“The Regulator has given a clear steer for pension scheme trustees, delivering a strong message about the value of an integrated risk-based approach. It recognises the economic realities of today – that we are living in a low interest rate and low expected return environment – and emphasises good governance when forming and applying a strategy for deficit reduction.
“Taking an integrated risk-based approach to scheme funding has to be the way forward and the Regulator’s statement endorses that. Those who take this more forward-looking approach, rather than traditional methods that ignore the value in risk reduction, should be in a better position to cope with current market conditions.
“The funding statement does paint a disappointing picture for some schemes, though. Many schemes are in an unfortunate position due to historic lows in gilt yields. A higher shortfall this time around will be a blow to trustees and companies given the £44m paid in contributions over the past three years.
“Schemes that based funding decisions on interest rates rising higher than market expectation three years ago will be feeling grim. The flip side though is those schemes that reduced interest rate risk soon after their last valuation – they’ll be in a better place, providing clear evidence that a lower risk strategy can be beneficial.
Commenting on what trustees should be considering looking forward, he added:
“Given low yields and low expected returns, it makes sense for trustees to reduce their return expectations and adjust risk-reduction triggers to reflect this.
“Hedging ratios are far too low, driven by people believing (at least implicitly) that rates will rise higher and/or faster than the market is predicting. That thesis has been proven wrong.
“Trustees should ask themselves these questions: does the view that rates can only rise from here make sense now? Do you want to run the risk of being wrong with persistently low rates increasing deficits further? Where trustees have set triggers to increase their hedging ratios, yield triggers have to be realistic and take into account the lower level of future expected rates.
“Conventional wisdom says that longer recovery periods mean more risk. While at face value that can be true, this is not the case if risk is reduced in other ways - for example, reducing allocations to growth assets and instead focusing on ensuring you have the income to meet your outgoings, and putting in place higher hedging levels.
“The whole point of an integrated approach, such as our 3DFunding, is to balance the risks. Taking less asset and liability risk means that a longer payment period might be ok. Indeed it arguably strengthens the covenant versus higher cash now.”
“While tPR’s annual statement rightly focuses on investment risk, particularly interest rate and inflation risk, longevity risk should also not be forgotten. Trustees should seek to understand and quantify longevity risk just in the same way as investment risk, so that they can prioritise and tackle which risks are important to their scheme.”
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