Twenty per cent of FTSE 100 defined benefit schemes would be at risk of failure in the event of an economic downturn, according to new research by Cardano and Lincoln Pensions.
The collective deficit of FTSE 100 schemes stood at £17bn on an accounting basis at the end of June 2017, according to LCP analysis. This represents an improvement from the previous year’s net position of £46bn.
Dubbed 'The Worry Index', the Cardano report applied the Pension Protection Fund’s stressed scenario – which assesses the impact of an economic slump – to FTSE 100 schemes. The results indicated that the schemes' collective deficit would increase by £100bn during a recession.
It would be good to more uniformly see the pensions industry and pension schemes consider stress testing their ability to withstand a recession scenario
Darren Redmayne, Lincoln Pensions
The International Monetary Fund revised its long-term outlook for annual UK growth from 1.9 per cent to 1.7 per cent this month. The report advocates integrating the employer covenant, funding and investment strategy into a unified risk management approach to combat the effects of any stressed scenario.
Run more stress tests
Darren Redmayne, chief executive at Lincoln Pensions, argued for a general increase in scheme stress testing. He cited a rise in stress testing in the insurance industry following the 2008 financial crisis.
“Similarly, it would be good to more uniformly see the pensions industry [and] pension schemes consider stress testing their ability to withstand a recession scenario and shocks,” he said.
A spokesperson for the PPF welcomed the study, but added: “Our modelling suggests that such an adverse scenario is unlikely to happen in practice. Members can though be reassured that the PPF is there to protect them should their employer go bust and their scheme not be able to pay at least what we would."
Matthew Arends, partner at Aon Hewitt, agreed with the need for holistic risk management. According to the consultancy’s Global Pensions Risk survey, only 4 per cent of UK schemes have implemented a plan for integrated risk management.
“The [risk factors] that are driving concerns are interest rates, inflation and longevity,” he said.
“Equity risk will be there in the mix, but the general view is that [it] tends to be rewarded, and so is a risk worth running,” he added.
Look to contingent assets
While schemes should seek to improve their ability to manage stressed scenarios, basing a scheme’s integrated funding strategy on the worst-case scenario could lead to weaker performance.
Martin Hunter, principal at Punter Southall, warned against an “alarmist” response to gloomy economic forecasts.
“You can’t plan for saying, ‘Well, there might be a recession, and therefore we might have a 30 per cent fall in our funding level,’” he said.
Hunter said schemes have recently explored the use of contingent assets to mitigate risk. These can protect schemes in the event of a sponsor struggling through economic difficulty.
“If you’ve got a good contingent asset over a strong and robust asset, like a property for example, the value of that should stand up fairly well, even in a distressed scenario,” he added.
Cardano and Lincoln’s research highlights differences in sector vulnerability to the economy, with consumer goods and services performing particularly poorly. Hunter was cautious over broad sector analysis.
“To say that some sectors are more exposed than others is a little bit simplistic. It very much depends on what it is that would drive an economic downturn,” he said.
Consider alternative valuation methodologies
Different valuation models can throw up wildly different results. Cardano and Lincoln have argued that current valuation methods can underestimate true deficits by nearly 90 per cent.
LCP research placed total FTSE 100 pensions liabilities in June 2017 at £625bn. According to LCP, the use of their treasury model to set schemes’ discount rate would actually lower liabilities by £25bn. The collective deficit would become a surplus of almost £20bn, lifting it to its position in 2007.
What can pension schemes learn from insurers?
Analysis: Prudent liability management features among the priorities of pension funds and insurers alike. Experts have previously called upon investors to think more like insurers, but differences in objectives, regulatory requirements and scale mean total strategic convergence between schemes and insurers is unlikely.
Sankar Mahalingham, head of DB growth at consultancy Xafinity, said strategies involving the "least risk", without the need for more financial support from the sponsor, would result in underestimated deficits.
"My counterpoint to that is that the valuation method can make quite a big difference to what deficit is being shown by the scheme, because you're very rarely asked to make those deficits up in the short term with one big one-off payment," he said.
"If you allow for increased investment return over time as well, then effectively your deficit will be lower, because you're expecting then the investment strategy to make up some of the shortfall," he added.
This article has been updated since original publication.
