One way of considering the wide-ranging and inter-connected implications is in terms of the timeframe over which these may develop:
- Near term: The highest priority focus should rightly be on the health and wellbeing of everyone, especially the more vulnerable members of our society. All have a part to play in slowing the progress of the pandemic, and our thoughts are especially with those in difficult situations and those who are working tirelessly to help others.
- Medium term: Many businesses are severely affected by the outbreak and the measures being put in place to contain it. The fall in paying customers and disruption to supply chains will test many to the limit, despite unprecedented government support packages around the world.
- Longer term: The very significant falls in mainstream investment markets, coupled with uncertain future conditions, pose a real threat to financial and other institutions. Defined benefit pension schemes are an important case, as they mainly rely on their asset reserves to support their long-term benefit promises to members.
Without exception, everyone has a role to play in the ongoing efforts to delay and control the virus and mitigate its impact. In addition, those of us involved in institutional investment (such as the trustees and sponsors of pension schemes, and those who support them) will have an additional duty to their stakeholders to manage the financial consequences. In this article we have set out some high level thoughts and recommended principles in this area.
Significant and permanent changes have taken place
In recent weeks, equities have taken a near-unprecedented fall in value, whilst the level of government bonds has also swung around unpredictably. In general, the relative movement between equities and bonds is a significant driver for the financial position of pension schemes due to their funding approach. Whilst bonds becoming more expensive is typically bad news, when they become much cheaper over a short period this could also lead to difficulties - for example a requirement to sell assets (which have just fallen in price) to meet an unexpected collateral call for a hedging programme.
Source: MSCI and FTSE as at 18 March 2020
Market participants generally agree that what we have seen so far is consistent with the sort of extreme downside event that might occur once a century, with some drawing a parallel with the 1918 influenza pandemic. The full consequences of the current outbreak will be felt over the coming months and years, and so the impact is not directly comparable (although it is broadly consistent) with the typical one-year risk metrics that are often adopted by investors, such as value-at-risk.
The precise impact on a pension scheme will depend heavily on individual circumstances, and no doubt trustees are in the process of assessing this. In the meantime, speaking generally:
- Well funded schemes: These schemes are more likely to have adopted low risk strategies or hold portfolios focusing on generating income rather than returns, making them less susceptible to recent market falls.
- Comprehensive governance framework: Likewise, some schemes have put in place dynamic de-risking processes, and have de-risked to lock into a stronger funding position following market gains towards the end of last year.
- Well protected schemes: Increasingly, schemes are adopting a variety of measures, including hedging programmes (to reduce exposure to bond pricing), options (to reduce exposure to equity pricing), diversification (to reduce concentration risk and reliance on mainstream equity and credit markets) and downside protection strategies (e.g. to gain exposure to flight-to-quality assets like US Treasuries). We are seeing that schemes with most or all of these measures in place have experienced only modest funding level falls so far this year.
- Other schemes: Schemes that do not belong to the above categories may find that their funding level has been significantly affected. In assessing the extent of the damage, the large shift in circumstances may also prompt a review of whether the actuarial method for valuing the liabilities remains fit for purpose, to avoid making the situation unnecessarily worse.
We would expect many trustees to review their overall strategy, in light of the updated funding level and assessment of the sponsor covenant.
Regardless of the precise circumstances, we would expect many trustees to review their overall strategy, in light of the updated funding level and assessment of the sponsor covenant. (In the UK, this may coincide with the revamped long-term funding framework being introduced by the Pensions Regulator). For some, the outcome of such a review could be a set of new investment objectives, in terms of the target return and timeframe for building up (or re-building) asset reserves.
In doing so, trustees should recognise the different economic landscape for both their scheme sponsor and the companies in which they invest. This goes beyond those businesses that are directly and obviously affected by current events. As supply chains realign and ways of working adapt during the coming months, we may well emerge on the other side with a permanently altered operational environment. Following recent market falls, we may also be entering a period of high risk and high potential returns, with heightened uncertainty driven by the complex interaction between the progress of the pandemic, government response and investor behaviour.
Adopting the right investment framework for the new environment
We begin our recommendations with a word of caution against knee-jerk reactions, relying on one-sided predictions of future market moves, or the temptation to wait for things to return to normal. Conditions remain uncertain, and it is extremely difficult to predict market behaviour – this is especially so as those involved in making decisions and those making trades are potentially personally affected by the virus.
Instead, we continue to advocate a risk managed approach, at a time when the “asymmetry” of pension risk outcomes is more relevant than ever. This is another way of saying that, at best, members will receive the benefits they always expected whereas, at worst, a further deterioration from here could lead to an untenable position for both the pension scheme and the sponsor.
In practical terms, we think this is likely to mean reviewing the investment beliefs that underlie the current approach, and considering the appropriate framework to adopt for the new environment, including:
- Level of hedging: A well designed hedging programme can protect against the plausible scenario under which interest rates fall (and bonds become more expensive) into unprecedented territory, and remain there for a long time.
- Diversification: Even if markets do recover, different types of investments can perform very differently. Generating a return across a wide range of sources avoiding the scenario of picking the “wrong” areas to invest in.
- Protection strategies: Adopting the right combination of strategies will mitigate the effect of further market falls, whether these are related to current or other events. However, the design and implementation should reflect the changed conditions (for example, traditional equity option protection has become much more expensive) and avoid giving up too much of the upside outcome should the markets bounce back.
- Dynamic governance frameworks: Whilst we think that only competent specialist managers are capable of making timing calls on a day-to-day basis, in volatile markets being able to react quickly to unfolding events will become more important. A robust governance process will allow changes to be made quickly by or on behalf of the trustees, for example to adjust the level of target return or increase the level of hedging at the right price.
- Flexibility: In line with the above, a nimble process (relative to other investors) will help to identify and capture opportunities for better returns in specific areas - or, more accurately, a better balance between risk and returns. This is helped by having the right governance framework as well as holding some liquid assets as “dry powder”.
The above are some specific changes that trustees may consider in the coming months. More generally, our recommendation for putting in place an investment framework for the new environment continues to be based around a measured, risk managed approach for generating returns.
Concluding thoughts
Our thoughts are with those across our global community who are most affected by the current turmoil, whether in terms of their health or financial security. In a professional context, we recommend that institutional investors should review their situation and adopt the right strategy, investment approach and governance structure for a permanently changed environment. A robust framework should not depend on waiting for a recovery or playing “double or quits” with the markets, especially where the level of support from a financial sponsor has been weakened at the same time. Rather, the aim should be to be well positioned to deal with a continued period of uncertainty, whether this is directly related to the current pandemic or something that is as yet unforeseen.
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