Article October 14, 2020

DB Funding levels: Are we too trigger happy?

As Trustees look forward to setting their long-term objectives post the step down in funding earlier this year, a question I regularly get asked about relates to how we implement “triggers” for clients.

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As Trustees look forward to setting their long-term objectives post the step down in funding earlier this year, a question I regularly get asked about relates to how we implement “triggers” for clients. In lay parlance, a trigger is a mechanism that can set off a (chain) reaction.

Turning back to trustees, triggers result in changes being made to scheme investment strategy, often de-risking the strategy as the scheme progresses towards its goal. This is broadly consistent with the expectations from the Pensions Regulator. But in this note I question whether they are really fit for purpose in today’s environment.

In a world of heightened governance, volatile markets and increasing regulatory focus, a mechanism to take risk off the table would seem a sensible course of action for Trustees. But in doing so, Trustee need to appreciate the implications of pulling the trigger. In particular, has it been calibrated to reflect current market conditions? How does it take account of your longer term funding goals?

In my recent article (Focusing on the DB funding level misses the point - can you see the wood from the trees?), I highlighted that with the sustained fall in gilt yields, schemes may have seen their funding level remain steady since the end of last year and may even have approached a potential “trigger point”. But their GBP amount deficit may have ballooned as the value of liabilities has soared.

This can have profound consequences as most triggers today are based on funding level and result in three things happening – a lower target return, a lower level of risk, a higher level of liability hedging. This all seems sensible until we more closely examine the problem in hand - the deficit.

If my deficit has got bigger in GBP amount terms, the only way I fix this is through more return or more contributions. So, the “automated trigger” has immediately put a greater onus on the Sponsoring Employer at a time they can ill afford. It also places the challenge back to the Trustees to reverse or re-risk the portfolio at a future point in time.

Taking this a step further, let’s now incorporate the Pensions Regulator’s expectations on Trustee’s setting long-term funding targets. It is therefore imperative to ensure you calibrate your triggers to your end destination, not just Technical Provisions or other nearer term funding goals. Doing the latter can add 5-10 years to your funding journey, placing further strain on the scheme and Sponsor into the future, where we have far less certainty.

"Alongside the funding level, trustees should monitor the deficit and required return to reach their long-term funding goal."

At R&M, we will typically consider a low dependency on the Sponsoring Employer, progressive incorporation of insurance buy-ins or a complete buyout of the scheme’s liabilities at a chosen future point in time as the destination in mind. By starting at your end destination, this ensures your risk management framework is fit for purpose and mitigates the risk of being too trigger-happy today.

Whilst funding level can be useful as a quick barometer of the health of a pension scheme, it ultimately misses the point. What matters is there is a GBP hole to fill and metrics which account for this are far more informative. Alongside the funding level, trustees should monitor the deficit and required return to reach their long-term funding goal.

Caution should also be taken in blindly moving from Growth Assets into LDI once a trigger is hit. A more nuanced approach which considers the full tool kit of investment solutions will ultimately lead to better results.

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