FTSE 100 steps up derisking drive as deficits shrink

A quarterly report by consultancy JLT Employee Benefits found that 10 blue chip schemes had converted more than 10 per cent of their assets into bonds from other investments over the year to December 2017.

Across the index, bond allocations increased by 2 percentage points to 64 per cent, up from 35 per cent a decade ago. Experts said the move is explained by the growing popularity of cash flow-driven investments among mature schemes.

If you’ve got yourself into a situation where your deficit is very, very much lower, you can afford to take quite a lot of risk off the table, and why wouldn’t you?

Charles Cowling, JLT Employee Benefits

However, the report also found that schemes prepared to take equity risk were handsomely rewarded in 2017.

Large equity positions combined with sponsor contributions saw aggregate IAS 19 funding levels improve by 34 per cent. JLT said it was not possible to determine whether these equity investments were made while hedging interest rate risk with leveraged liability-driven investments.

Lock in positive results

Given the returns enjoyed by schemes over the year, Charles Cowling, chief actuary at JLT, said it made sense that schemes were now looking to control their risk.

He viewed the enduring popularity of risky assets like equities as evidence of schemes “sweating the assets” because their employers could not afford to plug the funding gap that a low-risk investment would present.

“If you’ve got yourself into a situation where your deficit is very, very much lower, you can afford to take quite a lot of risk off the table, and why wouldn’t you?” he said.

With 27 of the FTSE 100 DB schemes completely closed to future accrual, many employers will now be thinking about the destination for their schemes.

This explains the popularity of locking down risk via CDI, which matches liabilities with a range of fixed income assets while still generating a modest return, according to Cowling.

“It’s a much easier logical approach for trustees and employers to buy into if your investment time frame is much shorter,” he said, but added that it may be appropriate for others as well.

Immature schemes can use CDI

Simeon Willis, chief investment officer at consultancy XPS pensions, said there is a misconception that CDI is only appropriate for mature, well funded schemes.

“Any pension scheme, immature or very mature, will benefit from having greater certainty over returns,” he said. “There is a limit to how much return you can generate, but that limit is often higher than people envisage, because there are lots of illiquid credit assets out there.”

Overall, FTSE 100 schemes had a positive year, at least according to the IAS 19 funding levels disclosed in annual accounts.

Sponsor contributions plugged some £8.7bn of the funding gap, although this was down on last year’s £11.3bn and dwarfed by dividends. Over the year, 39 companies paid out dividends greater than their total deficit.

Nonetheless, deficits fell £14bn on aggregate, leaving the companies with a net unfunded liability of £41bn, despite total liabilities increasing.

Deficit disclosures under spotlight

One potential headwind for DB employers is a crackdown on the way they disclose their pension obligations, announced by the Financial Reporting Council last week.

The accounting watchdog said there was “room for improvement” in the audit of pensions disclosures in company accounts. It asked auditors to challenge key assumptions, including long-term yields and longevity, which experts said would likely narrow the range of discount rates used in deficit calculations.

“The direction of travel from the FRC seems to be wanting auditors potentially to challenge assumptions more,” said Matt Davis, partner at consultancy Hymans Robertson. “What they really want to see is the justifications for the assumptions.”

Of course, accounting deficits do not give a particularly clear picture of the health of a scheme or its likely cash requirements. But Davis said enhanced disclosures could help solve this problem.

“Anything that says more about funding arrangements and key sensitivities or anything like that should be useful for investors,” he said.