Pensions » De-risking pensions: taking control of balance sheets in 2021

The FTSE 250 aggregate IFRS pension deficit in 2020 hit double that of the 2008 credit crunch, with funding levels falling from 97 percent to 86 percent. A wide gap remains between the best and worst funded schemes, and with no recovery in sight it is more crucial than ever for scheme sponsors to capitalise on 2021 opportunities in order to redress the balance. It is worth noting that FTSE 100 sponsors performed better than their FTSE 250 counterparts, with deficits much lower than levels observed by more domestically-focused businesses.

“2020 was a horrendous year for pension schemes,” says Trevor Brooks, Partner at global professional services firm Aon. “The volatility was mainly contained in the first half of the year and since then it has been quite stable, although there has not been a lot of recovery.

“At the start of the year there were concerns about Russia and the Middle East over oil prices, and then COVID-19 arrived and the stock markets crashed. Since then, the US economy has recovered, well buoyed by the tech companies, but there has been less of a recovery in the UK and not much has fed through to pension schemes’ funding levels.”

There has, in fact, been a marked difference between the best and worst funded pension schemes. The schemes that could afford to implement higher levels of protection from the fall in yields, through a series of measures including adopting a lower risk investment strategy, hedging against higher interest rates or inflation, and implementing member options to manage the liabilities, overall performed better, whereas schemes with lower levels of protection experienced greater volatility.

“It is a worrying trend,” says Brooks. “The ever-widening gap suggests that the schemes with the best resources and governance structures fared best, largely due to their investment strategies and how much money was put into the schemes. The worst don’t have that structure.

“In theory it should have been possible to weather the storm by putting in place protection against interest rate and inflation rises. The worst performing schemes typically had a lower level of that protection and a higher exposure to stocks and shares.”

It is time, Brooks believes, for pension scheme sponsors to take control, and periods of lower volatility are the right time to do just that. In fact, there is a window of opportunity right now, provided by a wave of optimism amid an easing of lockdown restrictions and low interest rates propping up asset prices.

“Investment strategy is fundamentally the biggest differential when it comes to performance,” he says. “Poorly funded schemes are not protecting themselves enough – stocks and shares have performed very well in recent years, but 2020 has shown us that there’s a balance to be struck.”

The first step to remedy the situation is for a scheme’s sponsor to compare itself with its peer group and acknowledge immediately if something has gone wrong. There should also be an acknowledgement that it is not necessarily the task of the accountant who oversees the pension scheme, but an issue for the management team to address (and discuss with pension scheme trustees who set the investment strategy). However, in normal circumstances, firms only look at these issues every three years in the reporting cycle, but this should be accelerated and prioritised now.

“They should consider strategy holistically,” says Brooks. “They should be planning now to see if contributions should increase. There are other options for maximum flexibility, like looking at the way members take their benefits.”

He points out that there are a lot of assumptions that should be challenged proactively before the next reporting cycle, including how long individuals live in light of the pandemic, and assumptions for inflation in light of Government RPI Reform proposals. In some cases proactive reviews of assumptions aren’t happening, and these plus other assumptions can be wildly inaccurate, adding significant unrewarded prudence to company balance sheets – this is inconsistent with IFRS accounting principles, and creates an unnecessary drag on P&L.

Above all, Brooks emphasises that while pension schemes may perform well or poorly, it is not always obvious to the sponsors which category they fall into. That is why it is crucial to reach out to advisors and actuaries and start asking the right questions. The point about peer group comparisons is crucial, be they companies or pension schemes of a certain size, or direct competitors. By benchmarking a scheme against the relevant peer group, the true picture will emerge.

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