The Pension Regulator | Comment
Setting clearer expectations for defined benefit pension investments
Neil Bull
Neil Bull is an investment consultant at The Pensions Regulator.
This year, we have been clearer than ever before on our expectations for pension investments. Investment strategy is a key factor in determining the likelihood of benefits being paid and in our Annual Funding Statement (AFS), published in March, we set out our expectations in more detail. We recognise that every scheme is different, and the defined benefit (DB) funding regime is scheme specific. But we feel it is important to be clear on what we expect from all schemes. All schemes should set a long-term funding target (LTFT) and a long-term asset allocation consistent with this. We talk about this in the AFS as being a strategy that is consistent with a low-level investment risk which provides high resilience and independence from the employer. Once a scheme establishes this long-term strategy we want to ensure every scheme has a journey plan of how to get there. This is likely to involve a combination of a plan to de-risk over time (assuming the current strategy is riskier than the long-term asset allocation) with the potential to use funding triggers to de-risk quicker if investment returns are favourable and funding levels increase. In addition to a long-term asset allo- cation and an investment journey plan, we want trustees to focus on downside investment risk. This ranges from using a simple scenario test, looking at a combination of a downside event for risky assets and interest rates reducing, to a more complicated value at risk (VAR) analysis. Once this measure of downside risk is quantified, we see a much more mixed position on how this is used. We say in the AFS that our expectation is to quantify, test and evidence the degree to which the covenant can support this level of downside risk. We encourage trustees to have upfront discussions with the sponsoring employer and agree a plan of action in the event of an unlikely but possible event. We see all too often the answer to a period of underperformance is to simply extend the recovery plan at the next valuation. We don’t believe such an approach is consistent with the investment risk being supportable. Where all or a proportion of the investment risk is unsupportable we have some addi- tional expectations.
The use of hedging has long been established in the investment industry as a way of reducing the level of investment risk. Where investment risk is unsupportable we would strongly encourage trustees to consider introducing hedging or increasing their existing levels of hedging to reduce the level of downside risk. This hedging could be focused on interest rate, inflation or currency risk or a combi- nation of all three. Many pension plans make use of funding level triggers to de-risk if investment returns mean that funding levels improve. Where investment risk is unsupportable we would strongly encourage trustees to adopt such an approach.
I will finish by talking about the new DB funding code. It should come as no surprise that given our focus on investment in the AFS, we are keen to ensure the new code addresses the level of investment risk in pension funds. This was covered in our blog in early May. We will consult on how to do this with the potential use of a simple stress test to ensure the level of investment risk is appropriate.
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Issue 84 | May–June 2019 | portfolio institutional | 15
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