Tortoise vs Hare - a pensions fable
February 01, 2016
We all know the folklore race between the fleet-of-foot Hare and slow-moving Tortoise. The hare charges ahead but, confident of winning, takes a nap and wakes to find the tortoise, having moving slowly but steadily, had crossed the finish line. The proverbial upshot is "less haste, more speed". What can Aesop's fable tell us with regards to pensions?
Risk (haste) has generally not paid off for UK pension funds - in fact it has swallowed up more than £50bn in aggregate cash contributions over the last three years with no meaningful improvement in funding - the hare had steamed ahead but came back to the starting line. As a result, Recovery Plan lengths (speed) haven't changed - what was a 10 year target in 2012 is often being reset to a 10 year target from today. Is it good enough to just shrug and carry on?
Ultimately the UK pensions problem will be solved by future contributions and investment strategy plugging away towards a self sufficient goal. I'd like to focus on the hare-footed approach being taken to an aspect which drives both factors: the Technical Provisions recovery period (the pace of our race, if you will). The PwC 2015 Pension Scheme Funding Survey shows that the majority of schemes are targeting (and have historically targeted) less than 10 year recovery periods, and perennially fail to meet that arbitrary target. This timeframe drives the future contributions required and the investment returns required to achieve full funding on the chosen Technical Provisions basis, and consequently results in a level of risk being taken. The shorter the timeframe, the more risk the scheme is exposed to, either in terms of Sponsor reliance or investment risk. Analysis from Redington suggests that based upon current approaches, schemes are closer to 20 years away from reaching self sufficiency - and yet their contributions and investment strategies (and risk) are being driven by a 10 year timeframe to reach full funding on a Technical Provisions basis.
So why is there a herding of Recovery Plan lengths around 10 years? Historic guidance has not helped. The Pensions Regulator states that deficit Recovery Plans that have a duration of longer than 10 years trigger greater scrutiny. And while every funding agreement is unique, with careful negotiation around changes in scheme design, investment strategy, security offered by the sponsor, balance of powers and so on, such discussions are evidently anchored around the 10 year point. Anchoring instead at a 20 year target doesn't in principle change the framework for discussions, but Aesop's tortoise approach does have a better chance of actually finishing the race and reaching self sufficiency.
What would change if the herd (strictly speaking, it is a drove of hares...) began to move towards a more realistic timeframe of 20 years?
- The objective of meeting the Technical Provisions deficit could be spread over a longer period of time.
This would mean investment returns would need to be far more modest year-on-year (tortoise steps) to reach the goal, reducing the need to chase fleeting returns in a low yielding world.
- The cash drain on sponsors could be similarly spread, improving the immediate and ongoing viability of the UK private sector.
- This reduced need for investment returns immediately results in portfolios which can be structured to have "more certainty" of expected returns and are therefore better able to deal with the tipping point where benefit outgo exceeds contributions, which will be facing the schemes over the coming years.
- Most importantly there is an immediate ability to substantially de-risk. We believe far in excess of a 50% reduction of funding risk should be possible for most schemes, greatly reducing the likelihood that market movements wipe out gains so easily and the likelihood that sponsor contributions continue to fall into the pensions black hole.
It is time to challenge the accepted wisdom because 'slow and steady' really is more likely to get us to the end of this race.
Nikesh Patel FIA CERA
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