UK pension funds have increased their spending on stress testing and scenario modelling and forecast investment as they grapple with growing risks, according to new research from Ortec Finance.

Its study with UK pension fund managers responsible for a collective $186bn in assets under management found that 93% of participants have had their stress testing budget increased and all predict industry spending will rise over the next three years.

The research also found 27% of UK pension fund managers expect a dramatic increase in spending on stress testing and scenario modelling.

Deon Dreyer, managing director at Ortec Finance UK, said: “Stress testing and scenario modelling is becoming more important for pension funds in the UK and that is reflected in the increased budgets across the industry and plans to keep investing more.”

Key risks include inflation and climate change but less than half (47%) of fund managers surveyed believe pension schemes are well-prepared to deliver yield while remaining fully-funded or buy-out ready in the face of those challenges.

“The risks funds are facing are increasing with inflation and climate change identified as the biggest challenges to schemes trying to deliver yield so they can remain fully-funded or be buyout ready,” Dreyer added.

Around 27% said pension funds are poorly prepared while 23% characterised preparations as merely ‘okay’.

All fund managers are braced for rising inflation with 47% expecting a dramatic increase over the year ahead and 53% a slight increase. However, 50% said their scheme was very well hedged while 47% said it was quite well hedged.

Plans to address climate change risks include increasing their allocations to green investments – 77% said they would increase their allocation to climate-focused funds over the next two years while 63% intend to increase allocations to green bonds.

The research found the asset class most in demand would be investment grade fixed income which 90% said they would increase their allocation to it.

Technological advances are also playing a part in boosting spending on stress testing – almost all (97%) of those questioned said the adoption of more sophisticated investment strategies which technology enables means more time has to spent on stress testing.

“Pension funds need to manage their balance sheet effectively in order to achieve long-term objectives while dealing with short-term risks. That includes identifying major risk sources as well as looking at future pensions, contributions, and funding levels,” Dreyer said. 

FTSE 350 pension schemes’ surplus falls back to £5bn

Mercer’s Pensions Risk Survey data analysis has showed that the accounting surplus of defined benefit (DB) pension schemes for the UK’s 350 largest listed companies decreased to £5bn at the end of September.

Liabilities fell from £657bn at 31 August 2022 to £605bn at the end of September driven by rising corporate bond yields. Asset values also fell over the period to £610bn compared to £666bn at the end of August, which reduced the impact of the liability falls.

Tess Page, UK wealth trustee leader at Mercer, said, “The aggregate funding position on an accounting basis has been incredibly volatile during September, soaring to a surplus of over £100bn last week, before settling at a surplus £5bn at the end of September.

“The catalyst was in gilt markets – notably a surge in yields after the UK Chancellor of the Exchequer’s ‘mini-budget’ was announced on 23 September, which increased speculation of further interest rate hikes to curb inflation amid expectations of increased government borrowing.”

With many pension schemes prudently managing inflation and interest rate risks with liability-driven investment (LDI) mandates, many schemes faced stress tests on the collateral levels needed to support these investments.

The Bank of England stepping in to stabilise the market to a degree, but many schemes were still urgently sourcing cash to shore up collateral buffers. With the headlines focusing on gilt yields, inflation has gone somewhat unnoticed, but by the end of the month there had been a significant rise in future implied inflation expectations, which is currently at its highest level in a decade.

“There will be schemes that were forced sellers of assets, and funding positions will have been sorely tested,” Page said.

“To add to trustees’ headaches, the current situation could potentially have implications on the covenant strength of some employers, and their ability to pay contributions, as higher interest rates will mean that borrowing becomes more expensive at a time where they are also facing rising costs and global supply chain issues,” she added.

“It is crucial for trustees and employers to take stock of where they are and consider what future scenarios may unfold, and what contingency plans are in place through their integrated risk management frameworks, to manage risk.”

Professional trustee market soars

There has been a rapid rise in the amount of schemes appointing a professional trustee, with 43% of pension schemes now having one, according to LCP research.

In the year to July 2022 there has been a 10% growth in UK schemes appointing professional trustees, as LCP’s latest report on the professional trustee market noted, also highlighting that sole trustee arrangements now account for a third of these appointments and that their popularity is growing for larger schemes, driven by the need for simpler governance and cost savings.

Recent volatile markets in particular have resulted in good governance to be at the centre of making effective decisions, often helped by a professional or sole trustee.

A sole trustee appointment, according to LCP, is where entire trustee boards are replaced with a professional trustee firm, typically consisting of two to four named individuals from the firm.

Whilst historically the sole trustee solution was often considered for pension schemes with assets of £100m and below, however LCP’s research noted a growing trend for larger schemes in the £1bn+ range and those with overseas plan sponsors now opting for a sole trustee arrangement often driven by the need for simpler governance, cost savings and endgame planning.

Nathalie Sims, report author and partner at LCP, said: “The rapid rise in larger pension schemes opting for a sole trustee arrangement is staggering and is testament to the many benefits such as fee saving, quicker decision making and succession planning. The ongoing evolution of efficient sole trustee models offered by each of the different firms as well as their increased focus on DE&I [diversity, equity, and inclusion] makes the sole trustee model an attractive proposition.”

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