Why short-term investment volatility cannot be ignored

For years, many schemes employed a long-term approach to investing, without much focus on short-term volatility, and the results were disastrous.

Over the 18-year period to 2012, the average funding level for the defined benefit schemes of the FTSE 100 companies declined to 87 per cent from 120 per cent, according to a survey by consultancy LCP.

When fully funded, a small amount of investment risk may be appropriate

With 86 per cent of DB pension schemes now closed to new members or to future accruals, in our view the vast majority should be concerned with managing short-term investment volatility in order to maintain a funding level that allows them to pay benefits for as long as possible.

Trustees and plan sponsors are both incentivised to focus on short-term volatility. A trustee’s first duty is to the scheme beneficiaries.

Therefore, the primary responsibility is to ensure an adequate funding level for the scheme so that it can pay its beneficiaries.

If trustees take inadvertent or unnecessary risk that erodes the funding level, the scheme will be left with an unfunded obligation.

While a funding gap could be closed with a contribution from the plan sponsor, this is a risky strategy itself.

Sponsor contributions are equivalent to an untradeable, illiquid, debt obligation of a single corporate sponsor. Therefore, relying on them to close deficits poses an outsized, highly concentrated risk to the sponsor.

Regulatory imperative

While fiduciary duty should encourage trustees to carefully consider risk, accounting regulations are providing plan sponsors with a reason to focus on short-term volatility.

The general trend in corporate accounting guidelines discourages risk-taking, which should be consistent with most DB schemes’ goals of maintaining funding levels.

The 2013 changes to IAS19 now require companies to fully mark to market any surplus or deficit in the scheme on the balance sheet.

As such, even a temporary deficit in the pension could negatively impact corporate earnings because of the hit to the balance sheet.

In addition, a change in the standard requires that company assumptions about the expected return on assets, which impacts pension expense and, in turn, company profits, not depend on the asset allocation. Therefore, there will be less incentive to have high equity allocations in order to justify a high expected return.

Under some circumstances, taking some risk may be appropriate, such as when a scheme is open and growing, small relative to the size of the company, or underfunded.

When a scheme is open and growing, cash inflows to cover the new service accrued by employees are large relative to investment returns, and can cover many investment mistakes.

When the scheme is small relative to the size of the company, the sponsor can more easily make contributions to close funding deficits.

Lastly, if a scheme is underfunded, it may be dependent on sponsor contributions, which have risks akin to a single, untradeable, illiquid bond, so trustees and sponsors may seek to balance that highly concentrated risk with other risks, such as equities.

However, as soon as the scheme has matured, is back to fully funded, or if the added risk threatens to have a material impact on the sponsor, the risk should be reduced.

Judging exposure

When fully funded, a small amount of investment risk may be appropriate to cover the remaining risks, such as inflation and longevity risk, and variation in actuarial assumptions, which are difficult to completely hedge.

Yet our 2013 UK corporate pension plan survey indicates this year’s rise in interest rates and equity rally have left many schemes significantly underallocated to debt with respect to their journey plans.

The trend is even more pronounced with small schemes, where the average allocation to equity for schemes less than £100m is 52 per cent, which is 20 percentage points higher than the allocation for schemes with assets in excess of £5bn.

In all cases, the high equity levels may in part reflect the prevalence of yield-based derisking triggers. We instead advocate derisking triggers based on funding levels, because they are more outcome-oriented.

Challenging investment results, changing accounting regulations and the fiduciary duties of trustees are aligning stakeholder interests and shedding light on the risks of not considering short-term investment volatility.

Katie Koch is the head of the global portfolio solutions group for EMEA and Asia-Pacific ex-Japan at Goldman Sachs Asset Management