Increase investment returns and give back surplus to sponsors

Why do we trustees live in an environment of “don’t take risks” and insurers live in one of “take as much risk as you can, within the rules”?

PSA: Sort this out and we can share many £-billions with our scheme beneficiaries which includes UK sponsors.

For the last 15 years, during which the phrase “de-risk” became common parlance in the defined benefit pension industry, sponsors and trustees generally complied (some willingly, some not so, but very few not at all), with pressures, including regulatory, to de-risk the pension asset liability puzzle. Right now, it would seem, looking at funding levels, to have worked to great effect, despite one or two lapses.  It is fair to say that there were many schemes 15 years ago taking far more risk than insurers (under “Solvency I”). So much so, insurers looked like the paragon of low risk taking virtue, the “gold standard” perhaps?

And now, I would argue the reverse is true.  So many DB schemes are running at G+25-50bp (or heading that way) yet insurers are running at ~ 100bp more.  By reinvesting, in part, in higher yielding and illiquid assets than the pension scheme does, I believe an insurer re-risks a pension scheme’s portfolio. Pension schemes could now be thought of as the paragons of the virtue of low risk and are now the gold standard.

Re-risking… to a degree

But there is an essential difference. Critics (and many sponsors) would argue that it is right to take risks where there are appropriate and robust risk management skills and structures in place. Where the people taking those risks are risk professionals and have systems on tap to guide them in decision making processes.  Given the constant refrain to de-risk TPR (the Pensions Regulator) and any independent observers seem to be saying pension schemes are not the place to take risk. There are no robust risk management systems, the people who take those risk decisions rely on third party advice and the LDI crisis reminded everyone that this just might be the case.  TPR and the insurers (and Solvency II) seem to be telling us that taking risk is an executive exercise and not a non-executive function.

A pension scheme, with a traditional set up, running at G+25bp is probably at the right level given its risk management resources. Whereas, an insurer running at say G+125bp may well be at the right level given its skillset and resources.  These two levels might, despite some of my other musings, be equivalent on a risk adjusted basis.

The problem now means that schemes are over-funded relative to insurers by many, many £-billions.   Another observer may conclude that schemes have to be over-funded because they are not the place to take risk.  For the sponsor, unfortunately these surpluses are destined to become part of insurers’ shareholders equity given the current advised trend towards a buy-in or buy-out (risk transfer).  This situation seems odd to both sponsors (who have funded billions into schemes) and to members (who have their potential upside removed).

So what is the fix?

How do we get that money back to sponsors?  How can members and sponsors share this over-funding?  You will note that there are a number of industry pundits pushing in this direction who are looking for government-supported initiatives to drive the changes.  I believe we can make significant steps in the right direction ourselves and don’t need government-led changes to make a robust start.

How do we do this? We can start by providing a trustee board with the resources to manage risk centrally, transparently and directly, with the sponsor.  This may well require a paradigm shift in trustee attitude: moving from the non-executive role towards a more executive role.

Let’s set up a pension scheme to have the same risk-taking capabilities as ……. an insurer!  Then let’s share those governance systems and processes across numerous schemes sharing a single point of fact.  Let’s take that benefit and use it for sponsors and members.

This is already being done internally to an extent by schemes in the £5bn+ scheme arena: but the rest of the market cannot readily access these benefits.  That means a lot of financial resources trapped in low-yielding assets.  Moving to an executive risk management-driven framework will result in numerous benefits: such as improved funding levels which will in turn result in contribution schedules being reviewed downwards generating lower trapped surpluses. This may perhaps provide sufficient funding to justify setting up associated DC sections, improved scenarios for trustee discretions, potentially even joint ventures and so on.  Other GAAP benefits also come to mind.

Closing thoughts

The key issue I see will be the crystallisation of “likely to be trapped surplus” into “definitely trapped surplus”.  It would be economic with reality to describe this as a quality problem. It is a problem since current legislation is not friendly to surplus dividends back to the sponsor (unlike in the insurance sector to the shareholders).  But while HMG sorts that area out, schemes could start safely to bank sufficient additional returns for the benefit of all.

Interested to read more about my thoughts? Head over to our insights page and read my latest musing there. Connect with me on LinkedIn or visit my team profile.

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