RBS scheme slashes equities after £2bn contribution

The move comes on the back of huge contributions into the £48.8bn group of schemes, with the bank pumping in £2bn in October 2018 to offset the impact of ring-fencing on the sponsor covenant. A further £1.5bn in dividend-linked contributions could yet be paid.

Equity holdings in RBS' main section dropped from 25.9 per cent of assets to 8.9 per cent over the past year, while allocations to index-linked bonds, government bonds, corporate bonds and derivatives used in liability-driven investment strategies all grew.

The prize with a lot of pension funds is to grow the assets enough so that the asset is performing, plus some contribution coming from the sponsor

Nick Evans, KPMG

Reducing the schemes' exposure to risky equity investments has helped RBS, which is still 62 per cent owned by the UK taxpayer, to strengthen its balance sheet and capital position, according to its annual report.

The bank’s “risk profile improved materially in 2018, with progress made in relation to pensions, the settlement of the US Department of Justice’s investigation into residential mortgage-backed securities, and ringfencing implementation", the accounts state.

The bank reported a pre-tax profit of £961m for the third quarter of 2018. Its schemes are also in accounting surplus, with the group reporting a net pension asset of £355m (£263m in 2017). Schemes in surplus had an extra £520m of assets over liabilities, while schemes in surplus and £165m of schemes in deficit had a total funding gap of £165m.

Bank derisking influenced by ringfencing

Derisking of investment strategy has been particularly evident among banks, who must consider their overall risk in line with regulation from the Prudential Regulation Authority and requirements such as ring-fencing, where essential banking services are separated form investment banking to limit financial contagion.

Henry Tapper, a director at actuarial consultancy First Actuarial, says: “Ringfencing has got nothing to do with pensions and security. It has got everything to do with the banks own solvency requirements and to do with their relationship with another regulator, the Prudential Regulation Authority. That’s typically why banks are so keen to derisk their pensions.”

He disputes whether the move into safer assets has actually improved the situation for members.

“I think it’s a good thing that pension schemes take less risk in general. But the kind of derisking strategies which these banks are adopting are very drastic derisking strategies. They are so drastic; the derisking is so deep that they are causing unseen consequences,” Mr Tapper says.

"Taking a transfer value is not a good idea and yet hundreds and thousands of people take transfer values every year because they see them as being so high. One of the reasons they are so high is because pension schemes have this business of wanting to derisk,” he adds.

Why is derisking popular?

However, other experts take a different view, and derisking has become the norm for mature DB schemes. Trustees have cut allocations gradually, and in some cases substantially – trimming their equity exposure over time in favour of greater diversification, less volatility, and more predictable cash flows.

The drive to derisk is spurred on further by the current state of equity markets, according to Simon Cohen, chief investment officer at Dalriada Trustees. Muted earnings growth, weak economic momentum and political risks have all weighed on the asset class.

“As a trustee, I am seeing this all the time, derisking the portfolio and moving out of equities and into bonds. One key element of banks derisking is that we have had a strong bull market in equities. We’ve seen the recent volatility in December when over the quarter equities fell 10 to 15 per cent," he says. “We have had a long bull market with a few dips on the way. The economic commentators are saying that it will end soon, we have had a bit of a rally in January.”

"Pensions schemes are becoming mature and looking at alternative investments to derisk their portfolio. It is not something that is unusual," Mr Cohen adds, stressing that bonds are not the only answer: “Pension schemes are looking at different asset classes to diversify away from equities. It is not just about going into bonds, it is going into illiquid asset classes as well.”

Cash flow negativity begins to bite

According to a report from PwC, four in five pension schemes believe they are likely to become cash flow negative within the next five years and are considering changing their investment strategy.

The professional services firm's Pension Investment and Governance Survey 2018 shows that schemes are increasingly looking towards lower-risk, higher-yielding assets, leading to an increased interest in illiquid assets matching scheme cash flows, combined with a reduction in equity allocations.

The survey also found increasing allocation to liability-driven investments to hedge interest rate and inflation risks.

Nick Evans, head of investment advisory at KPMG, says this is what has led to the growth in cash flow-driven investment: “If you asked 100 pension funds what are your main aims for the next few years, it would be to improve the funding level and derisk."

“The prize with a lot of pension funds is to grow the assets enough so that the asset is performing, plus some contribution coming from the sponsor. So, at some point in the future, I don’t have to take many risks at all. I can invest as an insurance company would in really safe assets like corporate bonds, maybe long lease property,” he continues.

Mr Evans notes that derisking can be good or bad depending on the client circumstances: “Everything you do with a client has to start with their specific objective and circumstances, and it might be the case that you have a client with a really strong sponsor; they are not well funded and going for growth is a perfectly reasonable thing to do."

“On the flip side you might have a client who has a lower funded position; the sponsor might be in something like retail, so there is not a huge level of visibility on the covenant, you can’t rely on it when things are poorly and therefore for that scheme it might make sense to derisk,” says Mr Evans.

GMP equalisation will increase scheme liabilities

RBS has also announced that it expects its schemes to take a £102m hit from the adoption of a new method for equalising guaranteed pensions. Despite the large sum, this changes the main section's liabilities by 0.2 per cent, according to the bank.

Felt widely across the DB sector, appropriate methods for equalisation were established by a court case between Lloyds Bank and its scheme trustees.

Darren Redmayne, chief executive officer, Lincoln Pensions, says: “While it varies, the GMP issue has been generally leading to a 1 per cent increase in liabilities for our clients."

Mr Redmayne adds that the key issue is whether the covenant can absorb the risk and additional cost of this extra liability.

“For sponsors where things are tight, there is stress in their trading performance and where the scheme is larger, this impact will be more significant relative to scenarios where a sponsor is performing well and the scheme is relatively small. For most schemes, GMP, of itself, is manageable and supportable by their covenant,” he says.