We are all now familiar with the integrated risk management framework introduced by The Pensions Regulator (TPR). For me, this was a very important step in the evolution of DB scheme funding, forcing trustees to think about the sponsoring employer’s covenant, the scheme’s investment strategy and the pace of funding.
Covenant, investment and funding working seamlessly together. That’s the panacea, but in my view, the reality is sometimes quite different. In practice, I cannot help feel that too many schemes pay lip service to the integration of covenant, investment and funding. When I look at the reasons why, it is not the trustees who I blame, it is the advisors. And, I am not saying that to protect myself and my peers (after all I am a trustee!), but I say it based on what I have seen.
Let me elaborate by looking at a typical example. I turn up at a trustee meeting and I get advised by the Scheme Actuary that the valuation discount rate should be gilts plus 1% p.a. (or something similar). When you ask why, then the answers are interesting and varied:
1. It is what we used last time
2. It is our view for a scheme like yours
3. It is what everyone else is doing
4. Market returns are uncertain what with Brexit, Trump, trade wars etc… so we need to be prudent and this is prudent.
And that’s about it.
Hardly a mention of the covenant or the trustees’ current and future investment strategy. So, it does not feel very integrated at all.
In my view, trustees need to start by considering the sponsor’s covenant. This is usually the hardest bit of the risk management framework. It can be very “touchy feely”. We need to know about the long-term position, but our covenant advisors just tell us about the short-term position. And, we all know that companies can hit the rocks, all-of-a-sudden and so we still might not get paid what we are expecting anyway. But none of this means we should spend time considering the strength of our sponsoring employer.
The covenant review paints a picture and forces the trustees to examine their employer. All very useful. But there are no definite answers.
Now we consider the investment strategy. We can calculate the best-estimate return from the assets we currently hold, and then take a margin against that for prudence. How big a margin will be determined by what we think of the sponsor’s covenant. A weak covenant means a big margin and a strong covenant means we can take a smaller margin. That’s up to us, but it would be helpful if our advisors can quantify the margin we choose – I like it when my advisor tells me that a particular margin equates to a 60% chance of benefits getting paid, or 70% or 80% or 100% (i.e. buy-out). Then I can choose my discount rate knowing the probability of having enough money to pay my members, until that last payment falls due. For example, if I have a tending to weak covenant and I choose a 70% chance of having enough money then my discount rate will drop out automatically.
Doing it this way means that the discount rate becomes a function of covenant and investment strategy. When the covenant changes then the discount rate changes. When the investment strategy changes then the discount rate changes. Further, if the discount rate that drops out means that the contributions required threaten the existence of the employer (i.e. the contributions impact the covenant) then we can reassess, talk to the employer again and reconsider the discount rate. In this way, covenant, investment and funding are truly integrated – no hard borders.
And this is better than using gilts plus 1 %.