There are two ways for a finance director to deal with their
company’s final salary scheme: ignore it until the trustees request additional
funding and accept that these funding demands will come out the blue, will
always be painful and might be terminal under certain circumstances or work
more closely with the trustee body to agree a total strategy for both de-risking
the scheme and getting it into a fully funded position.
The first option we can ignore, since it can only be pursued by schemes that
have no problems worth speaking about and such schemes are extremely hard to
find. The first thing to be said about the second option, as Kevin MacLaughlin,
a principal at reward specialist Mercer observes, is that the FD starts from a
difficult position: he is not in control of the scheme’s investment strategy.
That is taken care of in its entirety by the trustee body. The main point here
is to reiterate that for FDs to execute any strategy, they need to cultivate a
positive relationship with trustees.
Assuming this exists, there are six major risk categories FDs can look to
work on investment risk, interest rate risk, inflation risk, mortality risk,
risks associated with the strength of the employer covenant and salary risk
the risk that wages will spiral over time, or that particular employees will get
huge increases in their final years.
In an ideal world, a pension fund would match its liabilities, which generally
run over 20 to 30 years or more, with assets that have a long maturity date and
little or no risk.
Long-dated government bonds are ideal if we stick to the presumption that
there is no particular risk the UK is going to go bankrupt and default on its
loans (since modern economies in desperate times inflate their way out of their
debts by printing money, rather than by defaulting which impacts the value of
the returns and goes to inflation rate risk, but you still get your money back
even if it doesn’t buy very much any more).
Matching liabilities to assets is called Liability Driven Investing (LDI) and
is a goal schemes aspire to. However, the problem for FDs is that because
government bonds are considered such low-risk instruments, the government does
not need to offer much by way of interest to reward investors. If the scheme had
nothing but government bonds, then the company would have to put a great deal
more into the scheme.
“Trustees know that they have to get the scheme to a fully-funded position
and there are only two sources of funds for this. Either they get the funds
through growth in the asset base, or the company puts the money in,” says
Mercer’s MacLaughlin. It follows that if trustees want to reduce the proportion
of equities in the scheme from 50%, which is the proportion followed by many
schemes today, to just 30%, they know they are going to have a very difficult
conversation with the FD.
“FDs are all for reducing risk in their pension scheme, but they cannot
endure the additional funding costs of moving out of growth assets, such as
equities, to that extent,” says MacLaughlin.
One way around this might be for the FD to persuade the trustees to give away
some of the anticipated growth in return for putting a ‘floor’ on some of the
downside. The way this works, MacLaughlin explains, is that a fund provider
might agree to indemnify the scheme against losses of, say, more than 10%. The
scheme then agrees to limit its share of any market gain to, say, 6% per annum,
with the rest going to the provider.
That way, the FD and the trustees neutralise some of the downside risk, while
retaining the chance of gaining 6% per annum growth. It is worth pointing out
that many of these kinds of deals will only offer a limited floor. This means
the scheme would bear, say, the first 5% of any downward movement in the market.
The provider would bear the next 20%, but if the market fell more than 25%, then
the scheme takes the rest of the loss. The attraction of this kind of
arrangement is no upfront costs to the scheme and it is protected as soon as
the deal is signed.
Another approach to retaining growth assets, but trying to de-risk equities,
is to move at least part of the fund to a more sophisticated “total return”
strategy that is not wholly predicated on global growth. As Christopher Nicols,
a member of the Global Absolute Return Strategy fund team at Standard Life
Investments explains, what the recent crash showed was that when market
conditions become extreme, many of the usual approaches to de-risking an
investment portfolio through diversification techniques simply fail.
A good part of the reason for this failure was that so many of the strategies
being deployed in these so-called diversified portfolios were all dependent on
the world continuing to grow at a reasonable rate. As soon as global growth
crashed, the correlation between all the strategies became obvious.
Part of a new modus operandi with this lesson in mind, Nicols says, is for
pension fund managers to look to funds that find investment strategies based on
underlying patterns, such as the relative volatility of two markets, the German
DAX and the FTSE indices being two examples. The DAX has fewer stocks than the
FTSE, so is typically more volatile.
However, there are occasions when the reverse is true. Structurally, this has
to happen again over time, so using derivatives to exploit these anomalies
generates strong returns for the fund whatever global growth happens to be
That is just one strategy among many. The point is that this kind of fund
does worse than a pure buy-and-hold equity fund when markets are rising
strongly, but outperforms strongly when equity markets crash. Nicols says that
since the crash, the fund has seen very strong inflows from pension funds, with
many funds choosing to invest between 5% and 10% of their portfolio with the
fund in the first instance. Again, an FD has to have an excellent relationship
with the trustee body, and be able to make the case in some detail, to push
through this kind of de-risking shift in the fund’s investment strategy.
Turning to interest rate risk, Punter Southall principal Danny Vassiliades
points out that trustees and pension funds generally like rising interest rates,
as when interest rates rise the discount rate rises too, so the scheme’s
liabilities are discounted to a greater extent. One of the advantages of the LDI
strategy, Vassiliades points out, is that if a trustee body was lucky enough to
have a fully-funded scheme that was wholly matched, bonds to liabilities, then
although a rise in interest rates would hurt returns from bonds it would
diminish the liabilities by a matching amount: the effect would be neutral.
However, since we know most schemes are far from having a perfect LDI plan
implemented, if the company and the trustees want to take interest rate risk off
the table, they have the choice of either looking to be 100% hedged against
falling rates, which is expensive, or simply taking a view on interest rates.
The former costs money and only time can tell if it turns out to be a good or a
bad move, but it will remove the risk. The latter approach is to accept the risk
and for the trustees and the company and their advisors to form a view of where
in the yield curve they expect interest rates to move. “This is a perfectly
legitimate approach but it is an investment approach, taking a position on
interest rate movements, rather than being about removing risk,” says
If the FD and the trustees are not going to remove all risk absolutely by
going for a buyout, then each chunk of risk you remove from the scheme will cost
you money. “You can go in for a range of swaps, including interest rate swaps,
inflation swaps and life insurance swaps, but you have to bear in mind that
swaps always have a counterparty and that counterparty is someone who is taking
a diametrically opposite point of view from the one you are taking,” says
Take a punt
But this does not mean swaps are pure punts. Take inflation rate swaps. Pension
funds have inflation rate exposure so they want assets that are fully exposed to
inflation and increase in value along with inflation. Vassiliades points out
that there are organisations that already have lots of inflation exposure and
want to sell it to diversify their risk. Banks sit in the middle and arrange a
deal between the parties on either side of the swap.
The one risk Vassiliades says funds are struggling to dispose of is longevity
risk. “The problem here is that it is very difficult to find natural
counterparties for a longevity swap. It comes down to some hedge funds and
private investors deciding they are happy to write these contracts at a price
where they think they can see a return.”
Vassiliades points out that another dilemma currently bedevilling the
pensions market is an anomaly around risk and the strength of the employer
covenant. “As an FD, you have to balance the fact that you want your fund to
generate a return, against the fact that return-seeking assets can also go
backwards and worsen your funding position. If the company is weak and could not
cope with a poor scenario of very negative returns, then the trustees should not
allow the employer to set out a high returns strategy,” he says.
However and this is the anomaly if the employer is wobbly and it looks
like it will take many years to get fully funded even to the level of the
Pension Protection Fund (which provides reduced benefits to members), then
trustees might be tempted to say: “The only way we can do better for the members
in this situation is to be very aggressive in our return-seeking strategy and
hope it pays off.” So, in a perverse way, the existence of the PPF can mean that
the weakest and worst pension schemes are incentivised to take maximum risks
with their investment policy. Only politicians can create this kind of
scintillating unintended consequence.