How to set up your scheme's derisking strategy

This should target enough return to satisfy the recovery plan while offering a low cost of failure – that is, a low expectation of significant, unbudgeted contributions.

The review should seek to reconcile the interests of the trustees, the sponsor and the Pensions Regulator. Taking into account sponsor covenant and the outlook for investment returns, it would seek to address the following key issues:

• The split between return-seeking assets and liability-matching assets;

• The efficiency of the return-seeking assets;

• The level of interest and inflation rate protection on return-seeking assets.

The most important thing when setting this strategy is to begin with clear objectives and clarity around which risks you want to take and which you want to avoid.

Once a medium-term strategy has been set, trustees will want efficient and effective processes to keep it fit for purpose. 

This will involve reassessing objectives in light of actual versus assumed experience and funding level development, as well as making strategic asset decisions in light of revised objectives and the prevailing outlook for investment markets.

Such processes are not difficult to implement and should include the introduction of a dynamic derisking plan. This seeks to reduce risk as and when this is affordable, in light of positive scheme experience, and desirable, if the trustees’ risk appetite wanes.

Triggers can be implemented to either prompt discussion about derisking – derisking 'with recourse' – or to make strategic changes automatically, derisking 'without recourse'. Both approaches have a role to play. 

With-recourse triggers require regular reappraisal of the chances of success of the prevailing and alternative strategies. Clearly this is simple, but not easy. 

It requires the ability to construct forecasts for capital market returns under different economic scenarios and new funding level projections.

Trustees must decide how to react to this new information. It can lead to some action, no action or quite radical capital rotation.

In the case of without-recourse triggers, the inherent difficulty of predicting the future means it is reasonable to make some asset allocation changes on the basis of past experience only, without the need for intellectual effort. 

This includes banking assets that represent an excess relative to the level of assets assumed in the recovery plan and investing them in liability-matching assets.

Setting your LDI strategy

There are numerous practical issues to consider when setting up a liability-driven investment governance programme.

The first is how to measure the funding level. This information is time sensitive and a 'quick and dirty' figure can trounce one that is precise but outdated. 

Talk to the actuary about the need to be nimble. Can indices be used rather than actual returns to update asset and liability values?

Is there a minimum level of derisking? Minimum unanticipated funding gains can be set to help prevent the merits of the switch being undermined by transition costs and short-term market reversals.

The next question is which return-seeking assets can finance new matching assets. Usually these will be the assets that have performed best. 

It is important these are sufficiently liquid that they can be disinvested quickly at reasonable cost while the derisking opportunity persists.

What if other schemes are derisking at the same time? It is useful to set interest and inflation rate triggers that are scheme-specific.

Additional protection can be introduced when the average rate, weighted by the scheme’s own liability profile, breaches a threshold.

Good governance requires fully informed decisions being taken with confidence and implemented decisively. Clear systems must be established, possibly delegating powers of attorney to advisers and managers.

Many of these practical issues can be simplified by grouping assets on an investment platform or in a managed account.

Remember that this is an imperfect science; decisive moves in the right direction of travel can call rank on timid steps along a specific path.

Rob Davies is a partner at Quantum Advisory