Scheme funding: Three industry experts have their say

Tim Banks
Principal, delegated services
Mercer

Tim Banks is a principal in Mercer's delegated services team and is responsible for business development.

He joined Mercer from AllianceBernstein where he was responsible for fiduciary investment solutions for defined contribution, defined benefit and wealth management clients.

Banks has 25 years industry experience, with broad experience across the pensions and investments landscape - and has held a variety of senior positions at firms including Fidelity Investments, Prudential, Lloyds TSB Registrars, and Standard Life having started his career at Willis Towers Watson.

Darren Redmayne
Chief executive
Lincoln Pensions

Darren Redmayne is chief executive of Lincoln Pensions, the specialist covenant advisory subsidiary of The Cardano Group.

Redmayne's background is in corporate finance, M&A and restructuring. He undertook a secondment to the Pensions Regulator in 2006 and helped establish its scheme funding team and develop its approach to employer covenant.

He took this experience to go on to form and lead Lincoln Pensions which now advises schemes and sponsors of all sizes across a wide range of sectors.

Matt Wilmington
Director of strategic transactions
Legal & General

Matt Wilmington is responsible for structuring and implementing large scale de-risking transactions as well as product strategy.

Prior to joining Legal & General, Wilmington was a partner at a major actuarial consultancy where he was a partner responsible for advising trustees and corporates on de-risking strategy.

He has led on a number of high profile buy-ins and been instrumental in developing Legal & General's longevity insurance strategy.

How big is the funding challenge facing DB schemes currently? To what extent should trustees be concerned about the scale of the funding challenge?

Tim Banks: Mercer's Pensions Risk Survey data shows the accounting deficit of defined benefit (DB) pension schemes for the UK's 350 largest listed companies was an eye-watering £152bn as at 30 September 2016. This highlights the scale of the funding challenge facing DB scheme trustees, deficits near an all-time high, compounded by the time horizons for securing benefits continuing to fall.

Clearly each scheme's circumstances differ dependent on the current funding levels, sponsor covenant and the scheme demographics. Trustees need to carefully consider all of the issues against the backdrop of their own circumstances, and set out their key strategic objectives to meet the liabilities. These will reflect both their investment beliefs and the sponsors' commitment.

In addition to long term objectives, trustees need to manage an increasing number of short-terms factors along the journey. With a sharp fall, and subsequent rebound in bond yields over 2016, market volatility and generous equity valuations, governance models need to be able to cope with the ever faster changing environment. Added to this schemes are increasingly becoming cash-flow negative, bringing with it an increasing focus on funding level volatility.

Darren Redmayne: Market uncertainty surround events like Brexit and concerns about future global economic growth together with further QE has created further demand for safe haven assets and driven down long-term government bond yields. For the UK, the impact of sharp falls in gilt yields has ballooned DB liability valuations, as these are typically based on longer term gilt yield curves.

Estimates of the aggregate funding challenge - i.e. the aggregate value of UK DB pensions deficits - vary with a number of commentators citing figures up to £1trn. The scale of this funding challenge is clearly enormous and seems to have no end. Any trustee reading these figures would understandably be concerned. Indeed, the figures now appear so large that it has led to a recent re-emergence of a spirited debate about whether or not pension scheme trustees, sponsors and actuaries are using the right approach to valuing DB liabilities.

Broadly, two distinct tribes have surfaced: one which believes pension schemes can and should operate with a material level of risk for considerable time, seeking to benefit from investment returns and generating cash-flow to fund benefits as and when they fall due over decades (the collateralised pay-as-you-go approach); the other which believes that pension schemes should target full-funding, on a de-risked measure which enables an eventual buy-out / risk transfer to an insurance company (the flightpath to buyout approach).

The area that has received less attention in the debate and which helps reconcile the two views is the crucial concept of sponsor covenant - i.e. the corporate sponsor's ability to stand behind the investment and funding risks of the scheme over the required term.

The extent to which trustees should be concerned about the funding challenge for their scheme should be very directly related to their view of their sponsor covenant. If they have a strong sponsor, with a business that can underwrite substantial risk (be they operational risks in the business or risks in the pension scheme) then there is less reason to be concerned. Conversely, trustees should seek help where they believe their covenant may be weak.

Matt Wilmington: Maintaining and improving scheme funding is, and should be, at the forefront of trustee considerations. Prolonged periods of low interest rates and volatile markets, coupled with increasing life expectancy means that challenge is now greater than ever.

There is no need, however, for trustees to be concerned over the scale of the challenge. The range of opportunities available to trustees to manage their funding position is now greater than ever. By being well organised, nimble and open to ideas trustees can take advantage of these opportunities, improving their funding position and the security of their members' benefits.

What do you believe are some of the key steps trustees could consider to help address their DB funding challenges?

Tim Banks: We strongly believe that strengthened governance leads to better outcomes. Many trustee boards have reconsidered their governance model in the light of The Pension Regulator's (TPR's) guidance on integrated risk management, and set out a journey plan of how to secure member benefits, bringing together the scheme funding, investment strategy and employer covenant.

It is important to firstly understand the end-game as this will influence the investment strategy implemented. Our fiduciary management business assists trustees in setting out the most efficient journey plan, the optimal investment strategy and short terms targets (for example, de-risking triggers).

Having set out a realistic journey plan, with the trustees and employer on the same page, it is then important to understand how the journey plan will be executed and how short term risks can be managed. In implementing against the journey plan trustees will require visibility of how the scheme is performing against its funding level.

Our Fiduciary Management service provides that level of visibility, and proactively manages the investment strategy, taking advantage of opportunities and reacting to risks, on a daily basis. So far this year we have hit over 36 funding level triggers for our clients, allowing us to de-risk investment strategies. Some of those opportunities only lasted for a few days, so for many UK pension schemes that utilize a traditional governance model they would have never identified an opportunity in the first place, nevermind taking action on the back of it.

Brexit provided a clear example, where all schemes debated the risks the pension scheme faced, but with most lacking the capacity to take decisive action in time. This is in sharp contrast to our fiduciary management clients.

Darren Redmayne: TPR has highlighted the importance of an objective evaluation of the sponsor covenant for over a decade. In its recent integrated risk management guidance, covenant risk was cited as one of the three fundamental risks (alongside investment and funding/actuarial risks) to a DB scheme.

Notwithstanding this guidance, while covenant risk is increasingly well-understood among larger schemes, mid-sized and smaller schemes have often been slower to respond. Indeed many trustees still only appoint a covenant adviser when they encounter a problem, or are given a gentle nudge to do so by TPR. The best time to bring a covenant adviser on board is when both sponsor and trustees don't think they need one. It is typically during this benign period that the petri dish of future covenant risks is put in the airing cupboard and, if trustees are active and well-advised during this period, policies can be implemented that ensure the scheme's position is better protected if covenant issues develop.

Related to understanding the covenant is gaining a far better understanding of the competing demands for cash within the business and what is an appropriate level of affordable contributions. As part of that assessment, the equitable treatment of all stakeholders is a relevant consideration. For example, dividends, of themselves, can be a necessary and important aspect of delivering a return to shareholders thereby enabling sponsors to access capital from investors. However, if dividend payments are disproportionate to either scheme contributions or appropriate reinvestment in the operating business then covenant issues can quickly develop.

Matt Wilmington: There are three main areas where trustees can invest some time up-front to ensure they can make the most of any opportunities to improve and secure funding - understanding, preparation and governance.

The first, understanding, relates to ensuring they have the full picture. There are a multitude of options available to trustees to de-risk and/or improve their funding position, insurance solutions, liability management, other investments and so on. By ensuring the full picture is understood, trustees are putting themselves in the best possible position to meet their funding challenges. Legal & General are always happy to provide training to trustees on their solutions - a free resource trustees should take advantage of.

Preparation is important in many areas. Areas to consider are:

• getting the right advisors with demonstrable relevant experience - a well-run process not only reduces advisor fees, but also ensures that the trustees are able to quickly and effectively decide upon and implement the optimum solutions.
• working with insurers to reshape liabilities to achieve the best outcomes - schemes and insurers may have different views on a number of factors (for example inflation expectations), by working with an insurer on such projects, schemes can ensure they get the best 'bang-for-buck' out of any possible transaction. Legal & General worked this way with the TRW pension scheme, putting full buy-out (previously thought to be unaffordable) well within reach, completing a transaction in 2014.
• ensuring data is clean and up to date - understanding the true liability position and being in a position to de-risk quickly can lead to substantial funding benefits when the time comes to enter into any form of potential funding activity.

Governance is the final area. Pricing for insurance or other de-risking assets can move quickly - an example of this is the Brexit vote in the UK in June. Bulk annuity pricing fell by as much as 10% in the week following the vote - those schemes that were prepared and had the governance process in place to move quickly were able to take advantage of this pricing and address some of their main funding challenges. The ICI Pension Fund is a great case study - by being prepared and by having a well-defined and transparent governance process they were able to execute a buy-in transaction covering £750m of liabilities with Legal & General a handful of days after the results of the referendum.

Too often opportunities can be missed as they do not fit within the trustees' regular quarterly meeting cycle. By delegating authority to smaller committees with well-defined responsibilities and price targets, trustee boards can position themselves to react much more quickly when pricing might move in their favour.

Engaging with an insurer early as part of that governance process will also reap benefits for trustees. In particular this will enable insurers to work for the trustees - knowing a transaction will happen if a certain price target is met allows the insurer to seek out investments to meet those targets.

Do schemes need to do things differently going forward? To what extent do they need to revaluate the amount and security of sponsor contributions; look beyond traditional investment strategies; or overhaul governance structures in order to help solve the DB funding challenge?

Tim Banks: As the fiduciary management market evolves, trustees continue to look for the most efficient means of achieving their objectives, taking full advantage of investment innovation and market opportunities. On average schemes utilising fiduciary management services, have outperformed the average UK pension scheme, saving money in the process.

The ability to task a team to pro-actively manage the investments to a fully defined journey plan, ensures that the trustees have a team looking after the schemes assets at all times. Managing the growth and matching assets against the scheme specific objectives, taking market driven opportunities as they present themselves.

Many schemes are able to source a better risk adjusted return, through optimising their portfolio, finding better managers or utilising better sources of return. For example many schemes have an illiquidity budget but often do not make use of this, sometimes due to knowledge, but commonly due to implementation difficulties. Mercer's private markets business allows schemes to implement private markets exposure across a highly diversified set of opportunities for as little as £5m of assets, allowing trustees to benefit from superior risk adjusted returns. This would also apply to hedge funds where a diversified portfolio of alternative risk premia can be used.

In considering fiduciary management , new innovation has continued to be implemented for the benefit of clients. The full end to end journey of a scheme should be considered when considering partners. A full tool kit would include techniques such as cash-flow driven investing. Typically for those at or near self-sufficiency, cash flow driven investing aligns the scheme funding with the investment strategy and is specifically designed to meet each scheme's cash flow requirements as they fall due. For those considering an insured solution, new innovation such as Mercer's Pension Risk Exchange, giving full price discovery on tranches of assets, assist trustees in securing benefits.

Darren Redmayne: There will need to be much greater collaboration with sponsors and information sharing than previously. Sponsors that want trustees to take risk for prolonged periods will need to demonstrate that they have the capacity to underwrite those risks. Schemes will need to work with sponsors to understand the underwriting capacity of their sponsor's business (another way of expressing the strength of the covenant). With that, and a good understanding of the risk inherent within the sponsor's operational business plans, the amount of available underwriting capacity left to stand behind scheme risks can be established.

With a clear understanding of the risk capacity available to support different investment strategies it is possible to look beyond more traditional investment approaches and utilise covenant-driven-investment (CDI) strategies. This will require covenant advisers to work more closely with their client's investment advisors to optimise the approach directed by the scheme trustees and their sponsors. In this way trustees and sponsors can ensure that the scheme investment risks being run are appropriate for that strength of covenant and their risk appetite.

Whether pursuing a full-funding objective on a relatively de-risked funding basis or seeking to operate the scheme with material risk for the longer-term, it will be almost universally be the case that sponsors and trustees will need to work together for much longer than previously expected to meet the DB funding challenge. This may indeed necessitate a revaluation of the amount and security of sponsor contributions to ensure that any covenant risk is mitigated where necessary and kept in balance with other risks.

Matt Wilmington: Security of members' benefits is paramount, and despite the safety blanket of the PPF, trustees will be concerned with ensuring each member receives their promised benefits in full.

Being well funded on a risk free basis is the first line of defence - but, of course, relatively few pension schemes enjoy this luxury. Security of future contributions therefore becomes a critical factor. As well as understanding and allowing for sponsor covenant, trustees must also concern themselves that funding continues to move in the right direction and the reliance on the sponsor does not become greater.

Trustees should look beyond the traditional asset classes, and in particular to insurance, which does not have to be an all-or-nothing decision. Schemes are increasingly thinking of insurance as another asset class - and gradually de-risking through a series of insurance transactions each making the scheme more secure and less reliant on the sponsor.

By becoming more nimble in their decision making, trustees can take advantage of insurance opportunities to ensure existing funding is secure. Ensuring the governance process allows a speedy execution puts trustees in the position of being able to take advantage of attractive market pricing when it arises and de-risk with no impact on the overall funding level.