Norbert Fullerton talks about the dark pensions clouds on the horizon and gives some advice on how to navigate towards a sunnier outlook
Bob Marley was one of the most innovative and well-known reggae musicians of all time. He had a passion for social change and, with a stroke of genius, got his fans to dance their troubles away. Although some were love songs, much of his music dealt with the struggles of the poor and the powerless. He would have been of pensionable age now at 70 years old.
So as a fan of his, I sometimes wonder what he would think of modern times and the new economic threats that face us.
So much trouble in the world
Speaking of the poor and powerless, the pensions poverty trap in the UK is very real and imminent. A report by Age UK says that 1.6 million pensioners in the UK are living below the poverty line, and are "floundering" on low incomes. In addition, according to a YouGov study, almost two-thirds of working adults in the UK are worried about a lack of money in retirement. This is staggering.
We also know that the world economy is not in good shape. The news from the US and the UK has been reasonably positive, but Japan's economy is struggling and China's growth is now slower than at any time since 2009. Unpredictable dangers, including stagflation, deflation, wars, terrorism and epidemics, such as Ebola, are rife.
Europe is one of the biggest economic threats by far. The Eurozone is on the verge of tipping into its third recession in six years. The European Central Bank recently announced a massive quantitative easing programme to stimulate spending and avoid a deflationary trap but it is unclear whether, and to what extent, it will be successful. Bob Marley once sang "One good thing about music, when it hits you, you feel no pain". Have the intermittent market recoveries in recent years dulled the painful memories of the crises and hindered pension fiduciaries from taking precautionary actions?
The big picture is sometimes forgotten; when running a defined benefit (DB) pension plan, the main aim is to ensure that members' promised pensions are secure and adequate, irrespective of the strength of the economy. Workers need to be able to retire with the amount of money they expect to have. Pension plan fiduciaries should focus on the things that matter - for example, setting realistic and aligned funding and investment goals, managing risks properly, and doing all it takes to have appropriate governance procedures in place to implement changes quickly. These steps are crucial in order to survive the 'new normal' world that we live in.
Falling bond yields and rising expected inflation are still the main liability risks within most DB pension plans. However, the risk of deflation is raising its ugly head and employers and trustees are increasingly worried about the impact of members living longer than expected. These risks must be managed appropriately. What is appropriate differs for each DB plan and is largely driven by the extent to which an employer's covenant can withstand even larger deficits.
Focusing on the above risks in isolation would help, but it's not enough. The Pensions Regulator's updated UK code of practice on funding defined benefits stresses the need to take a more integrated approach to funding, investment and covenant. The code also stresses the need for trustees and employers to be more collaborative. A lot of time and effort is usually spent debating the DB funding assumptions. However, they mainly affect the timing of employers' contributions - more money now and less later, or vice versa. More attention needs to be paid to the investment strategy that directly affects the pension cost to the employer. The strength of the employer's covenant is also quite often not properly taken into account. Reviewing investment strategy at the same time as the triennial valuation is no longer optional, it's a basic requirement to ensure fiduciaries are doing all it takes to align the key components that matter.
The focus now has to be on 'strategic risk management'. This involves managing the main asset, liability and employer covenant risks and putting the necessary measures in place to reduce them. It may not be glamorous, but the pain that we feel on the downside can be a lot more intense and longer-lasting than the thrill that we feel on the upside. After all, members are panicked by the doomsday scenario in which there is a big funding hole in their pension plan and their employer can no longer support it.
Stand up for your rights
It seems odd that many employers are not very actively engaged with DB pension plan investment decisions. Employers should take the initiative, conduct independent investment strategy reviews and formulate their own opinions. Agreeing an appropriate investment strategy with the trustees will help the employer meet its objectives of managing the variability of accounting disclosures and maintaining an efficient capital allocation process within the business. The trustees will also benefit from a well-governed DB plan, ensuring any agreed combined funding and investment strategies, including contingent assets, will increase the chances of retaining the employer's support, while increasing security for members' benefits.
Improving governance is also important. In his research, Keith Ambachtsheer, director emeritus of the Rotman International Centre for Pension Management at the University of Toronto, shows that the difference between good and bad governance can be worth between 1% and 2% of additional return per year. For some, increasing the frequency of meetings between a focus group of trustees and their advisers works well. For others, it may be more appropriate to delegate the implementation of investment strategy and day-to-day investment decision-making to either an in-house or outsourced team. It is also becoming more attractive to outsource some of the investment functions as increasing complexity means more time and expertise is required.
Some trustee boards and/or investment committees without a good risk management framework end up waiting on infrequent meeting dates to make critical investment decisions. On many occasions, this means that they can't respond quickly to favourable market opportunities or imminent dangers.
High tide or low tide
Despite the gloomy backdrop, DB pension plan trustees and employers can do a lot to minimise the potential damages:
Don't lose sight of the big picture. Set up a strategic risk management framework that looks at funding, investment and covenant issues together.
Keep track of how the above and other important risks develop over time.
Put in place a fit-for-purpose governance framework. Keep it simple. Have an action plan for how to react quickly if events turn out to be materially better or worse than expected.
Bob Marley's song So Much Trouble in the World sounds appropriate for the recent dark clouds of economic crises, wars, terrorist activities and epidemics around the world. The global market outlook might be positive in some places, but there are looming dangers and things can go from bad to worse very quickly. Sponsors and trustees need to collaborate more and take action to improve the financial security of those that rely on their decisions.