With pension schemes wondering if things can get any worse, we look at the market and wonder if things can get any better.
This is a statement that is uttered with increasing frequency in relation to pension scheme deficits. Indeed things have got worse, increasingly and unrelentingly. Do we now find ourselves in such a position that it can’t get worse than this? How plausible is it that yields will fall materially further pushing us to zero or even negative nominal yields? Surely it can’t be long before past misfortunes are reversed?
Firstly, it is understandable that many feel this way. Over 2016, three sharp falls in yields in eight short months barely left time for the pensions world to stop and take breath. Whilst schemes that had already put in place significant liability hedging programmes may have exhaled a relieved sigh, those with limited hedging (or none) would have been forgiven for feeling winded. The uptick in yields that followed, whilst welcomed, is modest for most schemes particularly given the rise in expected inflation that accompanied it.
However, to conclude that things can’t possibly get worse is misguided, and could lead to dangerous risks being run and poor decisions being made. After all, Murphy’s law tells us: “What can go wrong will go wrong”. Further, even if it were true that sometimes things get so bad they can’t get worse, are things actually that bad? Is it arguable that where we currently find ourselves is not actually as bad as people think?
Let’s look at things from a different angle. There are two sides of the pensions story and it is the liabilities that have been the cause of all of the recent pain for schemes, but on the flip side practically all assets have actually performed extremely well. Equities are at an all-time high. The FTSE 100 despite being below 1999 price levels has actually returned 75% since 1999 once dividend income is taken into account. This is particularly astonishing in light of the uncertain international economic and political environment we find ourselves in. Property prices have boomed. Investment grade credit spreads trended back towards pre-2008 levels. So on the asset side this is not a picture of desperate times, and begs the question - can things really get much better? We live in a world of inflated prices, and this applies equally to both assets and liabilities.
Trustees and sponsors of schemes that have experienced growing deficits now face a quandary. Should they maintain their scheme’s current position in the hope assets continue to outperform, and yields to revert to their former levels, running the risk that there could be further pain to bear if they in fact trend even lower? Or should they take steps to reduce risks and contain the problem given the magnitude of the current situation and its scope to deteriorate further?
Any one solution is unlikely to be the answer to such a complex problem. Taking a measured strategy to close some of the deficit through moderate investment returns and considering strategies for reducing and mitigating the liabilities, whilst also having a structurally affordable means for the sponsor to close the remaining deficit over a suitable time frame will be key to a workable solution. If the industry has learned anything from what we have seen to date, it is that thorough and comprehensive management of liability risk needs to be at the heart of any sensible strategy. A strategy that only delivers a satisfactory outcome if yields revert can hardly be called ‘robust’. In our view, no strategy’s success should hinge on the reversal of past misfortune, or any single factor for that matter.
So on the question “it can’t get worse can it?”, perhaps the answer is that the likelihood of it getting substantially worse, is about the same as the likelihood of it getting substantially better but a sound pension strategy should be able to ultimately deliver in either of those scenarios.
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