respond to it. A CFA UK working party has already started the thinking on this with a paper, 'Social investing by UK pension schemes at home and overseas
', which trustees might like to read.
I have focussed more on investment and economic challenges, but there are so many others I could have discussed: compliance with the requirements of the single code; cyber security; dashboard readiness (where in simple terms, every scheme has to respond immediately to any person enquiring if they have a pension with the scheme); GMP equalisation; overstretched administration teams failing on service standards; resourcing and insourcing/outsourcing…
Trustees are facing governance and regulatory overload. So my parting comment is to note that one of the very biggest challenges faced by pension schemes is just the sheer volume of challenges they face; they have to effectively prioritise them to focus a finite resource on the right things.