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Over the past month, the response to the Covid-19 pandemic has combined with tumbling oil prices to result in dramatic falls in many asset classes, as well as reduced liquidity.
With this in mind, pension scheme trustees are facing falling yields (and thereby funding levels), reductions in investment income and even, in some cases, deferrals in employer contributions. Against this backdrop, trustees will be asking themselves not only what the long-term implications are for their pension schemes but also what they should be doing in the immediate term.
On that last point, from an investment perspective, there are two areas that trustees should ensure they have discussed with their investment advisors:
- How to meet ongoing cashflow demands
- Whether to rebalance the portfolio
There will be longer-term considerations around the continued suitability of the investment strategy in light of possible changes in the covenant and funding position of the scheme. We do not tackle these issues in this particular note, as we stay focused on the very short-term issues above (our upcoming Investment Insight paper will address the longer-term issues).
1. How to meet ongoing cashflow demands
Meeting benefit payments is the number one priority of trustees. This continues to be the case despite the current circumstances. However, there are a number of reasons why your current approach to meeting your scheme’s cashflows may need to be reviewed:
- Your investment income may be lower than previously expected – in particular we have seen lower dividends from equities, many property funds suspend distributions and are expecting a higher rate of default from high-yield bonds and loans going forward, which would lead to lower distributions from funds of this type.
- Your sponsor may need to review their contributions – the Pensions Regulator (TPR) has suggested that trustees, where necessary, should be open to supporting employers by allowing them to review their contributions into the scheme, subject to a number of conditions.
- Your outgoings may be higher than expected – a number of our clients have seen transfer values and early retirements increase as members face financial uncertainties surrounding their jobs.
- Accessing investments may be more difficult or take longer than expected – whether due to liquidity issues in assets or availability of trustees to print, sign and scan instructions while working from home.
All of these may mean a more prudent and forward-looking approach is needed, possibly increasing your bank account float to cover any unexpected large outgoes or issues accessing investments.
The most critical aspect here, is to ensure good communication between the various parties involved – from the sponsor to the administrators to the investment managers and in-house pension team – in order to enable you and your investment advisor to prepare for most eventualities and identify possible pinch-points.
Thereafter, should you need them, there are a number of tools at your disposal for meeting cashflows, including making advanced disinvestments, taking regular income from low-risk assets, and even asking the sponsor to bring forward contributions to avoid having to crystallise investment losses.
We have some clients where sponsors are deferring contributions and others where sponsors are stepping into help schemes with their cashflow. Some schemes are seeing a big increase in the number of early retirements and others where there is no change. Some property funds are halting distributions, others are continuing to pay them. In other words...
"Your scheme’s situation will be specific to you, so your plan of action will need to be just as specific."
2. Approach to rebalancing the portfolio
As you start to receive your quarter-end reports, some schemes will be in a position where the significant moves in assets over the quarter mean their allocation is different to the strategic benchmark. In this situation, should you rebalance? Moreover, should you be rebalancing your investments more often whilst markets are turbulent?
Our view is that, in general, assessing the asset allocation and whether there is a need to rebalance on a quarterly basis remains sufficient. Rebalancing more often than this could result in excessive turnover and transaction costs, which are particularly high at the moment.
Due to market volatility, you will need to use up-to-date information when deciding whether to rebalance and implement any trades shortly after making a decision. If this is not possible within your governance structure, then rebalancing may not be appropriate for you.
Otherwise, when deciding whether to rebalance, trustees should be cognisant of the following (in order of importance):
Rebalancing will generally involve increasing growth exposure, and therefore risk. However, strong growth in 2019 means many schemes were ahead of schedule versus their long-term plans as they started 2020. Furthermore, expected returns on many risky assets will be higher now (relative to liabilities) than they were before. Therefore, increasing the allocation to growth assets may be unnecessary in the context of achieving your long-term funding plan.
A decision to change the level of interest rate and inflation protection is a significant strategic decision and therefore, in most cases, rebalancing should not affect your level of hedging.
Whilst we would not advocate trying to time markets, if you (or your consultant) have a strong negative view on an asset class, you may wish to avoid rebalancing into that asset. Our quarterly investment monitoring reports set out Barnett Waddingham’s view on the return on all major asset classes over the next 12-18 months.
Transaction costs are higher in most assets – especially credit assets – at the moment and so this will need to be considered.
It is not easy (or even possible) to move into, or out of some illiquid asset classes at this time. This may therefore restrict the extent to which you are able to rebalance.
In some cases, it will be appropriate to only rebalance part way back to benchmark. This reduces the risk of trading a significant amount at a particularly adverse time, as well as reducing transaction costs and excessive turnover if markets reverse over the next quarter.
As with everything else, the timing and frequency of rebalancing will depend on specific scheme circumstances and will depend on the assets that are being bought and sold. We do expect a greater level of rebalancing to take place and feel that is a sensible approach to take. Trustee boards should work with their investment consultants to consider what is appropriate for their schemes.
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