2016

Three key questions to ask in an effective investment review

Navigating an investment strategy review can be a daunting task. To help trustees, we have distilled down the process to the three key questions we believe they need to focus on

7 July 2016

1. What does “fully funded” really mean?

Trustees receive an update on how well funded their scheme is every three years during the actuarial valuation. To produce this valuation, the scheme actuary estimates what all the scheme’s future benefit payments are worth in today’s money using a discount rate.

An important focus of the valuation is the technical provisions funding level. Trustees must negotiate a deficit recovery plan with their sponsor if there is a deficit on this basis.

However, reaching full funding on a technical provisions basis isn’t enough to secure members’ benefits in the long term. This is because the technical provisions basis usually assumes the scheme’s assets grow faster than the liabilities.

This means the assets must continue to outperform the liabilities to remain fully funded on this basis.

Trustees should have a long-term goal beyond full funding on the technical provisions basis: one where members’ benefits are secured without the need for further outperformance. This can be measured by using a second, more prudent basis for determining the liabilities, with no outperformance built in.

2. How sensitive is the funding level to actuarial assumptions?

The discount rate is crucial. The higher the discount rate, the lower the liability value and vice-versa.

To determine the discount rate, the actuary makes certain predictions about the period until pension payments are due:

  • The interest rate on bonds
  • The return on the scheme’s growth assets
  • The level of inflation

A typical UK defined benefit scheme has a very long time before it must meet its liabilities (around 20 years). This makes those liabilities very sensitive to slight changes in the actuary’s forecasts of interest rates, returns and inflation.

3. What are the biggest investment risks for the scheme?

The aim of the investment strategy review is to decide how much investment risk to take, and where to take it.

Trustees often focus on the assets, but a much bigger risk often lies with the unhedged liabilities. This is because, as discussed above, they are so sensitive to changes in expected future interest rates and inflation.

The average scheme is only covering (hedging) about 31% of these risks with liability matching assets1.

The current asset allocation of UK DB schemes on a simple average basis can be seen in the char on the left below. The righthand chart breaks down the sources of funding level risk assuming 31% is covered by matching assets.

It is clear that the risk from the liabilities is greater than the risk from all the growth assets added together. So while the average scheme may have spread the risks from its growth strategy using a range of assets, it is still taking a very concentrated bet on interest rates and inflation through its uncovered liabilities.

1 2015 KPMG LDI Survey and PPF Purple Book 2015

Important Information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.  To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.