Defined benefit deficits worsened during December to an aggregate IAS 19 deficit of £434bn, as experts added an uptick in inflation to their concerns for pension funds over the course of 2017.
Analysis by consultancy JLT Employee Benefits showed that funding levels had dropped by seven per cent during the year, although deficits have recovered from record levels of more than £500bn at the end of August.
They aren’t getting the contributions in and enough income in to pay out
Rob Barrett, Axa Investment Managers
The findings contribute to a mixed outlook for 2017, with industry insiders divided over the investment and regulatory prospects for trustees.
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Deficits totalled £414bn at the end of November. Over the year as a whole, FTSE 350 companies have seen a larger hit to their schemes than their smaller counterparts, but still maintain a higher average funding level.
Charles Cowling, director at JLT, said the valuation pain for DB schemes looks set to continue into 2017, as perpetual low interest rates are compounded by uncertainty surrounding geopolitical events in Britain and Europe.
Schemes with strong employer backing might not be too worried by a gloomy market outlook. “They can invest in equities and say, ‘Why should I worry about bond rates?’,” said Cowling.
But he added that for those schemes with a weak or small employer, the situation looks much worse, and is complicated further by the high cost of hedging against further movements in interest rates or inflation.
Despite this cost, Cowling said: “Hedging ought to be what all pension schemes are doing. There’s no economic benefit from playing markets.”
Stephanie Flanders, chief market strategist at JP Morgan Asset Management, struck a more optimistic tone, arguing that the compression of long-term interest rates should ease through 2017 as reflation creeps in.
“We should see discount rates go up,” she said. “I think the overriding feeling is that higher interest rates will be broadly beneficial, even if that’s partly to do with higher inflation expectations.”
However, she added that sustained interest in fixed income as schemes mature could put a ceiling on that rise in long-term interest rates, and added that the maturity of the equity cycle could limit returns.
Chasing income
Just under 22 per cent of UK DB schemes owe more than half of their section 179 liabilities to pensioner members, according to the Pension Protection Fund’s latest Purple Book.
This proportion is only set to rise, making cash flow management a key concern for the coming years, even if the industry has previously overestimated the amount of schemes that are cash-flow negative.
As schemes in deficit become cash-flow negative, they could enter a situation where “they aren’t getting the contributions in and enough income in to pay out”, said Rob Barrett, UK head of institutional sales at Axa Investment Managers*.
To avoid being a forced seller of assets and crystallising or worsening the scheme’s deficit, Barrett recommended trustees adopt a 10 to 15-year investment strategy, with a sustained focus on diversification.
“It’s a combination of a buy-and-maintain bond portfolio that matches the income streams in the medium to long term, having liability-driven investment, and real estate and long lease assets,” he said.
All change for regulatory framework?
Trustees of DB schemes will also have a keen eye on the regulatory framework moving into 2017, with reform offering the potential for both respite as well as further headaches.
The high profile insolvencies of 2016 have unleashed a string of legislative responses, including the Work and Pensions Committee’s report into DB, which called for “nuclear fines” to be levied against employers, flexible indexation rules and a bolstering of the regulator’s powers.
Cowling said it was unlikely that the majority of these reforms would be implemented, owing to the conflict between calls for tougher regulation and requests to ease the strain of DB on sponsors.
Catherine McKenna, pensions partner at law firm Squire Patton Boggs, agreed corporate sponsors can be unjustly criticised, but still expected the Department for Work and Pensions to heed the concerns of the select committee in its forthcoming green paper on DB.
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“The DWP isn’t completely led by that committee, but one of the purposes of it is to influence and give some feedback,” she said.
She welcomed proposals to give trustees greater powers to demand information from employers, but favoured a better use of the regulator’s existing powers over adding further ones.
She also described data protection and proper adoption of integrated risk management as key concerns to be added to trustee agendas for the year.
*An earlier version of this story called this company Axa Investment Management, this has now been corrected
