The annual funding statement: Creating certainty from uncertainty

The low-inflation, falling interest rate environment has come to a juddering stop and has been replaced with inflation not seen since the early 1990s, with long-dated gilt yields rising significantly.  

While this poses some material risks, it also creates opportunities for schemes to reposition their investment strategies and reduce the uncertainty for their members. 

The AFS emphasises the importance of integrated risk management, providing a timely reminder of the key dynamics around funding, investment and covenant risks.

Given inflation expectations have risen materially and there is a risk of heightened inflation volatility in the foreseeable future, it is important to regularly check that inflation hedges remain fit for purpose

While these dynamics are not new, the interplay between them and potential consequences have shifted materially as a result of Covid-19, the war in Ukraine, and changing geopolitical dynamics.

With this in mind, there are four areas referenced within the AFS that are particularly noteworthy:

Funding level and sponsor covenant

The impact of recent market moves on schemes’ funding levels will partly depend on the extent to which the liabilities have been hedged. 

Those schemes with a full liability hedge may have seen funding levels fall in the current “risk-off” environment depending on the extent and nature of any risk assets held. 

In contrast, those that have under-hedged interest rates may have seen funding levels improve. In some cases, the impact may have been material, given how much gilt yields have risen.  

This highlights the importance of the interplay between the scheme’s financial health and that of the sponsor. 

While liability hedging is often viewed as a risk-reduction strategy, it raises some fundamental questions if it results in investment losses at a time when the sponsor is struggling due to rising inflation and interest rates. 

As the AFS mentions, scenario modelling can be used to help better understand those dynamics.

Liquidity risks

Unless there was a material risk of a sponsor insolvency event, liquidity risks may not have been a material concern for schemes in recent years, given that only a small proportion of assets were typically needed to cover benefit payments over a 12-month period. 

Indeed, where material deficit contributions were payable, investment — not disinvestment — considerations will have been the main focus. 

Further, the impact of falling interest rates on leveraged liability-driven investment funds will have provided further flexibility in meeting member benefit payments or adjusting a scheme’s asset allocation.

However, circumstances appear to be changing fast. 

Not only are most schemes maturing, but if deficit contributions shrink as a result of improving funding levels while leveraged LDI cash calls increase, the risk of having insufficient, lower-volatile assets to meet those increasing cash outflows grows. 

Not only does this run the risk of crystallising mark-to-market losses, but the sale of growth assets could require a rethink of the long-term funding and investment plans. 

Changing inflation expectations

As funding levels improve and schemes derisk, any inaccuracies in a scheme’s liability hedging become relatively more important. 

That said, liability hedging is only approximate at best. Not only are the projected cash flows estimates, but the selection of hedging assets also relies on a range of assumptions. Further, the AFS reminds us that the convergence of the retail price index with the consumer price index including housing costs is still not settled.

Inflation hedging is as much art as science, particularly where scheme benefits are subject to caps and collars. For example, it relies heavily on the assumed level of inflation volatility in the modelling. 

The chart illustrates how the proportion of the liability-matching assets can change with different inflation expectations for two inflation volatility assumptions, where inflation-linked benefits are subject to a floor of 0 per cent and a cap of 5 per cent.

Given inflation expectations have risen materially and there is a risk of heightened inflation volatility in the foreseeable future, it is important to regularly check that inflation hedges remain fit for purpose.

Mortality risks

The AFS highlighted the increased uncertainty over future mortality rates as a result of Covid-19.  

This widens the margin of error in the size and incidence of future benefit outflows, which increases not only uncertainty around funding plans but also liquidity and liability-hedging risks. 

Therefore, as schemes mature it becomes increasingly important to stress-test investment strategy results to changes in mortality projections. 

Opportunities

Funding level improvements driven by rising gilt yields provide an opportunity for some schemes to derisk without impacting their current funding plans. 

Indeed, in some cases, while they may not have sufficient assets to cover buyout today, they may be in a position to adopt a much lower-risk investment strategy. 

For fully hedged schemes that may not have seen such improvements in their funding levels, the recent widening of investment-grade credit spreads will have provided an opportunity to reduce allocations to more volatile growth assets. 

In those circumstances, schemes may be able to retain their liability-hedging ratios but with lower leverage, thereby reducing cash call risk.

In making such changes, the merits of investing in corporate bonds on a buy-and-maintain basis should be considered as part of a wider cash flow-oriented investment approach. 

Pooled vehicles are now available that facilitate the proxy matching of income and maturity proceeds over periods of up to circa 30 years. 

Covering some or all of the early years’ projected cash flows with corporate bonds leaves the remaining growth assets to cover the later years’ cash flows, while providing two key benefits:

1. Mitigating the risk of being a forced seller of growth assets creates a greater window of opportunity to exploit their upside volatility and divest from those assets at a more appropriate time.

2. Because the growth assets are not expected to be sold anytime soon, and their allocation as a proportion of total scheme assets is expected to grow over time, the amount needed to be held now is likely to be lower than under a typical fixed weight benchmark strategy, thereby facilitating further derisking. 

The comment in point two above plays to a wider point. Typical funding approaches assume either “linear” or “stepped” derisking as outlined in TPR’s consultation document DB code of practice dated March 2020.  

However, given the increased economic and market uncertainty and challenges associated with assessing sponsor covenant, it would be prudent to consider the merits of a “horizon” approach, which targets lower risk now but maintains the level of risk over a longer period. 

If maintaining risk for longer means investing in investment-grade corporate bonds rather than gilts, then while this would not remove the reliance on the sponsor covenant we think it should materially reduce it.    

In summary, recent market events will have helped improve funding levels for some schemes, with widening credit spreads creating opportunities for many more. 

While the widening spreads reflect increased risks, these need to be offset against the risks associated with retaining growth assets such as equities. 

The endgame may well appear almost within touching distance with a temptation to stay on risk and cross the finishing line quickly. 

However, as stated in the AFS, funding positions and covenant can also change quickly. Is that a risk worth taking in the current environment?

Carl Hitchman is chief investment officer for UK investment consulting at Buck