The role of a pension plan is simple: ensure members receive their pension in full, and on time. However, the tools, approaches and terminology used to govern these plans are anything but simple. There are multiple valuation bases — technical provisions, buyout, self-sufficiency, International Accounting Standard 19 — to name a few.
There are many statistical approaches to measuring risks, such as volatility, value at risk and conditional VaR. How these various measures relate back to the specific role of paying pensions takes significant skill and judgment. It is exceptionally hard for trustees to establish how to trade off the various risk and return measures as part of their fiduciary duties.
A new approach, which I believe helps provide a much more intuitive framework for decision-making and that focuses on a more long-term measure than the predominantly short-term measures currently employed, should be considered. The approach recommends carrying out asset-liability modeling on thousands of different scenarios for the entire life of the plan (i.e., until the last payment is made). It then looks at how successful the plan has been at paying all pensions in full and on time across all simulations.
The approach uses a measure of success for a scenario that we call "proportion of benefits met," or PBM. As a simplified example, suppose the trustees have promised payments of £100 a year for the next 20 years. The plan's assets meet these promises for the first 10 years but then the sponsor defaults, the scheme is terminated, and only 50% of the remaining benefits are met on buyout (the likely scenario in the result of a sponsor default). In this instance the PBM value would be 75%.
Trustees can explore a range of asset allocations and choose the one with the most attractive distribution of PBM. A benefit of this approach is that it recognizes pension plans are long-term investors and ensures the benefit of being able to hold an asset over the long term is considered. This is not the case using shorter term measures of risk and return. For example, with corporate bonds it will focus on the risk of default rather than shorter-term mark-to-market impacts.
A further benefit is that this approach incorporates covenant risk explicitly. This is the risk that a sponsor becomes insolvent, forcing the scheme to dissolve. This would typically either result in a buyout or cause the scheme to enter the Pension Protection Fund. Both events are unlikely to meet our definition of success because pension payments would not be paid in full as the plan is very unlikely to be in surplus on a buyout basis.
Covenant risk is typically a long-term risk. For example, based on history, the probability of the average sponsor defaulting over one year is only around 1%. But over 20 years, this probability is as high as 1-in-3 and with perhaps half of the liability cash-flows remaining. Current approaches either ignore covenant within the asset-liability modeling or allow for it in a broad and implicit way. Longevity risk is similar in that its long-term nature can be captured better using long-term measures such as those based on PBM.
Trustees of well-funded pension schemes might not think covenant risk is too important. However, even a fund that is 100% funded on a self-sufficiency basis — such as a government plus-zero basis — runs some form of covenant risk because it is unlikely to be fully funded on a buyout basis. This means in the instance of a sponsor default that members are likely to have to take a reduction in pension payments.
Target higher returns
Allowing for covenant risk can promote targeting a higher return from the plan's assets. For example, we believe a typical scheme with a BB rated sponsor should hold a significant (10%) allocation to growth assets even when 95% funded on a buyout basis.
Given that buyout is the most expensive way of securing benefits, optimization suggests holding more in return-seeking assets to help close the larger funding gap on buyout sooner. Plans are very likely to regret not having targeted a higher return if the sponsor goes bust in 20 or 30 years.
In terms of a derisking glidepath, this can mean derisking later or by less than if covenant risk were ignored.
Plan executives do not need to completely replace the approaches now used. They could instead use the longer-term, PBM approach to provide additional input into their decision-making. This can help check the judgment they have applied to the more traditional, shorter-term approaches stacks up over the long term.
We believe this would be more intuitive, helping align the asset allocation approach more closely with the ultimate role of the trustees and the pension scheme and factoring in longer term risks in a more understandable manner than the current framework used by many schemes.
As a first step, if there are allocations that provide better longer-term security without materially worsening the short-term dynamics, why not move to them?
Graham Moles is head of portfolio solutions at Legal & General Investment Management, London. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.