We all have those things we don’t like doing that don’t give instant gratification but that we have to do. For me, it’s usually cleaning the flat, sorting out bills or, and I’m not sure I should be admitting this, paying into an ISA/pension. If I can’t immediately see the tangible benefit of it then how is it exciting and worth putting much effort into?
I guess the pension scheme trustee equivalent of this is dealing with liabilities which for most schemes far exceed their asset values leaving them with poor funding ratios. Of course, in an ideal world pension funds would be 100% funded but low gilt yields, low interest rates, high inflation and mark-to-market accounting standards have ensured this is not the case. Meanwhile, difficult markets have meant lacklustre asset growth has done little to counteract this incessant escalation of liabilities. But, given the fact these liabilities are not due to be paid for several years down the line, it is no surprise many scheme trustees tend to spend the bulk of their time looking at the more immediate or ‘sexier’ stuff on the growth side of the portfolio, such as asset manager selection, assets that offer a yield and where the opportunities to invest are.
Trustee attention to this side of the portfolio has been further heightened by how they view the risks associated with the growth portfolio – equity market risk and active manager risk – which they see as posing the biggest threat to their funding positions. However, interest rate and inflation risk actually have a much greater impact on a scheme’s funding ratio than asset risk does. Indeed, as F&C director, client relations, Simon Bentley explained earlier this week, for a scheme with £200m liabilities, £160m assets and assuming a 50% weighting and an illustrative one-year move of 15%, equity market risk has only a 6% (£12m) impact on funding ratio.
However, interest rate risk which has a 100% weighting has a 20% impact on the funding ratio (£40m). So proof that liability risk does outweigh asset risk, but the difficult thing about liability driven investment (LDI) is timing it correctly, especially with market conditions currently so unpredictable. That is why schemes should act mechanistically and investigate triggers to address this unrewarded risk rather than jump into LDI wholesale. As Bentley also said, the biggest risk is posed by not putting anything in place because “things move before you think they do”. It may seem like a chore now but will surely pay off in the long run.
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