Managing downside risk in defined benefit schemes
17 November 2021
Investment strategy is the powerhouse of any defined benefit (DB) scheme.
Strategies are as unique as schemes themselves, based on characteristics such as the maturity of the membership, strength of the sponsor covenant, scheme rules and a host of other factors.
Every scheme can be certain about its own internal structure, but investment market behaviours and their impact on funding positions are less easy to predict. Political uncertainty, the long-term effects of Covid-19, and looming inflation will all impact markets over the coming years and will increase the pressure on trustees to carefully manage downside risk.
Uncertain market conditions carry opportunities as well as risks, but for trustees, achieving predictable, consistent returns over many years will be a closer match for pension scheme liabilities than achieving stellar growth in a single quarter.
Ways to manage downside risk
The traditional route to managing downside risk has been through diversification: holding a mix of different asset classes in the expectation that if some assets go down in value, others will go up and the portfolio will ultimately balance out, with a slow but consistent rate of growth.
However, there are also interesting new directions and options available to trustees, both within individual asset classes and across portfolios as a whole. One example is the deployment of structured equity portfolios, which can make a potentially volatile growth asset class a closer match to the needs of a pension scheme. These work by sacrificing some of the potential gains from equities in order to provide greater protection against losses.
Other real asset classes, such as commercial property and infrastructure, can provide good protection against the threat of inflation in particular – although deciding to invest in illiquid assets requires careful thought about the long-term direction of the scheme, particularly if the sponsor and trustees are working towards a buyout.
Over the last 10 to 15 years, we’ve seen a boom in liability-driven investment (LDI). These products aim to manage funding level risk, which arise when a scheme’s liabilities increase at a different pace to the assets, due to small changes in interest rate or inflation expectations, for example. A well-run LDI approach should stabilise the funding level and ensure that a scheme’s assets can keep pace with its liabilities, even if markets underperform.
With so many different ideas and new investment thinking in the market, it can be difficult for trustees to keep on top of the options available to them. Through our experiences of working with a range of different schemes, in a variety of different situations, here are four tips that will help all schemes manage downside risk:
Stay on top of the latest investment thinking: Emerging ideas, such as structured equity portfolios, give schemes new ways of managing risk. We can help boards stay up to date with current trends as well as checking that investment consultants and fund managers are putting forward the best options for each scheme.
Make sure all stakeholders are comfortable with the approach to risk: Trustees, sponsors, and other stakeholders such as regulators need to be comfortable with the amount of risk within a scheme’s investment strategy. For example, a charitable sponsor should feel confident that trustees aren’t exposing the scheme to large losses and the possibility of more, potentially unaffordable, deficit repair contributions in future. And likewise, if the sponsor covenant is weak then the trustees will have to balance protecting the existing funding position against investing in riskier assets to reduce the need for further ongoing contributions.
In exceptional circumstances there can be a mismatch between sponsor and trustee expectations: for example, trustees may be put under pressure by the employer to take more risk than they feel comfortable with, in order to reduce scheme deficits. In these cases, agreeing the long-term goals for both the sponsor and the scheme is often the route to arriving at an investment strategy agreeable to all.
Plan for the long term: For schemes that are closed to future accrual, the ‘end game’ – whether that’s self-sufficiency or insurance buyout – is a major consideration for both trustees and sponsors that will help to shape future investment plans both in terms of growth and downside protection.
Be confident that you can manage the strategy: Any investment approach needs a clear, appropriate strategy that the trustee board is confident it can manage well over the long term.
Professional trustees can help to equip any scheme with the skills and knowledge they need to manage downside risk effectively, from accessing the best consultant ideas, through to building, managing and monitoring a suitable investment strategy.