UK - Implementing a "conservative" investment strategy for the average defined benefit (DB) scheme could mean it takes an extra 16 years to become fully-funded, a research paper from the Association of British Insurers (ABI) and Fathom Consulting has revealed.

The research paper entitled 'Coping with uncertainty and the importance of the sponsor's covenant' examined the impact certain scenarios would have on an average DB scheme over a 90-year period.

It revealed the typical 'baseline' scheme - with a BBB-rated sponsor and 80% funding level - would have a 3% chance of insolvency in 90 years, while the employer would have a 45% chance of going bust.

More importantly, with an asset allocation of 60% equities and 15% gilts the schemes would have a 75% chance of being fully-funded to 125% within 10 years.

Peter Montagnon, director of investment affairs at the ABI, said the report resulted from the "recognition that the single number from accounting standards, such as FRS17, is useful but it doesn't give a complete picture".

He pointed out "a lot of decisions have to be made with pension deficits", which makes it a complex process which needs to be "thought through", and warned the "danger is everyone takes one option that's fashionable but which has risks that are not understood and which might not right for them".

The research examined a number of scenarios and issues, including the impact of different asset allocation strategies on the length of time taken to reach a fully-funded basis of 125% of liabilities - the conclusion being that a move to Asset Liability Matching (ALM) models reduces uncertainty but at a cost.

Figures showed if the average 'baseline' DB scheme moved to a more "conservative" strategy of 20% equities and 55% gilts the likelihood of the scheme becoming insolvent would only drop from 3% to 2%.

The change in strategy would not affect the chances of the sponsoring employer going bust - which remained at 45% - however it increased the median value of employer contributions needed to make up a deficit from £1.6m to £3.2m.

In addition, Rebecca Driver, director of research at the ABI, said the move towards gilts would increase the time for the scheme to reach a funding level of 125% by 16 years, making the switch to an ALM strategy a "bit of a double-edged sword".

The report also revealed a rise in longevity of five years would increase the probability of a scheme going bust from 3% to 5%, and employers would be more likely to become insolvent - rising from 45% to 50% - while the median 'top-up' contributions needed to offset the increase would rise from £1.6m to £13.5m.

However, the research showed if longevity increases are not recognised until the end of a scheme's initial recovery plan - around 10 years - then the asset allocation of the fund would have more impact on the survival of the scheme.

Figures showed a scheme invested 60% in assets would be 6% likely to become insolvent, compared to 3%, while the probability of an employer going bust rises to just 49% from 45%.

But a conservative investment strategy of 20% equities and 55% gilts would increase the likelihood of the scheme becoming insolvent to 7%, while the average top-up contributions from employers would rise from £1.6m to £12.4m.

As a result, the ABI warned "the belief that bonds can perfectly match pension liabilities is misplaced" and added "DB schemes that adopt liability-driven investment dogmatically may end up being ill-equipped to deal with future adverse outcomes".

The report also revealed switching from a discount rate based on corporate bonds to one based on gilts would have a "very limited impact on scheme outcomes" - with the risk of insolvency falling form 3% to 2%.

However it said top-up contributions would almost double to £3.6m, although the likelihood of the sponsoring employer becoming insolvent as a result of the increased liabilities only rises from 45% to 46%.

Other findings from the research showed increasing the recovery plan from 10 to 20 years would not affect the survival of the scheme, but would reduce employer contributions from £1.6m to £100,000.

That said, if an employer decides to make no additional or 'top-up' contributions over the life of the scheme the fund is 17% likely to become insolvent and the risk to the employer only drops to 40%, while if the scheme receives no employer contributions at all the probability of insolvency jumps to 23%.

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