Volatility playing havoc with defined benefit funding ratios may speed the transition towards fiduciary management and consolidation of final salary schemes, according to governance specialists.
Delayed reaction times are reportedly prompting trustee boards to ask themselves whether they are best placed to protect member value through wildly changing conditions in equity and fixed income markets.
In the gilt market, the UK 10-year yield has seen day-to-day swings in excess of 50 per cent. While the story in equity markets has been one of rapidly shedding value, domestic indices have moved sharply upwards at times, including a rally on the back of the Bank of England’s latest intervention.
Trustees should pause and make a mental note to themselves to look at this in three months’ time, say, to see what damage has been done to their scheme and to compare that with what the damage might have been had they been in a better position
Barry Mack, Muse Advisory
Making the most of these conditions is “much trickier” for trustees in an advisory relationship with an investment consultant than for those who have enlisted a fiduciary manager, according to IC Select director Donny Hay, especially given the lack of preparation many will have had for working full-time from home.
“It requires quorums, people to get together, people to get up to speed with their equipment,” he said, saying that for many trustee boards, “nothing much will happen” through this period of turmoil.
“Talking to those people that have made the change, they say ‘I’m just so relieved that we’ve got this in place and I can call them up and find out what they’re doing’,” Mr Hay continued.
IC Select analysis suggests that over the next three to five years, around half of the DB schemes in the Pension Protection Fund’s universe will have moved to consolidated models such as fiduciary management, sole trusteeship, master trusts, or commercial consolidation.
Aggressive returns require diversification
A huge weight of research suggests that the key driver of scheme returns is strategic asset allocation, rather than tactical moves to take advantage of daily moves in pricing.
However, IC Select has argued that investment consultancy relationships are usually unable to support the diversification needed to implement a strategic asset allocation that delivers good returns, even in choppy markets.
This need for diversification has seen an increasingly large subsection of schemes move towards the sector, once only reserved for schemes with less than £500m in assets. Fiduciary manager SEI reported that the average asset size in tenders it had seen had grown almost three-fold from 2015-2019, and said 2019 saw several multi-billion pound tender processes.
“The more return you’re seeking, the more sophisticated your portfolio needs to be. Advisory, we find, can only cope with five to six asset classes,” Mr Hay said.
“Now that we’ve had the dislocation in the markets that we’ve seen, we think it just adds another dimension of complexity.”
He added that fiduciary managers’ insistence on removing unrewarded liability risks like exposure to interest rate changes and inflation has shown up investment consultants over the past five years.
FMs tweak equity position
While liability management may have been the fiduciary manager’s star play in recent times, some are now touting their ability to pick up extra return amid volatility, compared with a more static allocation.
Aon’s fiduciary management service, for example, has maintained an underweight position in equities for some time, feeling that valuations were stretched. In a recent dip, the company eased this position, citing the 25 per cent discount to the price at which they had originally sold.
“We’re still underweight equities,” said Tony Baily, Aon investment partner. “We’re not wholesale buyers of risk as of yet. I think it’s just too early to tell because this is uncharted territory.”
He added that while the buying opportunity might have disappeared by the time a trustee board had considered advice from a consultant and reached a decision, there are steps schemes can take to become more nimble.
“An investment subcommittee could be a useful addition,” he said. “But what really makes a big difference is if the subcommittee can meet on an ad hoc basis and still have some authority.”
Time will tell
Whichever governance structure trustees decide is best for them, schemes are unlikely to rush to make changes now, said Barry Mack, director at Muse Advisory.
“They will wait and see how the FM providers fare in this climate; after all, acting quickly and ill-advisedly can be just as bad,” he said.
Mr Mack added that much of the damage may have already been done, especially for schemes with March 2020 valuations that have under-hedged or seen their sponsor covenant weakened.
“I think trustees should pause and make a mental note to themselves to look at this in three months’ time, say, to see what damage has been done to their scheme and to compare that with what the damage might have been had they been in a better position, such as those with greater delegation of investment activity including being with an FM provider,” he said.
