DB taskforce encourages credit innovation to tackle deficits

Speaking at the PLSA’s Future of DB seminar, Ashok Gupta urged schemes to respond to the taskforce’s call for evidence, which ends this week.

He also hinted at support for reform of the way scheme funding requirements are measured.

It’s like steering an oil tanker by following a school of dolphins

Ashok Gupta, PLSA

Asset managers called for a similar rethink of the industry’s dependence on gilts, arguing that funds would only be able to invest their way out of deficits if they sought out higher yielding assets.

Highlighting the scale of the challenge facing the sector, Gupta said: "We’re talking about 50 to 60-year run-off. So if we don’t address the problems that we identified, not only is this bad for members, but it’s bad for industry, it’s bad for the economy, and it’s bad for younger generations.”

Assessing the deficit

One problem he identified was the industry’s use of deficits as a measure of scheme funding.

Scheme deficits experienced huge volatility before and after the UK’s EU referendum, hitting a combined total of £935bn on a full buyout basis at the end of June.

“Deficits essentially use short-term measures of risk,” he said, adding: “When I think about risk for a pension scheme, it’s what’s the likelihood of paying those benefits.”

He said the perceived volatility of schemes’ deficits might put strain on the employer covenant, and prompt both employers and trustees towards the wrong outcomes.

“It’s like steering an oil tanker by following a school of dolphins,” he said.

Andrew Warwick-Thompson, executive director for regulatory policy at the Pensions Regulator, sought to restore confidence in the sector.

“There’s no evidence to suggest a systemic affordability issue for employers with defined benefit schemes,” he said.

Instead he suggested improvements to the regulatory framework might help prevent schemes from falling into difficulty with funding.

But asset managers said DB schemes will also need to invest their way out of funding deficits, which may involve breaking away from their historical attachment to gilts.

Investing your way out?

“At the end of the day there still needs to be income,” said Jeff Mueller, portfolio manager and global analyst on Eaton Vance’s high-yield team.

He said innovative fixed income solutions, typically involving low exposure to interest rate changes, would be needed to generate those returns in a period of historically low gilt yields.

“That credit risk premium is still available,” he said, arguing for actively managed multi-asset strategies focused on minimising duration risk while retaining high yields.

He said high-yield fixed income assets were usually the best or worst performing assets over a year, making the case for active managers with the expertise to avoid default cycles.

“I do believe there’s alpha out there,” said David Furey, vice president and portfolio strategist in State Street Global Advisors’ fixed income, cash and currency team, although he admitted: “It’s becoming more difficult to find and more expensive to get.”

He said active management of fixed income products was too cost and governance-intensive for the needs of many modern DB schemes. In stark contrast to Mueller’s advice, he encouraged investors to extend duration and go “lower for longer”.

“There’s also what’s known as factor investing or smart beta,” he said. While smart beta strategies are relatively advanced in the equity sector, they have only recently been developed in the fixed income space.

“If we reconstruct the underlying portfolio and tilt it towards some prevalent risk premiums in the markets, we can actually deliver a proportion of that alpha,” Furey said.