Think now - reducing the risk in your pension scheme

Published by Adam Poulson, Martin Hooper on

Estimated reading time: 3 minutes


Now is a good time for companies with end of March or early April year-ends to consider how their pension scheme liabilities will impact their balance sheet – and it may not all be bad news.

Over the period since 31 March 2017, we have seen inflation expectations reduce slightly and corporate bond yields decrease at longer terms. Returns from equities have been strong over the period and for schemes with a more growth orientated strategy the position should have improved. For schemes with greater allocations to protection assets, the position is likely to have held broadly steady.

If markets remain stable for the next couple of months this is the position we might expect at the end of March 2018:

However:

  • Equity markets valuations are now in excess of those prior to the global financial crisis; and
  • The downward pressure on global bond yields shows no sign of relenting (despite several rate hikes in 2017 and the almost certainty of further in 2018).

A small change in either could cause a material change in the pension balance sheet figure, and the prospect cannot be discounted given market conditions.

Most of the past decade has seen an incredibly durable equity bull run. This has pushed up equity valuations across developed markets. The cyclically adjusted price-earnings ratio (CAPE) of the US stock market is at a level not seen since the dotcom bubble and the 1929 crash, at around 34. Historically, when the CAPE has exceeded 28 the returns achieved over the next decade have averaged approximately zero.

"You should understand the risk being run and how you can influence the investment strategy to reduce that risk."

Current bond yields, which feed into low discount rates (and high liability values), have caused many companies to revisit how their discount rate and other assumptions are set, resulting in lower balance sheet deficits – for example, Tesco shaved approximately £3bn from its pension liability value by reviewing assumptions.

Whilst the trustees have effective control of the investment strategy, the sponsoring employer retains all the risk. You should understand the risk being run and how you can influence the investment strategy to reduce that risk.

Reducing risk does not necessarily mean selling growth assets. In fact, most schemes need growth assets (and the associated returns) to ultimately pay all of the promised benefits. Reducing risk means increasing the certainty that the money currently set aside (plus committed contributions) is sufficient to pay benefits. Taking this approach should reduce (and eventually remove) the pensions burden from sponsors.

The time for thinking is now so, if you would like to discuss how you can reduce the risk in your pension scheme, we want to hear from you.