SEI’s Cyprian Njamma highlights some of the pitfalls for trustees during the re-risking process.
Journey planning for a pension scheme involves balancing the risk taken in the pension scheme in accordance with the need to take risk. As a result, higher funding-level positions are usually accompanied by de-risking of the scheme’s portfolio to bank gains and protect the future funding level.
In practice, this involves regular monitoring of the funding level, and where significant outperformance occurs relative to its expected path, the portfolio is ‘de-risked’ by reallocating a portion of growth assets such as equities to liability-matching assets – i.e. bonds and other liability-sensitive instruments. Funding-level outperformance usually leads to a lower deficit position and typically lower repair contributions required from the sponsor. For these reasons, de-risking has a feel-good factor to it.
In contrast, re-risking naturally has anything but a feel-good factor to it. Why? Because it is only necessary to consider re-risking after an adverse market event has already hurt the funding level position of the scheme. Re-risking may be required where the funding level performs below journey plan expectations, and other options such as higher contributions and/or lengthening the journey plan have already been considered. Quite simply, to get back onto the ‘journey path’, higher returns would be required, which invariably entails assuming higher risk. As pension schemes have been made all too aware over the past decade, scenarios can arise that necessitate re-risking, and these include:
- A significant interest rate fall. This may adversely increase the liabilities of schemes insufficiently hedged against interest rate risk.
- A substantial fall in equity markets. Likely to increase deficits of schemes with large equity exposures and minimal downside protection.
- Increase in market expectation of future inflation. A sharp increase may materially increase the value of scheme liabilities.
Reaching a consensus to re-risk is a difficult journey, one beset with many awkward decisions. For instance, the trustee board may feel uncomfortable about buying in to a falling equity market and metaphorically ‘catching a falling knife’. Furthermore, the adverse market conditions that triggered re-risking may negatively impact the financial position of the sponsor and possibly the strength of the sponsor covenant.
However, once an agreement to re-risk has been reached, trustees need to consider the practicalities of implementation carefully. This includes determining an appropriate level to which the scheme should be re-risked. For example, should the scheme be re-risked back to the allocation at the start of the journey plan, beyond this level or just back to the previous point of de-risking?
Trustees also need to consider whether re-risking should be an automatic process delegated to their chosen adviser, or if they would prefer trustees, company representatives and advisers to review the position when a re-risking trigger is breached.
With de-risking, there is usually a pre-defined agreement that, once funding level triggers have been breached, the asset allocation will be adjusted with a view to lowering the inherent level of risk being undertaken in the portfolio. By contrast, when a re-risking trigger has been breached, the process requires far more discussion and engagement from a wider range of stakeholders, not least the company sponsor.
Execution is key
Both re-risking and de-risking are amongst the practical techniques trustees can employ to help manage funding volatility in line with the need to take risk along a recovery plan. And although re-risking may conceptually sit uncomfortably with trustees, occasions may arise that warrant its use. As such, it is advisable to incorporate re-risking along with the full range of de-risking and insurance-based de-risking options into a fully bespoke journey plan for pension schemes.
Naturally, both re-risking and de-risking require regular monitoring of the funding level together with an ability to react to fast moving market changes. This is hugely challenging for many trustees who are constrained by a lack of resources, be that of their own time or expertise. Market conditions can change rapidly, requiring strategic changes in a far timelier manner than is possible through a quarterly decision-making process.
Outsourced solutions such as fiduciary management –otherwise known as ‘implemented consulting’ or ‘delegated consulting’ – can help address these problems by effectively acting as an in-house manager and plugging any resource and knowledge gaps. This includes taking responsibility for continuously monitoring the funding level and de-risking or re-risking along the journey plan as opportunities arise. The beauty of this arrangement is that trustees retain strategic control of the scheme but have the comfort of knowing that day-to-day investment responsibilities are being undertaken on their behalf within clearly defined parameters.
Cyprian Njamma is an asset and liability analyst at SEI
This article reflects the views of the individual author and not necessarily those of SEI