News analysis: More schemes are starting to take an integrated approach to investment, covenant and funding in their risk management planning, but there is still a disconnect between schemes’ investment strategy and the valuation process, according to new research.
A third of schemes have a plan in place to mitigate the risk of their investment strategy, covenant or funding position being weakened, while 32 per cent are considering putting a plan in place, according to research by consultancy PwC.
Schemes should manage risk in a holistic way rather than in a silo, said Lynda Whitney, principal at Aon Hewitt.
This means covenant strength impacts on the viability of different investment strategies; funding requirements also inform investment decisions and the funding strategy is taken into account when determining covenant.
“You can either have a virtuous or a vicious circle if one of those elements in that circle goes wrong,” said Whitney.
Larger schemes are the best prepared, with the majority either having a plan in place or considering it, according to the research.
Setting your discount rate
However not enough schemes are allowing for changes in their investment strategy when setting their discount rate, PwC's research stated.
Sixteen per cent of schemes are using a single discount rate, while 57 per cent take a dual discount rate approach, where the rate is different before and after the member retires.
Shropshire Pension Fund takes a pre and post-retirement approach to setting its discount rate, according to Justin Bridges, the council's treasury and pension service manager.
“[The recovery plan] depends on what guarantees employers have in place and if other employers are guaranteeing that employer,” said Bridges.
Having the same discount rate for a 22-year-old and a pensioner can lead to poor decision-making because it does not reflect the fact you are looking to invest in different types of assets, said Paul Kitson, partner in PwC’s pension advisory team.
However taking a dual discount rate approach is still quite flawed, he added.
“It means you’re sort of assuming that you’re going to change the way you invest as soon as you retire. It produces a real discontinuity between the way you assume how you treat someone who is about to retire and [someone] who has just retired,” said Kitson.
However the advantage of using a pre and post-retirement rate is that it has automatic, in-built derisking, Whitney said.
More schemes are using alternative methods to set their discount rate, such as an asset-led approach, the research found.
“It’s much more about saying, ‘What actually is our long-term investment strategy? How are we actually going to invest for older members versus younger members? And let’s work out our discount rate after that’,” Kitson said.
More schemes are also turning away from using gilts as a basis for discounting their liabilities, he added.
Tyne and Wear Pension Fund recently stated it was considering using the total return on the fund’s assets as a basis for calculating their discount rate to improve its funding level.
