Equities - too much risk for your scheme?
Many schemes have a relatively large exposure to equities and other return seeking assets ("RSA"). In a number of cases, this will lead to a mismatch between the scheme's liabilities and its investment strategy. This is particularly so if the scheme has closed or is about to close to new entrants and / or future accruals. In any event, many employers will be concerned at the volatility this exposure creates on the company’s balance sheet.
It could be argued that although reducing the scheme’s exposure to RSA will reduce the risk, it will also place a greater emphasis on the company’s covenant. The loss of potential outperformance created by reducing the scheme’s exposure to these assets may result in increased company contributions. Equally, the converse could also be true, particularly if a scheme valuation takes place following a reduction in the value of the scheme’s RSA portfolio, for example as a result of a substantial or prolonged fall in equity markets. Hence, there are benefits to be had for both the trustees and the employer in taking a more matched position in the pension scheme’s investment strategy as this should lead to a more stable funding position. It will also lead to less volatility and less of a direct impact on the company’s balance sheet.
The challenge facing many schemes and their trustees however is how to successfully manage the change from a high risk portfolio to a lower risk, more balanced investment strategy, whilst still maintaining current value?
Many schemes could adopt a basic strategy of increasing their exposure to bonds (gilts, index linked gilts and corporate bonds) while reducing their RSA exposure. Alternatively, a full Liability Driven Investment ("LDI") portfolio could be adopted whereby the scheme’s cash flows are matched and both inflation and interest rate risk is fully hedged.
When considering the options available, various views need to be taken into account and pertinent questions should be asked. What is the trustees’ appetite for risk? How does this differ to the employer’s? What is the current situation of the scheme, its assets, the company and its members? Has an end position for the scheme been identified?
To answer these questions and many more that need to be considered, there needs to be a continued dialogue between the trustees and the employer. There should be adequate expertise within the trustee board to ensure that the most appropriate advisers and / or investment managers are appointed to assist with both the review of the existing investment strategy and any subsequent transition to a lower risk, more matched position. Every scheme has different requirements but having individuals involved who have been through similar processes before, bringing their experience and knowledge to the scheme is invaluable. Scheme advisors and investment managers can bring this knowledge but their advice must be pro-actively challenged by the trustee board to ensure it fully meets the scheme’s needs.
Reviewing the existing portfolio and deciding on the scheme’s future investment structure is only the first step in the journey towards having a more balanced portfolio. A measured and workable transition plan is also key to ensure that current value is maintained and the ultimate investment portfolio is suitable for the scheme.
If the scheme decides to move from a large RSA portfolio to a more matched position, it may not be beneficial to carry out the transition in one transfer but rather to adopt a route map, with appropriate trigger points. This may be a lengthy process during which time members’ positions must continue to be protected. It is important to decide early on who will have responsibility for the various action points and the trustee board will need to actively monitor the steps taken to ensure the overall process continues smoothly.
If an LDI portfolio is adopted, it is also of benefit if there is a small committee appointed and available to make quick decisions on adjusting the scheme’s LDI structure to take advantage of market anomalies. Real benefits to the scheme can often be achieved by switching the make-up of the underlying assets at short notice and not waiting for the next quarterly trustee meeting. These decisions must be made by the scheme trustees, not the employer, and having a knowledgeable and confident trustee on this committee, able to actively help in decision making, is very important.
In summary, there are a number of considerations which should be looked at when making the decision to move from a higher risk portfolio to a lower, more balanced investment strategy and then subsequently implementing this change. Throughout the entire process there is a real need for an experienced, professional trustee who can facilitate discussions between the trustee board and the employer to ensure that the needs of both are fully considered and that any change is implemented in a manner that is suitable for the particular scheme, the trustee body as a whole and that fits with the sponsor’s corporate objectives.
The team at Capita Pension Trustees has frequently facilitated open, positive discussion between trustees and employers to enable an agreed position relating to the pension scheme to be reached. We also have extensive experience in managing the transition from a high RSA content to a more closely matched investment position in a number of schemes where we act as trustee. Our team have also been involved in the implementation of a full LDI portfolio, using swaps to hedge interest and inflation rate risk, for a percentage of the overall scheme assets. The percentage to be allocated to LDI will vary depending upon the liability profile of the particular scheme and consequently analysis and debate may be needed before a final decision is made. This is a particular area where experience can be invaluable.
Can schemes really afford not to have a professional Trustee involved if they are wrestling with the investment / liability mismatch?
Company Profile
Capita Trust Company Limited provides trustee services to both private and corporate clients, and is backed by a FTSE 100 company.
We can act for occupational pension schemes of all sizes and pride ourselves on being able to balance the interests of the trustees with those of the employer. We also have experience of negotiating and resolving complex situations.
Our experienced team of trustees have been involved with all aspects of pensions trusteeship including assessing company covenants, involvement in the actuarial valuation process (including setting contribution rates with employers, recovery plans, rate of deficit contributions, etc) and adding value in all areas of scheme governance. We are also well versed in the adoption of revised investment strategies, particularly with a view to de-risking.
We have wide experience of regulatory action, winding-up schemes, buy-outs and schemes in the PPF assessment period.
www.capitafiduciary.co.uk
David Harris
Senior Trust Manager
Capita Trust Company Limited