Unprecedented DB scheme funding levels: Is this as good as it gets?

The funding ratio of the 5,215 UK DB schemes in the Pension Protection Fund’s 7800 index was 109.1 per cent funded in January — its highest level since at least October 2007 — while the aggregate full buyout funding ratio is at its highest level in 15 years, according to data from the PPF’s Purple Book.

This poses the question for the £2.4bn DB market: is it time to derisk? 

To answer this, we need to understand the macro environment that led to the current state of corporate DB schemes.

For schemes where current funding status exceeds 100 per cent on a full buyout basis, the present conditions may truly be as good as it gets

Monetary easing following the great financial crisis engineered one of the greatest bull markets in equities and global bonds. Against this backdrop of a very long credit cycle, the pandemic caused a blip.

However, thanks to the unprecedented monetary and fiscal response, nearly four times the response following the great financial crisis, there was a dramatic rise in the value of all risk assets and global bonds, while spreads and risk premia shrunk and volatility collapsed, sending funding ratios soaring.

We believe these investment gains and funding levels look unsustainable, and plan sponsors should start to consider derisking DB plans, particularly in light of the global macroeconomic outlook.

What drives DB funding levels?

The primary drivers of DB funding levels are investment performance, price inflation (cost of benefits), and the time horizon of payouts.

Accommodative monetary and fiscal policy initiatives since the great financial crisis have led to soaring valuations of equities and bonds, thus benefiting the asset side of the pensions balance sheet.

However, inflation is now at a 30-year high, after being subdued for at least the past 25 years, and long-term inflation expectations are close to a 10-year high.

Many scheme trustees have not had to watch too closely how accurately their investments are hedged against rising inflation and therefore increasing liabilities. But a persistence of the current bout of supply-driven inflation and market expectations are changing this.

Because most pension schemes have a long-time horizon, the primary decision to derisk will be driven by investment performance and inflation risk, and this is worth closer evaluation.

1. Equities have had a stellar performance over the past decade and, given current levels, expected returns on equities today are not as high as they were in the previous decade. Global monetary authorities have signalled rate increases, and thus expected price returns for sovereigns in 2022 is negative.

2. DB plans invest in investment-grade credit and, given very tight spreads, expected excess returns are paltry at best (50 basis points) and likely negative.

3. Most schemes will be less than 100 per cent hedged on inflation — therefore, higher realised and implied inflation (per the current trend) will result in a greater increase in liabilities relative to assets, and an increase in deficits. With uncertainty over inflation, sponsors and trustees should be braced for further volatility in 2022.

To derisk or not to derisk?

DB plans inherently have a growth risk built into their exposure due to significant allocations to equities.

Given the substantial gains in the past decade, particularly in growth equity indices, it is prudent to consider limiting this growth risk inherent in DB asset allocation models. This is the first benefit of derisking.

The second benefit is behavioural, namely ‘fear of regret’. The risk of not derisking is the regret from a reversal in funding levels.

Historically, high funding levels have not lasted long. We now have a cycle where funding levels (on a section 179 basis) are more than 90 per cent for a significant amount of time (since 2017), but investment returns in the next decade are highly unlikely to match those of the past decade.

Finally, there is the issue of volatility of asset-liability profiles. With central banks globally raising rates to respond to trends in inflation, volatility of rates increases, and, by inference, prospective volatility of funded status will also widen.

Thus, from a risk viewpoint, the consideration of derisking seems logical to ensure the end game target does not get further away.

The options

While there are many strategies to derisk, plans with a comfortable funding surplus can comfortably consider paying the insurance buyout premiums.

Otherwise, alternative strategies include cash flow-driven investing, liability-driven investing for managing liability risks (interest rate and inflation), or some form of tail risk protection for the inherent growth risk in portfolios.

Overall, for schemes where current funding status exceeds 100 per cent on a full buyout basis, the present conditions may truly be as good as it gets.

Jeremy Rideau is Emea head of liability-driven investment and derivative solutions at State Street Global Advisors