Is reckless conservatism choking DB?

ChokeAre DB schemes being too cautious or too aggressive in their investment strategy? And how does this issue impact BHS and Tata Steel? Pensions minister Ros Altmann and consultant John Ralfe take deeply opposing views. John Greenwood reports

Defined benefit pension deficits are back at the top of the political agenda. The BHS affair has highlighted weaknesses in the regulatory structure in relation to sponsors’ responsibilities, intensifying scrutiny of the 600 to 1,000 DB schemes identified by the Pensions Institute last December as being probably unlikely to ever meet all their liabilities, however long their recovery plan.

The Tata Steel dilemma meanwhile highlights questions of moral hazard for life without a sponsoring employer.

So what should any scheme running a big deficit do? Go conservative and condemn itself to never meeting its liabilities? Take enough risk to hopefully fill its funding gap and hope the gamble comes off? Or face reality today and keel over into the Pension Protection Fund? Every scheme, sponsor and board of trustees is different, but is current practice out of kilter with reality? And where on the risk/return spectrum should DB schemes sit?

Two big hitters sit on opposite sides of this crucially important debate. At the cautious end is John Ralfe, the former finance director of Boots who presided over a timely switch away from equities that meant the firm’s DB scheme avoided altogether the pain from the bursting of the dotcom bubble.
Now advising the work and pensions select committee on BHS, Ralfe, who is not an actuary, is a fervent believer that trustees should do all they can to get risk off the balance sheet.

Supporting a more aggressive approach to investment is pensions minister Ros Altmann, who, as a former trustee of the Trafalgar House pension scheme, has had to face the problem of stretching a finite asset pile – without an employer to inject more money – to make up a shortfall in funding.

With history on the side of equities over the long term – the Barclays equity/gilt study shows equities generally outperforming bonds over two decades or more – why shouldn’t underfunded schemes take on risk for liabilities they will not have to pay for several decades?

Ralfe says: “Individuals choose the mix of equities versus bonds to hold in their pension fund based on their personal risk appetite and expected risk/return. But the idea of expected risk/return does not apply to company pensions, where the pension is effectively
an unconsolidated subsidiary of the group. Holding equities in the pension scheme affects the group’s capital structure and credit risk in the same way as if it issued long-dated bonds and held the proceeds in equities.

“After deciding what credit rating it wants, a company will adjust its capital structure to achieve this. Risk should be taken directly on the company balance sheet, where it is transparent and can be managed, not at arm’s length in the pension scheme.”

Pensions minister Ros Altmann thinks that is fine where there is a sponsor awash with cash, but argues that is not the case for most employers.

She says: “The bottom line is that, if you do not get the upside, you can’t pay pensions. If you want to be like the Bank of England and can afford 50 per cent contribution rates, matching your liabilities is fine. But most employers can’t afford to do that, so why do it when there is an alternative approach?

“Schemes like Trafalgar House have tried to calculate how much extra return they can get while protecting against sharp downturns. Crucially, this requires skill.

“The idea that you can just fall back on bonds is flawed. They may be a closer match but they are not the same. And, if you are in deficit, you will not make enough return.

“In the post-QE world, having a broad diversification is a protection against the unknown. Not taking any equity risk seems to me like reckless conservatism.”

Altmann argues that, had Trafalgar House followed Ralfe’s philosophy, it would have a far bigger deficit than the £300m hole in the £1.6bn scheme as at 2015. Last year the FT reported its trustee chairman saying its assets had returned in excess of 10 per cent a year over the previous decade, outperforming typical DB schemes by around 70 per cent.

Altmann says: “This is a much broader issue than just equity versus bonds: it is about taking risk versus locking risk away.

“Equity is one of the risk premium asset classes that Trafalgar House has taken advantage of. But it has also taken advantage of others, such as infrastructure, real estate, some forestry, hedge funds and private equity. Trafalgar House has done what the Pension Protection Fund does, although the PPF does it more cautiously.”

Hargreaves Lansdown head of pensions policy Tom McPhail says: “DB pension schemes should be predominantly invested in equities. There is a perverse disincentive against taking risk – the impact of short-term fluctuations in asset values can drive trustees and investment advisers to want to avoid volatility. And the PPF levy is massively risk-based. Once you are in deficit it is harder to pursue an aggressive strategy to get out of it. But I think Ros’s position is right on this one and John’s is wrong.”

Spence & Partners head of investment Simon Cohen believes there is some merit in the argument that schemes wanting to invest in equities should do so by issuing debt and investing on balance sheet, rather than through their pension scheme.

He also sees plenty of reasons to derisk. Cohen says: “There are obvious reasons why schemes want to derisk – companies do not like the constant uncertainty on the balance sheet. Time horizons on some schemes have come in and some are now cash flow negative. So you do not want to be selling equities to pay pensions.

“But trustees need to remember that if they do so for part of the scheme, and that reduces the overall funding ratio, that will make it harder for the remainder of the assets to meet their target.”

Hymans Robertson partner Clive Fortes argues that the pressing need on paying pensions from assets means schemes’ profiles are very different today from their position a decade ago. He says: “Our research shows around half of FTSE 350 schemes are having to sell assets to pay beneficiaries. If you owe someone £1,000 in a year’s time and you have £1,000 to invest, what are you going to invest in?”

Heads we win, tails we win?

For Ralfe, the availability of the PPF to schemes without a sponsor creates a moral hazard issue. He says: “Strong companies may choose to hold equities in the pension scheme as long as they are able to meet any shortfalls. Where there is a weak sponsor, or no sponsor, as in Trafalgar House, this is just a bet: heads, we win; tails, the PPF loses.”

Newly appointed Association of Consulting Actuaries chairman Bob Scott cannot comment on the Trafalgar House scheme because he advises it. But on the general point he says: “The authorities frown on people taking a bet on the PPF. If your stated policy is to say we are way under the PPF level of benefits so we may as well gamble, that would be viewed as irresponsible. There is case law that says trustees should take decisions on the basis that the PPF is not there.”

Le Roy van Zyl, principal in Mercer’s financial strategy group, says: “It is a difficult situation and you do not want people gaming the system. But I get the sense that trustees are aware of their general fiduciary duty.”

Hymans Robertson partner Clive Fortes says: “Schemes should have to either go into the PPF or go forward without PPF protection if they go on without an employer sponsor. I have no problem with the British Steel scheme going to CPI if Tata Steel remains the sponsor. But when you divide the scheme from the sponsor you have to either go the PPF or go it alone. Otherwise you get a situation where if things go badly the PPF will pay, but if things go well members do well. That is not fair on all the other schemes.”

How much risk is too much?

Expunging the existence of the PPF from their thought processes arguably puts trustees in a similar position to the individual DC investor, who knows that, state pension and other assets aside, his or her income in retirement will be determined to a large extent by the investment strategy that is followed. In the DC world we urge savers to take as much equity exposure as they are capable of bearing, in the growth phase at the very least. So are DB schemes being unnecessarily cautious?

Warren Buffett is clearly comfortable with a super-aggressive approach being adopted by schemes within his Berkshire Hathaway empire. In stark contrast to the approach used by many UK pension funds, it has recently emerged that the £1.4bn pension fund of BNSF, a railroad subsidiary of Berkshire, is reportedly 90 per cent invested in equities, with 47 per cent of the fund’s assets in just three stocks.

Buffett is not the average CEO and if anyone can be comfortable bringing investment risk into the boardroom, it’s probably him. But with reams of data showing equities outperforming more secure asset classes over 20-plus year periods in almost all scenarios, and individual investors being advised to move away from ‘locking into gilts in their 50s’ through lifestyling, are DB schemes being overly cautious in the way they address liabilities extending over decades?

Punter Southall principal Craig Wootton says: “You typically get the scheme actuary saying that you need to be less risky the more mature you are, and the approach of TPR is to back that up. But the other side of the coin is that the problem is getting smaller with each passing year, so schemes with sponsors can afford to take more risk. Gilt yields have come down around 1 per cent in the last five years and that has pushed liabilities up. So in the mindset of trustees, the liabilities have got bigger.

“The DC world is a good analogy. We are telling people not to buy annuities. Yet in DB there is reckless conservatism, which actually compounds the problem because everyone is trying to buy the same gilts, pushing up prices.”

Van Zyl appreciates the point, but argues that things are never that straightforward for trustees. He says: “With yields so low – at historical lows, some trustees wonder whether they should be selling out of the market. The problem is it often turns out that next month things are even worse. Hindsight is a wonderful thing and trustees face huge challenges.”

British Steel Pension Fund – life without a sponsor?

Concern at the loss of thousands of jobs is driving business secretary Sajid Javid to look at cutting pension benefits for steelworkers to seriously consider cutting the British Steel Pension Scheme off from its employer, Tata Steel UK. Trustees believe a haircut on indexation, cutting it from RPI to CPI, to avoid being forced into the PPF, is a risk worth taking.

The British Steel scheme had assets of £13.3bn in December 2015, with liabilities of around £14bn, creating a deficit of £700m on a technical provisions basis, whereby the scheme continues to run. The scheme was around £1.5bn short on a PPF buyout basis (S179), and had a £7.5bn full buyout deficit.

On a technical provisions basis, that is a deficit of 5 per cent, yet data from Mercer published shows that FTSE 350 deficits rose by 6.5 per cent in May, a single month, as corporate bond yields fell. So how can trustees make long-term decisions on the basis of short-term data?

Van Zyl says: “With Tata, as with other schemes, there are long term obligations and trustees and sponsors are being asked to deal with them with short-term data. It is a difficult issue, but you can’t just walk away from it because it is a long-term problem. You have to find a short-term approach.”

For McPhail, a more flexible regulatory regime would allow for more schemes that fall between technical provisions and PPF funding to carry on and see if they can do better. He believes the work and pensions select committee’s inquiry into DB is well timed, with a number of issues worthy of scrutiny.

He says: “I am hopeful that what Frank Field and his team on the work and pensions committee will do is redefine the funding position of pension schemes and give them some lassitude that will allow them to increase their exposure to growth assets.