You have set your scheme’s funding target, articulated it in a risk management framework and built a portfolio that gives you the best possible chance of getting there.
You have made a great start, but don’t think it all ends here – your journey is just beginning. Now you have the opportunity to break out from the three-year cycle of statutory valuations in which many pension schemes find themselves taking decisions.
Breaking the mould to target a better outcome
Up and down the UK, as their triennial valuation comes around, pension funds are revisiting the same routine: liability projections are revised, covenant is re-assessed, and a snapshot of market conditions is taken.
With all that updated information available, investment objectives are usually sized up, with the associated investment strategy being reviewed at the same time.
This system used to work well.
Most schemes were open to new members, making them very long-term investors. They could focus on generating high investment returns and count on contributions to meet their day-to-day cashflow needs.
While this went on, they had little reason to change – but the world no longer works that way.
Today, most schemes are closed to new members – if not accrual altogether – and are often paying out more in benefits than they are receiving in contributions. Two thirds of schemes are in deficit, and some are now actually bigger than their sponsoring company ever was.
The game has changed and schemes now have much less time to correct when things go wrong.
Luckily, breaking out of this cycle and forging a new path does not require a lot of extra work. Forward planning and use of frameworks can help schemes set better objectives and react quickly when things do not go to plan.
The first task is to create a contingency plan. This means pre-identifying the scenarios that would warrant a change in investment objectives and consequently require a review of strategy. One scenario could be the downgrade of a sponsor’s credit rating and deterioration in covenant strength. In this case, the trustees could plan to adopt a more prudent funding basis and higher return target to achieve it.
The second task is to set a dynamic risk management framework, which helps you decide whether to add or reduce risk according to your funding level. Instead of focusing on how the investment strategy is going to make the return, the focus is on what it needs to do and why. By fixing a date by when you want to be fully funded, on what basis and with how much additional contribution, the investment return you need can be designed appropriately.
Through this framework, the ‘right’ action to take in any scenario can be more easily identified and communicated to stakeholders.
Rather than waiting until the next valuation to cycle back around to find out what’s gone wrong and try and fix the problem, this framework enables pension schemes to quickly take the right action when things do not go according to plan.
Having these tools actively monitoring scheme health in changing market environments will help them stay – or get back – on track.
See below an example of how dynamic risk management works in practice.