Pandemic raises investment challenges for mature DB schemes


20 Oct 2020

The economic hit of Covid means pension funds might have to take more risk to hit their endgame target.

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The economic hit of Covid means pension funds might have to take more risk to hit their endgame target.

The economic hit of Covid means pension funds might have to take more risk to hit their endgame target.

The economic damages of the Covid pandemic have pushed back the potential endgame for mature schemes, due to a combination of falling equity markets and a decline in bond yields.

The average endgame for defined benefit (DB) schemes in the FTSE350 has increased by 18 months as a result of falling investment returns and lower bond yields pushing up deficit estimates, Barnett Waddingham said. In investment terms, this means that a scheme expecting to achieve buyout stage within five years would need an average investment return of 2.6% above gilts each year to remain on track for the endgame timescales anticipated at the end of 2019.

On average, final salary schemes would have to top up investment returns by an additional 1.4% to stay in line with their endgame plans, the consultancy predicts.

The forecast suggests that mature pension schemes might have lost some of the gains they booked over the past three years.

Since 2017, DB schemes have significantly reduced the timescale to self-sufficiency. Almost two thirds of schemes now expect to reach self-sufficiency within less than 10 years, an improvement of 1.7 years compared to 2017, according to Aon’s Pensions Risk survey. The vast majority of these improvements (78%) were due to higher than anticipated investment returns, Aon said.

But mature pension schemes with a high exposure to fixed income and a strategy to buy and hold might not have a lot of options to book additional returns in a low interest environment.

Yields on gilts of up to seven years have been trading below zero since the start of the pandemic and even government debt with a maturity of up to 30 years, exceeding the lifespan of many mature schemes, does not offer a return in excess of 1%.

In other words, investors will have to look elsewhere to make up the shortfall. Surveys among investors suggest that more than a third (39%) are considering increasing exposure to corporate bonds while index-linked bonds are on the shopping list for more than half (52%) of investors.

Increased exposure to property is also on the agenda for 15% of investors, while roughly a quarter intend to source other cashflow matching assets, according to Mercer’s latest Asset Allocation survey.

Investment challenges also affect larger schemes that are less mature. The Universities Superannuation Scheme (USS) announced earlier this year that its deficit had doubled to £12.9bn due to market volatility.

However, the effects of market volatility may have been reinforced by the fact that the scheme completed its valuation based on asset prices in March 2020, with some of the losses now being restored.

The Pension Protection Fund (PPF), which reported its annual figures in early October, had also been affected by the recent headwinds. While its investment performance remained constant compared to the previous year at 5.2%, its reserves dropped to £5.1bn from £6.1bn.

The pensions lifeboat now estimates that the probability of reaching its funding target at the scheduled time has dropped to 83% from 88.8%, year-on-year.

The pensions lifeboat acknowledged in its annual report that accurate forecasts had become more challenging. “There is more uncertainty than normal in our estimates of the current financial strength of the pension schemes we protect, as we need to make some high-level assumptions about the impact of the significant recent market volatility on their asset values. We are also facing a more uncertain claims environment than usual.

“It is clear that insolvency risk has increased, but at this early stage in the development of the expected worldwide recession, and in the presence of very significant government support for viable companies, it is very uncertain how that will manifest,” the PPF said in its annual report. A challenge, undoubtedly familiar for many other DB schemes.

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