A number of pension funds may well face a big test at their next actuarial valuation. With a combination of falling stock markets, low bond yields and increasing life expectancy pension fund solvency levels are coming under severe pressure. No wonder that in the UK the government has just announced reform measures to its Minimum Funding Requirement.
The draft regulations extend the period over which pension schemes have to correct their deficits. Under the existing regime, seriously underfunded schemes, whose assets were worth less than 90% of their liabilities, had to bring the assets up to more than 90% within one year. They will now have three years in which to do so. Schemes whose assets are worth between 90 and 100% of the liabilities will have 10 years, rather than three years, to make good the shortfall. In addition, we will have a regime of transparency and disclosure, a recovery plan for returning schemes to full funding, a statutory duty of care on the scheme actuary, stricter conditions on scheme wind-ups with a solvent sponsor and an extension to the fraud compensation scheme.
Any shortfall in a defined benefit pension (DB) fund has to be made good by the sponsoring company. This onerous responsibility and the existing timescales has proved to be a significant disincentive to companies sponsoring schemes. In too many cases it has helped persuade companies to close their pension schemes.
Of course, none of these reform measures will actually make UK funds better off but they should ease the pain of carrying a big deficit. However, and especially following the introduction of International Accounting Standards, trustees are not the only ones interested in the issue, all companies and especially quoted companies are forced to address their deficits and the increase in future pension liabilities.
Many companies are solving future problems by closing their DB schemes and moving to defined contribution (DC). Of course this doesn’t address the problem of the accumulated deficits. So what are funds doing to protect themselves, to manage the risk of liabilities exceeding assets?

According to Ron Liesching, chief research strategist at international currency specialist, Pareto Partners, four clear trends have emerged over the last few years. Firstly, funds are reducing their home country bias. Second, there is a universal investigation of alternative investments. This covers absolute return strategies, such as commodities and hedge funds as well as private equity and alternative fixed interest investments. Thirdly, institutions are confronting the challenge of the new low yield environment for government bonds and significantly increasing their allocation to corporate bonds. Lastly, funds are reassessing their current external managers. They are using performance attribution, and increasingly, risk attribution. As a result, funds are increasing the index-linked portion of their portfolios and cutting back on the number of managers they are employing in the large liquid markets.
The start of a risk management process is sometimes explicit but often less formal or even accidental. However, once the process is started it will continue and undoubtedly develop. The starting point must surely be an audit of the risks to which a fund is currently exposed. First find the risks then manage them. At a time when returns need to be enhanced, it may not be sensible to reduce a risk budget but using proper management it should be possible to ensure returns are increased.
We are not likely to see for some time, the level of fund returns we saw over the last two decades. This gives funds and sponsoring companies two main options: firstly they can move out of equities and lock their funds into lower risk asset classes such as index-linked or corporate bonds. This probably implies higher but more certain contribution levels. However, for the majority of funds this is not acceptable and the new situation means that for the foreseeable future the only way to significantly improve returns relative to acceptable risk levels is to diversify.
Diversification of a fund is a very simple method of reallocating a risk budget. For example, in the UK this means funds moving away from the heavy bias to UK equities; for Danish pension funds it means moving away from Danish government bonds. It also means internationalising bond and equity exposures, but proper diversification will also mean moving into alternatives and not just private equity.
In the increasing search for non-correlating asset classes, an increasing number of funds are moving into hedge funds and commodities. In Europe the big Dutch funds such as ABP, PGGM and Shell are leading the way in their study of alternative asset classes. Too many of the big UK pension funds are still lagging behind, still clinging to equities – and UK equities at that – as the answer to all their problems. If stock markets continue to collapse, one has to wonder just how UK companies and their pension funds will react.