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The Actuary The magazine of the Institute & Faculty of Actuaries

Are we missing the wood for the trees?

The main objective of trustees is to ensure sufficient assets are available to meet benefits as they become due. Traditionally, the focus in achieving this has been on investing in a balance of equities and bonds. Equities were considered to be a potential match for the active members due to their being longer term, whereas bonds were generally used to match the pensioner liabilities. In the run-up to 2000 many pension schemes had relatively large exposure to equities, and in many cases as much as 7080% of assets.

Widening deficits
However, following the period of significant equity falls from 2000 to 2003 many trustees and scheme sponsors found themselves facing substantial deficits and the strength of sponsor covenants in making good such deficits was questioned. In addition, increased regulation raised the sponsors’ awareness of the pension burden and their responsibilities.
At this time most trustees perceived equity risk to be one of the greatest risks they were taking but had accepted that there was a trade-off between the need to generate investment return to help reduce deficits and security in the sense of matching the liabilities.

New approaches
In the past decade, pension scheme trustees have adopted novel tools and techniques to help cope with the ever-growing pension problem. These have led to a new way of considering risk in a pension scheme and to a greater focus on achieving the objective while at the same time locking down risk. This has become known as liability-driven investment (LDI).
LDI can be an effective way of better matching the investment of assets to the expected movements in the value of the liabilities that they ultimately need to meet. LDI has come in many guises such as cashflow matching and duration matching. However, these approaches have not addressed the problem of reducing the burden on the company, especially where large deficits exist. This is predominantly because the more you match, the more you lose the potential for a higher return. LDI in this form still required a trade-off between ‘equity’ (return generating assets) and ‘bonds’ (matching assets). Here LDI was focused on the matching of assets but did not address the mismatch of the return-generating assets relative to the liabilities.
In the period 2000 to 2003, as equity markets plummeted, the focus of most pension scheme trustees was the impact on funding levels from the decline in equities. However, over this period equity falls accounted for just over half of the decline in funding levels while interest rates and inflation accounted for the remainder. This widening of deficits together with an increase in the regulatory focus on schemes has meant that trustees have needed to find new ways to address these risks.
The changing perception of risk combined with increasing acceptance of the use of derivatives by pension schemes is leading more and more trustees to consider locking down these types of risks. This has led to the development of a new approach to LDI, which uses derivatives to reduce these risks across all scheme assets, not just the matching assets. Historically, LDI has meant a loss in returns. However, combining this with holding a diversified portfolio of return-generating assets rather than just equities is likely to reduce volatility and allow a better attribution of the risk budget. This effectively enables a greater portion of the assets to be invested in higher return assets.

Wood or trees?
Ultimately, however, there is an even greater risk facing trustees, not from equities or inflation or interest rates over the short to medium term, but from a potential change to regime in the financial markets. For example, currently assumptions are made for long-term asset returns and yields, but what if these prove to be wrong?
The focus today is on the perceived current low-yield environment. However, this is only the case if we consider the past 30 years or so. Looking back over the history of bonds (which spans over 300 years) there have in fact been multiple-decade periods when yields averaged significantly lower than current levels. This may or may not be likely to recur, but it is a distinct possibility. Currently, most pension schemes are highly exposed to this sort of regime change, and the impact on the assets and funding level would be substantial. Such a scenario should be an important consideration in the decision whether to reduce these risks.