Many trustees are caught in a cycle of short-term thinking. This is totally understandable – the valuation cycle of trying to get each contribution schedule over the line can encourage a shorter-term time horizon.
But actions that seem sensible when assessed over a short time frame might actually be making the problem worse in the long term – and by the time these problems start to materialise it may be too late to rectify them. Examples of this could include a “too early” de-risking decision before you have reached a full level of safety. This could end up extending the time period over which the scheme relies on the sponsor too far into an unknown future.
Assessing and understanding your scheme’s specific time horizon is key to determining the actions you need to take now to ensure you get to a safe place before it is too late.
But how do we measure the time we have left?
Your journey time to full funding is driven by two crucial factors:
- When your scheme will start to become significantly cashflow negative
- How long you can realistically rely on your sponsor covenant
And we need to assess each individually.
Taking a positive steer from a negative signal
Once a pension scheme is paying out more in benefits than it is receiving in contributions and asset income, it is classed as ‘cashflow negative’. While this is not necessarily a cause for alarm, it is important to know in advance when that will be as there are some changes that can be made to support the scheme to the end of its journey.
The key change when turning cashflow negative is that a scheme begins to rely on a dwindling pool of assets for both benefit payments and to generate investment returns. This means that, should the investment portfolio suffer poor returns or a market shock, there is less left in the pot to help the scheme recover.
In some severe situations, schemes may be forced to sell assets to meet benefit payments or even fall back on a sponsor for help.
However, there are ways to avoid getting into this situation that can be applied well in advance. A good starting point would be to forecast when benefits payments will reach a critical level of asset absorption – or use for payment – in the future, typically in the region of 5% of total assets a year. This is then your “backstop” date, by which you know that you need to be comfortably de-risked and no longer rely on high-returning assets that can suffer drawdowns.
This analysis would then be one input to setting your flight plan and helping you to frame your required time horizon. Below we show an example of what such analysis could look like for a typical pension scheme, with a single chart giving you all the information you need.
Know your sponsor, know your road ahead
Even if you still have many years before you become cashflow negative, it might be sensible to shorten your time horizon if you don’t feel you can reasonably rely on your sponsor for support over the entirety of this period.
In the same way that you want to get to a ‘safe’ funding position by the time you are cashflow negative, you don’t want to be taking a lot of investment risk without a sponsor covenant to fall back on. This of course depends on the strength of the covenant – as shown in the chart below: For companies with a weaker credit rating, the cumulative probability of default rises steeply over time, indicating that even a modest extension of the flight plan could have a real impact on the likelihood of meeting members’ benefits.
The probability of default for a given sponsor can be incorporated into a single quantitative metric that gives you the “probability of paying out all pensions over the life of the scheme”, drawing on flight plan design, sponsor risk and investment risk to give you a clear and coherent decision-making framework.
Identifying how long you can afford to rely on your sponsor for and when you will become ‘cashflow negative’ gives you a good, objective measure of when you need to reach your long-term funding target. From here, you can work out what combination of contributions and investment returns will get you there in time.
Below we illustrate how you can pull all the information together in a simple table, helping you evaluate the trade-offs and determine the right call to action.
It’s important to note that the longer you wait to do this, the shorter the time you have to solve the problem – and the more difficult it becomes.
Take a step back now, while time is on your side.