Article 6 January, 2021

Long term funding: start with the end in mind

In the January 2021 edition of the Pensions Management Institute (PMI)'s Pension Aspects Magazine, we advise trustees to 'start with the end in mind'.

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As we emerge from a COVID world, setting long-term funding targets is a key 2021 focus for trustees. Galvanised by the Pensions Regulator (TPR)’s new Defined Benefit (DB) funding code of practice, trustees and sponsors need to pay acute attention to the maturing status of their DB schemes. TPR expects trustees to determine a clear journey plan towards a lower risk position as they close in on their goal.

TPR’s new DB funding code of practice succeeds a period of unprecedented turmoil, particularly as sponsoring employers across the country have seen their balance sheets come under strain, as free cashflow dries up. At the same time, schemes need additional funding to support their deficits. So where do trustees go from here? We see two key steps for trustees to guide scheme funding back on track, ensuring alignment to the sponsoring employer.

1. Start with the end in mind

As Defined Benefit (DB) schemes mature, their time horizon is progressively shrinking. As a result, the historic step-by-step approach to DB funding from technical provisions to self-sufficiency and beyond, may no longer be useful.

We suggest an alternative approach, aligning trustees and sponsors around a common goal. Let‘s start by placing a ‘stake in the sand’, say ten years from today. Where will the scheme be then? What proportion of members will be pensioners? Will annual pension cashflows have peaked? Two aspects that will apply to most schemes at this point are:

  1. The scheme‘s tolerance for risk will be much lower and should there be a significant market correction, asset returns alone may not be enough to eliminate the funding gap
  2. The sponsor‘s capacity to support the scheme is unknown - trustees have the most visibility today on the sponsor‘s ability to contribute. There are also non-financial risks, e.g. how poor Environmental, Social and Governance (ESG) practices impact the long-term viability of the sponsor.

By placing a stake in the sand, the trustees and sponsor can determine an appropriate destination aligned to self-sufficiency or buyout, and an associated risk appetite. With a timeframe and clear destination, they can strike an appropriate balance between affordable contributions and achievable investment returns.

2. Don't get blown off-course

By adopting this approach to setting long-term funding targets, all stakeholders have greater clarity on the task in hand. Importantly, for most Defined Benefit schemes, it is not without risk. TPR expects schemes to reduce the level of risk taken as they mature. However, this must be balanced against the long-term funding target. De- risking too soon can have profound implications, extending the timeframe to the ultimate destination and placing greater reliance on the sponsoring employer.

“Investment strategy is a hugely important factor in realising long-term funding targets; the difference between good and bad decisions can have a major impact on schemes.”

So, how can trustees avoid getting blown off course and avoid affecting the security of members’ pensions? There are five key steps for trustees to gain control of their outcome, for a more predictable funding journey:

Hedging liability risks: this is the risk of adverse movements in interest rates and inflation resulting in a gap growing between the assets and the Scheme Actuary‘s value of the liabilities. Whilst many schemes use hedging already, it is often expressed as a percentage of the funded technical provisions liabilities. The long-term funding value of the liabilities (e.g. self-sufficiency) may be materially bigger and much more sensitive to movements in rates and inflation. Therefore, adopting a much higher level of hedging may be appropriate.

Explicit cashflow matching: now available for schemes of all sizes these solutions enable trustees to match payment streams to high- quality investments that distribute regular income directly into the trustee bank account. This avoids the challenges in periods like March 2020, when markets fell sharply. Some schemes were forced sellers crystallising losses and missing the significant bounce back in markets over the rest of 2020.

Mitigating asset shocks: trustee should utilise the full toolkit at their disposal today to deliver a more consistent investment journey. One increasingly common example is equity protection strategies. These enable schemes to be fully invested while explicitly protecting against market falls over a specific period. This can be invaluable in periods of market stress, reassuring trustees to keep more assets on risk.

More investment return: having addressed all the key risks mentioned above, this offers trustees confidence to push for more return today. This will get trustees to their destination quicker.

Delegate where appropriate: With trustee obligations piling up, time to focus on investment is increasingly constrained. Trustees can delegate some investment decisions, and fiduciary management is a powerful tool to access investment expertise.

So, as we peer into 2021 and beyond, we advocate three key takeaways for trustees:

  1. focus on your end-game
  2. target the right level of return today and
  3. systematically tackle your key risks to give long-term certainty for all stakeholders.

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