Reshaping DB: Why we can't afford to repeat the mistakes of the past

The average funding level was 84.2 per cent and the average recovery plan was 8.8 years – which means that today, almost 10 years on, most pension funds should be fully funded. 

Unfortunately, the future proved otherwise.

At the end of June 2015 the Pension Protection Fund deficit stood at £223bn and the average funding level remains at 84.8 per cent, despite an estimated £250bn of sponsor contributions being paid in over the past decade. 

What went wrong?

Over this period, which includes the global financial crisis, equities have delivered a total return of 70 per cent.

Unless pension funds approach the problem differently in the next 10 years we will still have a DB funding problem in 2025

This is in line with an expected return of cash+3 per cent equity risk premium. However, the collapse in long-term yields, and specifically real yields, has had a major impact. 

The 30-year index-linked gilts fell from 1 per cent in December 2005 to -0.7 per cent, causing liabilities to soar by more than 106 per cent. 

Today the average recovery period is eight years. Unless pension funds approach the problem differently in the next 10 years we will still have a DB funding problem in 2025.

The past decade has seen pension funds employ new tools and techniques to manage and control their assets, liabilities and risk.

This has included diversification away from equities, liability-driven investing, liability management and buy-ins.

Some have adopted a new mindset of risk-based allocation, as opposed to the traditional asset allocation approach, and by applying these new tools and techniques they are now fully funded and on track to pay all their members.

Banking on higher yields

On the other hand, many pension funds are banking on higher yields to bail them out over the next 10 years.

But yields would have to rise a lot more over the forward curve to remove the deficit, and many already bake this into their recovery plan by using a model that assumes mean reversion in bond yields to much higher rates. 

The challenge is that many pension funds are running investment risk that could result in a material impact on their sponsor’s covenant

The challenge is that many pension funds are running investment risk that could result in a material impact on their sponsor’s covenant.

This is further compounded by the fact that – given current funding levels of 82.5 per cent – on a technical provisions basis pension funds need to earn 4.25 per cent to just stand still.

They would need to return between 5.25 per cent and 6.25 per cent every year to reach full funding in eight years – and this has a bit of mean reversion in rates built in.

Unless yields rise and equities continue performing, pension funds must adopt a new approach if they are to stand a chance of reaching full funding in the next decade. 

A broader vision

Last year, the regulator published a new funding code recommending a holistic approach between covenant, funding and investment. 

Given current funding levels of 82.5 per cent – on a technical provisions basis pension funds need to earn 4.25 per cent to just stand still

It also emphasises that trustees as well as employers understand the complex relationship between covenant, funding and investment, with risks understood and managed appropriately. 

The pensions industry cannot solve its problems with the same thinking it used when it created them.

We need to bring all stakeholders together to establish unique goals, objectives, constraints and responsibilities.

We must envisage a new era of synthesis within the industry, which demands a broader vision and shared capabilities if we are to overcome this pensions challenge.

It is time to do things differently.

Robert Gardner is co-CEO at Redington