In part 2, we explore what benefits a more formal reliance on the Pension Protection Fund (PPF) might have for trustees, sponsors and the wider economy.
In my previous article, I argued that a number of factors resulted in trustees ultimately targeting some form of buyout funding level. The first main reason is that trust law places a fiduciary duty on trustees to seek to make arrangements to pay members their benefits in full. The second main reason is that case law disallows consideration of the PPF in trustees’ funding decisions and combined with this, there is often uncertainty of sponsor survival in the longer term. Ideally this will happen before a sponsor becomes weak or vulnerable to failure. Such an approach then pushes trustees towards selecting actuarial funding bases that are:
(a) Gilts driven, because the ultimate target is underpinned by gilts based reserving requirements, and;
(b) Focused on reducing investment, (including mismatching), risk over time.
In practice, even the early market steps towards such an approach have created some controversy as, combined with falling gilt yields, the impact on scheme deficits and cash funding requirements has been significant. Further, there is a widely held view the ongoing and increasing demand for gilts by pension funds (for this very reason) is distorting the market and further supressing yields, particularly in the index linked market.
Various responses to these challenges have been developed and we regularly help clients implement investment strategies that utilise diversified credit portfolios to deliver returns above gilts with much lower risk than typical historic portfolios. These approaches remain consistent with targeting a ‘de-risked’ position over a given time period, while attempting to mitigate the very high cash costs consequent on a fully gilts based or more traditional ‘self-sufficiency style’ investment strategy.
The ‘cost’ of adopting these lower risk approaches is that the potential upside gain from economic growth and the success of the underlying businesses is lost, in comparison with investing in equity instruments. Of course, the gain is a reduction in downside risk and volatility. It is worth considering whether this is a desirable consequence or if there might be a better way?
We can start by considering the understandable reluctance of many sponsors to commit the significant cash required to meet the funding demands created by these circumstances. With credit so cheap, why not simply borrow to fund the pension scheme? A part of the answer lies in the alternative uses of capital that might be available to management. Discussing the projected hurdle yields adopted for a wide range of business projects suggests that companies often adopt hurdle returns well in excess of 15% pa before committing to a project. Obviously, not all projects or all companies succeed, but this suggests we may be selling schemes, their sponsors and, ultimately, members short by not continuing to invest in such companies. Should equity type investments form a core of most schemes’ investment strategies?
Another element of a case for equities is that, by investing in equity, schemes are able to support the wider economy directly and help support economic growth and activity. By focusing where they invest, schemes could even focus their support on particular sectors or regions – imagine a Northern Powerhouse fund!
Many sponsors would be far more ready to support schemes whose trustees felt able to adopt such investment strategies, which focus on delivering a higher return. Similarly, many trustees would be willing and eager to adopt such strategies, if they felt the law and regulatory environment supported them. What changes could be made to allow this to happen?
The single biggest stumbling block to allowing trustees to be comfortable in considering a wider spectrum of return seeking investment strategies and reducing the expected cost of funding defined benefit schemes over time, is to find ways of ensuring such strategies do not lead to impaired member security. A first step, with benefits for sponsors and the wider economy, would be to formally allow trustees to rely on the support provided by the PPF. By allowing formal reliance and encouraging trustees to then be mindful of the wider implications of the Pension Regulator’s statutory duty to support investment and the growth of sponsors, a change could be brought about that has long term benefits for sponsors, wider economic activity and the scheme members themselves.
Of course, there are challenges to be met in ensuring fair treatment of all schemes and sponsors and there are other options that could be explored – one suggestion is a ‘shadow’ PPF that could be available to provide ‘insurance’ for those who take this route, with different/higher levies. Other approaches emerge from the Swedish model and elsewhere – but a change of approach could provide benefits for all stakeholders in this complex area.
One interesting question is what can trustees do now? Some trustees may already be implicitly relying on the PPF when setting their investment strategy, possibly with a view to maximising the benefits to their members. Others should be considering how they can maximise the returns they obtain, while still targeting a very significantly reduced risk profile. These boards should be considering the credit based strategies I touched on above – strategies that deliver much reduced risk together with higher return expectations and still deliver support to business and the wider economy. Giving up the potential upside may well be an acceptable price to pay in the meantime, even if it is hoped that an alternative approach may become available in due course.