Derisk when you can afford to, not when it looks like good long term fair value to do so says Paul Francis, director, investment consulting at JLT Employee Benefits
Change – it’s everywhere; it always has been and it always will be. Entropy and the second law of thermodynamics see to that. But the pace of change for us humans is increasing. Much of this is due to technological advances and an increased flow of information. What were once localised events can now have global impact and the ease by which people can now share ideas and leverage upon the work of others has increased exponentially.
It is at times of systematic stress that our knowledge and requirement for education strain the most. The amount of information flowing towards us can then become an enemy, and we face what I call ‘choice paralysis’. This is the position that many pension fund trustees and sponsoring employers find themselves in today. These stakeholders are kept awake at night by worries about significant deficits in their pension schemes, but are unsure about how they should go about addressing the shortfall. Buzzwords are heard everywhere one goes: fiduciary management, flight planning, LDI, liability mitigations, swaps, buy-ins, mortality hedging – each offering to help solve the problem from a slightly different perspective.
For many the approach of do nothing now, keep calm and carry on, and let the economic stresses and the associated pension fund deficit work their way out has been the preferred way forward – or a result of choice paralysis. This is akin to saying that the current actuarial valuation methodology is flawed, and that crystallising the valuation of long term liabilities into one point in time does not tally with reality – a view that I have sympathy with. Or, put in perhaps a more intuitive way, that UK government debt (‘gilts’) and swaps are expensive relative to their long term fair value.
Change is an important factor here. It may be that historic long term fair value no longer represents a good guide to future fair value. For gilts, this is my own belief. Purchase a conventional longer-dated gilt today and hold it till it matures, and you lock into a future return of less than three per cent per annum. And this provides no explicit protection against inflation, at a time when the market is currently very concerned about shorter term inflationary pressures. Indeed, as we all know too well from the actuarial valuation pain that we feel, the real yield on index linked gilts is currently negative. Does it make sense to lend to the Government and expect to make a loss on your investment? It depends on how scared you are by the prospect of inflation and how much you’re prepared to pay to alleviate the risk.
What can we expect to happen? The UK Government may soon unwind its policy of quantitative easing and, on its own, the increased supply would be expected to drive down gilt prices. This would increase gilt yields, which in turn would help eradicate pension fund deficits. But the level of pent up demand to buy gilts is undoubtedly very significant and will, in my view, likely provide a cap on the level that gilt yields will rise to. This cap is likely to be below long term fair value, as very few will want to be last in the derisking queue. Investment derisking for pension funds is unlikely to look cheap for a good while yet.
So what should be done now? The key is to derisk when you can afford to, not when it looks like good long term fair value to do so. We are not trying to call the top, or bottom, of an investment market, rather we are looking to take gradual steps to remove investment risk when we can afford to do so. To do this, a dialogue for setting appropriate triggers and a mechanism for implementing change within the investment portfolio when they are reached is required. And like everything else, triggers are affected by change, so what represents an appropriate trigger today may not do so in the future. Ongoing monitoring of the suitability of triggers is therefore sensible.
And what for the next generation, for those concerned with defined contribution pension schemes? What is the best way to encourage members to contribute and what investment options should be available? Is a target date approach better than a predetermined lifecycle that phases into protection assets at the set point? But what is the member looking to protect against – is it annuity purchase or drawdown provision? And just what is the right time? Choice paralysis must not be allowed to rear its head once again.