The challenges facing pension trustees and corporate sponsors are well understood, but the fundamental problem that both sides must ultimately solve is that in order to secure and protect member benefits, deficits have to be repaired before all member benefits are paid out; this is the key ALM challenge facing the UK pensions industry and unfortunately deficits have proven to be a stubbornly intractable problem for more than a decade now.
The good news is that both trustees and sponsoring companies each bring an important and powerful lever to the table to repair deficits. On the one hand, trustees have at their disposal the power to set investment strategies that can target asset outperformance relative to liabilities, while on the other hand, sponsors can increase contributions to cover shortfalls. The bad news is that trustees and sponsors typically hold investment and funding discussions separately and have not historically considered investment and funding in an integrated way. This is changing. Indeed, the Pensions Regulator’s 2013 Annual Funding Statement encouraged trustees to take an integrated approach to address covenant, investment, and funding risks and to be in a position to evidence how this has been done.
In considering the Regulator’s guidance, a sensible question for trustees and sponsors to ask is how much of the deficit can and should be repaired through expected asset return versus how much through sponsor contributions. A more interesting question, however, is whether better outcomes for both trustees and sponsors can be found by investigating different combinations of the two levers for a given recovery period and to do this, trustees and sponsors need a framework that integrates investment and funding. The following schematic illustrates how such a framework can be put together by assessing the interaction among the different policy levers available to trustees and sponsors when establishing a deficit recovery plan (click to enlarge).
The key that brings investment and funding together in an integrated way is risk. If, for example, a sponsor is willing to repair most of the deficit through contributions, then the trustees may be able to run a lower risk investment strategy and/or put in place a shorter recovery period, whereas if the sponsor is unwilling or unable to increase contributions, then the trustees may need to target higher returns by running a more risky investment strategy and/or agree to a longer recovery period.
The following schematic illustrates how investment and funding can be integrated into a single framework by showing how changes in investment strategy and assumed contributions also changes risk. Within the integrated framework, risk would be defined in terms of contributions-at-risk (“CaR”) which measures the least amount that sponsor contributions would need to increase by in order for the scheme to meet its stated funding objective in response to an adverse market move. The sum of expected asset return, sponsor contributions, and CaR is in many respects the total amount that the sponsor covenant must support or “covenant load” (click to enlarge).
As the schematic shows, a lower covenant load can be achieved through a more balanced split between expected investment return and contributions. Where the framework is used to facilitate additional de-risking, such as increasing the hedge ratio, further reductions in the covenant load can also be accomplished, as illustrated above.
While the framework is relatively straightforward in concept, it is more challenging to implement in practice. A number of issues must be considered, including defining the funding objective, recovery period, and risk-adjusted valuation rate for assumed contributions as well as being able to facilitate constructive and timely discussions between trustees, sponsors, and other advisors, but when both trustees and sponsors work together to better balance investment and funding, true “win-win” outcomes can be found for both.