Spring 2015
For professional investors only. Not suitable for retail clients.
Schroders
Pensions Newsletter
The general election raises the
stakes for many pension funds
At a time when funding is already under
pressure, the general election has added a
new risk for many defined benefit pension
schemes. Sterling has already been hit by
fears that a hung parliament may create
political uncertainty. Although the currency
has since recovered, there are signs that
volatility has spread to the equity market as
investors’ fears grow that the election will
give no clear winner.
Protecting the value of pension schemes’
equity investments has always been
important, but it assumes greater
significance during such times of market
uncertainty or volatility. There are a number
of techniques pension schemes and plan
sponsors can consider when trying to
preserve the value of their equity investments.
Some of these can be employed on
an opportunistic basis. However many
schemes are also now considering putting
in place more formal mechanisms. The
ideal for many would be one that allowed
them to participate in equity market rises
but not to be overly exposed when they
start to fall. Structures are now available
Contents
which can provide such protection, while
retaining participation in the long-term
growth of the portfolio.
It is possible to create a structure that
can provide assurance that the value of
an equity fund will not fall by more than a
predetermined amount. This should give
the investor confidence that any equity
losses will be limited to a level of their
choosing. Significantly though, the structure
still allows a level of participation in equity
rises when markets are doing well.
The implicit cost of the protection provided
by this “collar” structure, which uses
derivatives, is met by sacrificing potential
gains above a certain capped level.
Trustees might consider such a technique
when there is a specific time period over
which they would like to protect their equity
portfolio, such as a valuation period, or a
known event that might trigger volatility in
equity markets, such as a general election.
Another strategy that could be put in place
aims to provide protection during short, but
severe, market downturns, whilst still aiming
A cap to help protect against electoral squalls
Frequency of returns
6,000
5,000
4,000
3,000
Downside risk is
specifically targeted
2,000
S&P500
130%
120%
110%
90%
100%
Annual Returns
Variable Volatility Capped S&P
80%
70%
60%
50%
40%
30%
20%
10%
0%
–10%
–20%
–30%
–40%
–50%
–60%
0
–70%
1,000
For illustration only. The above results are based on a back test. The strategies trade once daily at the close of business.
Indices used are the S&P 500 [Div Adjusted] (1928–1988), S&P 500 Total Return (1988–2012). Observations are for
12-month returns measured on a daily basis. These charts show the returns of the strategies applied to the S&P index.
An observation of –10% indicates the return was between –10% and –19%. Source: Bloomberg. Federal Reserve Bank of
St. Louis and Schroders. As of 31 December 2013.
www.schroders.com/ukpensions
Why doing nothing may be the
biggest risk any scheme can take
2
Forthcoming events
2
Can you define value for money
in 140 characters?
3
Funding levels remain depressed
after roller-coaster quarter
3
DC after the Budget: are your
members defaulting into danger?
4
to capture growth over the medium term.
Known as a volatility cap, in its simplest
form it seeks to limit volatility in a portfolio of
risky assets, such as equities, to a maximum
level, e.g. 15% a year. The prevailing volatility
is regularly monitored and whenever it
exceeds the “cap”, risky assets are sold for
cash until the portfolio volatility falls back to
the 15% level again. Once the volatility has
subsided, cash can be reinvested in the risky
assets to participate in any market recovery.
By following this simple, systematic rule, the
portfolio volatility should be effectively limited
to 15% per annum.
For schemes which require a higher level
of protection, say to prevent losses of
more than a fixed percentage, a variable
volatility cap can be used. This works
by automatically lowering the level of
the volatility cap as losses rise, thus
accelerating the move out of risk assets until
the portfolio stabilises. Once the market
starts to recover, the cap can be gradually
lifted back to its original level, allowing the
portfolio to participate in the recovery.
These are just two of a number of different
approaches that may be taken to reduce
the impact of short term market corrections,
depending on what the scheme is trying
to achieve, and for how long. We believe
that, as the UK enters a period of political
uncertainty, now may be a good moment
for trustees to consider using one or more
of them to help reduce their equity risk.
2
Schroders Pensions Newsletter Spring 2015
Forthcoming
events
Global fixed income
web conference:
1.30pm, 27 May
Join our bond team for their next
monthly online review of the global
fixed income market at
www.schroders.com/watch
Trustee training
Pension fund trustees who would
like to improve or refresh their
investment knowledge are invited to
come to one or more of our trustee
training mornings:
–– 29 May, Birmingham
–– 6 November, Leeds
–– 30 October, London Part 1
–– 27 November, London Part 2
Sign up at
www.schrodersevents.co.uk/TT2015
Defined Contribution
Conference:
21 May, London
Come and hear speakers from both
Schroders and some of the UK’s
biggest DC schemes discuss the
post-retirement revolution.
Register at
www.schrodersevents.co.uk/DC2015
Betting the house on red:
why doing nothing may be the
biggest risk any pension scheme
can take
The paramount risk faced by most trustees
is not being able to fund their members’
pension payments. While many trustees
want to reduce this risk by hedging their
liabilities, it is easy to feel that there could
be a more opportune moment than now.
Speculation that rates may rise has caused
some to put off the decision in the belief
that both liability values and scheme deficits
will fall as rates increase. The election may
also be encouraging some trustees to wait
for more political certainty before making
liability hedging commitments. However,
the decision to delay is a risky one.
Figure 1 shows the breakdown of a typical
pension scheme’s funding level risk,
measured by Value at Risk (VaR: see chart
for definition). The key bar is the first one,
which shows the total risk from changes
in the value of the liabilities of the typical
scheme and the reduction in risk likely to
be achieved by the bonds and LDI assets
held by the typical scheme to match
those liabilities.
The chart demonstrates that the unhedged
liability risk for a typical pension scheme
is larger than all the other investment risks
- from the growth assets such as equities
and alternatives – added together. So,
while most trustees recognise the need to
diversify investment risk across a range of
different assets, many may not be aware
that they could be running a much bigger
risk with their unhedged liability values.
Essentially, these latter are a big bet on
interest rates going up.
But even a rate rise may provide a false
sense of security. Many schemes are
under the impression that an increase in
yields will automatically reduce liability
values. Sadly, it is not that simple. The
current interest rate curve slopes upwards
Figure 1: Not hedging is the average
scheme’s top risk
% Ages
140%
120%
100%
Hedged
80%
Alternatives
60%
40%
Unhedged
20%
0%
Liability risk
Equities
Growth assets
Total
Example for illustration only. We have used VaR 95, a measure
of risk which estimates the least by which a scheme’s deficit
could increase in one year out of every 20. Average pension
scheme asset allocation taken from Pension Protection
Fund’s 2014 “Purple Book” and average level of liability
coverage derived from KMPG LDI survey 2014. Total risk is
lower than the sum of the individual risks due to the effect
of diversification. Source: Bloomberg, KPMG, PPF and
Schroders. As at 31 December 2014.
for the next 10 years. This means that the
market already expects rates to rise and
has priced that expectation into the future
cost of borrowing.
The implication for scheme funding is that
interest rates must not only increase, but
increase above market expectations in
order to reduce liability values (red area in
Figure 2). If rates remain at low levels or
merely rise in line with expectations, funding
levels will not improve, as illustrated by
the grey area in Figure 2. In other words,
remaining unhedged will only be beneficial if
rates rise above market expectations.
So, by leaving their liabilities unhedged,
schemes are making a large one-way bet
on interest rates. They could lose out if
rates do not rise as quickly as has already
been priced in by the market. Adopting
such a position might be compared to
betting the house on a single turn of the
roulette wheel.
Figure 2: What do interest rates price in over the next three years?
3.0%
Real Estate Conference:
3 June, London
Our focus will be on where to find
value and income in the global
property market.
Register at
www.schrodersevents.co.uk/RE2015
Win: reduced liability valuation
2.5%
2.0%
1.5%
Lose: increased liability valuation
1.0%
0.5%
0.0%
0
Source: Bank of England.
As at 27 April 2015
5
10
15
Years into the future
24 April 2015
3 years forward
20
25
Schroders Pensions Newsletter Spring 2015
3
Can you define value for money in 140 characters?
Value for money is moving up the agenda
for pension schemes. Since early April,
defined contribution (DC) pension schemes
have had both to assess “value for money”
and confirm that they are continuing to offer
it to members. And while no equivalent
requirement has yet been placed on
defined benefit schemes, we expect the
new emphasis on value to spill over and
affect trustees here too.
Despite its importance, the regulators have
made clear they do not intend to offer any
detailed guidance as to what they think
value for money means. Schemes are
being left to decide for themselves, so we
thought we would turn to you, our readers,
to find out what you think the term
should embrace when applied to pension
schemes. We want you to send us your
thoughts in a Twitter-length sentence,
with the chance to win a prize or donate
money to a charity of your choice
(more details below).
The immediate cause of all this interest is
the requirement that, from 6 April, trustees
of DC schemes must include in their annual
report and accounts an assessment of
what they see as being value for money.
In addition, they must carry out regular
reviews to confirm that their scheme
continues to provide good value for their
members. Very similar rules apply to the
new Independent Governance Committees
(IGCs) that must now be established to
oversee contract-based DC schemes.
However, while The Pensions Regulator
(for trust-based schemes) has suggested
that good value means that costs are
reasonable for the benefits and services
they provide, it admits that there is no
common definition of what it represents.
It merely states: “You need to understand
what your members will value most when
assessing the overall value of the scheme
and its individual components.”1
For contract-based schemes, the guidance
from the Financial Conduct Authority (FCA)
is similar: “In assessing value for money,
IGCs should consider whether costs and
charges borne by scheme members pay
for services that deliver value to scheme
members.”2 The FCA does concede that
value for money means different things to
different people, which is no doubt why it
intends to hold a forum of IGC chairs to
discuss how it should be assessed.
1 The Pensions Regulator web site:
http://www.thepensionsregulator.gov.uk/trustees/valuefor-money-in-your-dc-scheme.aspx
2 “Final rules for independent governance committees,
including feedback on CP14/16”, PS 15/3, Financial
Conduct Authority.
Until there is more direction from the
regulators, those charged with the duty
of overseeing pension schemes must
reach their own conclusions. To help them
out, we would like you to send us your
definitions in 140 characters.
Enter here:
schroders.com/valueformoney
or
Tweet your contribution to
@SchroderPension
or
Email it to
[email protected]
The reader whose definition our panel
of judges deems the best will receive a
bottle of champagne or a donation of
£50 to a charity of their choice. The
closing date is 31 May, with the
winner and runners up announced
in our summer edition of Pensions
Newsletter.
Terms and Conditions
By entering the competition, the reader is agreeing to
the terms and conditions which can be found on the
Schroders web site at schroders.com/valueformoney
or by writing to James Nunn at 31 Gresham Street,
London, EC2V 7QA.
Funding levels remain depressed after
roller-coaster quarter
Average pension scheme funding levels
endured a volatile ride in the first three
months of the year, but ended the period
largely unchanged at around 63%. At
that level, the typical scheme has seen no
recovery of the 8% lost since the recent
peak in funding levels at the end of 2013.
Average funding levels bounce around in the first quarter
In spite of another strong performance from
growth assets, such as equities, a rise in
pension scheme liabilities again wiped out
all the gains in the quarter. Interest rate
expectations were the main driver. Fears
of deflation in Europe and competing
interpretations of when US interest rates
would rise helped pull sentiment in different
directions during the period.
60%
Towards the end of the quarter, the lower
oil price and stronger dollar prompted Fed
Reserve Chair Janet Yellen to push back the
likely date of a US increase. The resulting
drop in expectations had a knock-on effect
on interest rates elsewhere and, crucially, on
UK gilts prices, which are the key factor in
pricing pension scheme liabilities.
80%
75%
70%
65%
55%
50%
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Sources for approximate funding levels, asset and liability values (buyout basis) and average asset allocation: Pension Protection
Fund as of 31 March each year (to March 2014). Interim asset returns: MSCI, FTSE, Barclays, IPD, HFRI, Bloomberg; gilt yields:
Bank of England; all as of 31 December 2014.
Our “funding level tracker” measures how
the average UK pension scheme’s funding
level may have changed. Although every
scheme is different, we hope it provides
useful context for discussions about funding
and investment strategies.
updates, our UK Strategic Solutions Team
estimates how funding levels have changed
each month:
We use annual defined benefit asset and
liability values from the Pension Protection
Fund’s Purple Book1. Between these
–– Changes in liability values are
based on changes in yields for
UK government bonds (‘gilts’)
1 http://www.pensionprotectionfund.org.uk/
Pages/ThePurpleBook.aspx
–– Changes in asset values are based on
values for market indices that represent the
average pension scheme asset allocation
4
Schroders Pensions Newsletter Spring 2015
DC after the Budget:
are your members defaulting into danger?
We think many older savers in defined
contribution (DC) pension schemes may
face a difficult retirement if they continue to
use default funds designed for an old world
which has disappeared.
Since last year’s Budget, DC savers have
been freed to use their pension “pots”
almost as they wish when they retire. The
evidence is that most will reject the old
world of annuities. According to one recent
survey1, sales of annuities had fallen by
more than 50% even before the pension
changes took full effect in April. Certainly,
the experience of other countries with
growing DC savings pools is that annuities
are unlikely to be favoured by the majority.
Yet most older members of UK DC schemes
are still automatically pushed into a default
fund which assumes that they will buy an
annuity at or around 65. These funds are
designed to increase the certainty that their
pot will buy the level of annuity income they
expect. They work by investing most of
the saver’s assets in gilts and other highgrade bonds in an effort to replicate the
construction of a typical annuity portfolio.
However, such a fund may be positively
unhelpful if the saver is not intending to buy
an annuity when they retire. These savers
are likely to have a rather different objective.
Even though they may have been saving for
three decades, it’s quite likely that by this
stage – say, the age of 56 – they will have
only reached half way to the savings pot
they could expect at 65. This is because
of the magical effect that even quite a low
rate of compound growth has on a relatively
large pile of money.
1 Single-life sales of annuities through advisers in
December were down nearly 59%, according to IRESS,
a financial software firm in its At Retirement Report,
edition three, January 2015.
Contact
James Nunn
UK Institutional Business Development
+44 (0)20 7658 2776
[email protected]
They therefore need some growth, yet a
gilt-heavy fund could prove disastrous.
If interest rates rise faster than generally
expected, a gilt-laden portfolio is likely to
suffer quite severe losses as bond values
adjust to the new prevailing cost of money.
This is certainly the lesson of history: over
the 115 years since the beginning of the
20th century, sharp rises in base rates have
prompted at least 13 single-year falls of
anywhere between 4.4% in 2006 to 17.6%
in 1973, in real terms (see chart). Of course,
if interest rates follow their expected path –
or even fall – a pre-retiree’s bond fund might
hold its value or even do quite well in the
short term. The crucial factor here, though,
is “in the short term”.
If the saver ends up keeping their savings
invested when they retire, either so they can
defer the purchase of an annuity or to draw
an income, then the minimal growth typical
of many pre-retirement funds could prove
a millstone. For one thing, the absence of
significant money-weighted returns could
significantly restrict the eventual size of their
pot. For another, over the medium term,
inflation will start to take its toll.
We believe some type of multi-asset fund
is likely to prove a far less risky way for latestage DC savers to secure their retirement.
Such a fund builds in the prospect of a
more reliable level of growth over most
periods than gilts and gilt-like investments
on their own, while providing diversification
against many risks. Adopted as a default
fund, possibly with some level of additional
insurance against significant loss, we
believe it is likely to be far more suited to
the choices most DC savers are likely to
make when they retire.
It’s therefore imperative, in our view, that
schemes give urgent thought to whether
their current default fund continues
to match the likely aspirations of their
members. Or whether it is merely leading
them into an uncertain – and possibly
dangerous – future.
Gilt returns tend to plummet when base rates jump
Real total returns on UK gilts when base rates have risen
0%
1907
1939
1952
1955
1956
1957
1961
1973
1978
1979
1981
1994
2006
-2%
-4%
-6%
-8%
-10%
-12%
-14%
-16%
-18%
-20%
Inflation-adjusted one-year returns, with income reinvested. For illustration only. Source: Barclays Equity Gilt Study 2015 and
Schroders. As at 31 December 2014.
Important Information: For professional investors only. This document is not suitable for retail clients. Past performance is not a guide to future performance and may not be
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