This is the second in a 4-part blog series on Implementation Managers (IM) and why, in my view, any pension scheme Trustee should consider appointing one. My first blog post aimed to sum up the main reasons why I think that Implementation Managers can be a good thing.
This post will zoom in on one of the key benefits of appointing an IM. I’m going to call it the Dynamic Risk Management Framework (DRMF). But before I get into it, it’s useful to remind ourselves of the basics of what a pension scheme Trustee is aiming to achieve.
What is a Trustee’s ultimate goal?
The goal for any Trustee is to fully secure member benefits. This is achieved by shepherding their scheme to a point where liabilities can be met through a very low risk investment portfolio or even better, secured with an insurance company (buy-in or buy-out). At this point, the probability of paying all pensions in full is maximised.
The reality for the vast majority of Trustees is that their schemes aren’t there yet. They need to grow their assets over a period of time to meet their liabilities (i.e. to full funding). This is where they can afford to remove investment risk (and maybe even other risks such as covenant and funding risk).
Why is a Dynamic Risk Management Framework beneficial to a Trustee?
The last few years are a great example of why Trustees running schemes with a DRMF probably slept better, on average, than those without.
From February 2016 to January 2018 (trough-to-peak), equities rose by a whopping 53%. Funding levels increased by 15% over the same time period*. As funding levels shot up, Trustees with a DRMF knew their IM was banking the gains in a measured and affordable way, ensuring that the scheme was taking no more risk than necessary to achieve the Trustees’ agreed investment objectives. No nail-biting wait until the next Trustee Board meeting to discuss a de-risking plan, the hassle of documents to sign and stakeholders to manage – whilst willing the market not to cliff-edge in the meantime.
Fast forward to today, and equities have backtracked – by around 15%. Not great news for Trustees admittedly. But for Trustees with a DRMF there will be comfort knowing that previous gains were banked. And no need to constantly monitor the funding level, because the IM can act on the Trustees’ behalf if necessary, re-introducing the right amount of return/risk to stay on track to target.
So how does a Dynamic Risk Management Framework work?
In the example below, the scheme starts to outperform its flight plan (maybe its assets performed better than expected). In year 1, a de-risking trigger is hit. At this point, the IM sells a pre-determined amount of growth assets, thereby ‘banking’ the outperformance the scheme has enjoyed. Projected asset growth therefore slows (i.e. the gradient of the dark green line gets shallower).
However, in year 6 there is a negative shock (maybe a trade war between the US and China?) and a re-risking trigger is hit. Once again, the IM intervenes by buying back some growth assets to increase portfolio expected return.
What role does the Implementation Manager play?
Crucially, the IM will never make any active decisions about when to trade assets, what assets to trade, or how much to trade. This is all pre-determined by the Trustees (with the help of your Investment Consultant) and hard-coded into the IMs Investment Management Agreement. So agreeing a set of triggers and writing these into the IMA is the first step.
The IM will be the one to de-risk or re-risk the portfolio. Therefore, they will need to be able to directly trade some of the scheme’s growth assets (we’ll call them rebalancing assets). This is easy if the rebalancing assets are managed by the IM, but it’s also fairly easy to get the IM set up to trade assets managed by other investment managers (e.g. on a “power of attorney” basis).
Finally, the IM needs to be able to regularly monitor the funding level versus the Trustees’ de/re-risking triggers. This is a key reason why it makes sense to make your LDI manager as your IM (see first blog post) – LDI managers who already manage the hedging strategy against a liability benchmark can use this to roll forward the scheme’s liabilities with ease. Rolling forward assets can be a little trickier (especially if you’re holding a larger proportion of illiquids), but liquid assets can be easily tracked via traded stock prices.
In the next part of the blog series, I will look at how Trustees can implement a more efficient interest rate / inflation hedging framework to reduce risk, governance burden and advisor costs(!).
