Pension investment - thinking differently about risk

UK defined benefit pension schemes are rapidly maturing, and within a few years the vast majority are expected to be experiencing net cash outflow, posing a different set of challenges for both trustees and sponsors. To date, the principal focus has been on the operational implications of net cash outflow; that is, how to manage the mismatch between benefits paid and income received. Going forward, there will likely need to be more focus on the implications for risk management. The risk management challenge is expected to be exacerbated given the likelihood that the next 20 to 30 years will see a very different market environment to that which we have become accustomed.

Since the early 1980s, global interest rates and bond yields have fallen steadily, reaching levels that were once unimaginable. This has resulted in higher price-earnings multiples for equities and led to a “chase-for-yield” across many other asset classes, inflating asset prices across the board. Will current yield levels persist for another decade or two, and risky assets provide only modest returns? Will we see rising yields and falling asset prices? Will we enter a new environment of a kind never before experienced?

Unfortunately, these questions cannot be answered with any degree of confidence.

However, there are some things we can more safely predict. If history is any guide, there will be another major financial market crisis over the remaining life of UK defined benefit schemes.

Indeed, two such crises are probable, and three are possible.1 While some might argue that policymakers now know how to avoid market meltdowns, history should also warn us against such hubris.

Faced with shrinking assets and liabilities, the likelihood of lower secular investment returns, and the prospect of one or more large market dislocations, we believe that pension schemes will need to adopt a different approach to portfolio construction and risk management. They will need to focus more on earning the required return on their portfolio consistently, and avoid large or frequent drawdowns of capital. Daunting as this may sound, thinking differently about the nature of the risks they face, and the way in which those risks are managed, will go a long way towards meeting the ultimate objective of paying pensions when they fall due.

But sponsors and trustees will need to act quickly. It took close to a decade before the majority of schemes embraced an asset-liability risk management framework, which arguably contributed to rising deficits and, ultimately, large scale sponsor contributions. The consequences of not addressing the challenges posed by net cash outflow could be even more significant - indeed existential - with the result that members may not receive the benefits to which they are entitled.

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1Financial crises have been recorded throughout history, arguably an inevitable consequence of human nature. See Charles Mackay, “Extraordinary Popular Delusions and the Madness of Crowds”, Harriman, 2003, first published 1841 and Charles P. Kindleberger, “Manias, Panics and Crashes”, Wiley, 4th edition, 2000, first published 1978. 

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