New pension data reveals that smaller schemes are exposed to greater risk
The 2016 Purple Book was published by the Pension Protection Fund (PPF) on 8 December 2016. This contains further evidence that larger defined benefit pension schemes continue to engage in risk management activities more quickly than smaller schemes who continue to be exposed to greater risk.
As a consequence, larger schemes have been better placed to ride out the significant funding volatility in 2016 that has been widely attributed to Brexit, the US presidential election and political uncertainty in Europe.
The 2016 Purple Book gives a comprehensive picture of the risks faced by PPF-eligible defined benefit pension schemes (around 5,800) for the period 1 April 2015 to 31 March 2016. It gives some detail on asset allocations, funding levels and sponsor insolvency probabilities – in many cases there are significant differences in the approaches taken and risk exposure faced by small schemes when compared to larger schemes.
Small schemes’ assets are less closely matched to their liabilities
The average exposure of schemes with more than £100m of assets to liability matching investments has increased to 47% (2015: 45%); schemes with less than £100m of assets showed an average allocation of 35% to 40% which is broadly the same as in 2015. Larger schemes have also removed inflation risk more readily with 39% (2015: 36%) of their matching assets in index-linked investments compared to 19% to 28% for smaller schemes (2015: 18% to 25%).
Since 31 March 2016, inflation-linked liabilities have significantly increased in value leading to a greater deterioration of schemes’ funding positions where their assets are not matched to liability values and, given the above, this has more negatively impacted small schemes than large schemes.
Small schemes hold a greater proportion of their assets in UK equities
Smaller schemes continue to hold a higher proportion of their equity investments in UK equities with 38% to 53% (2015: 40% to 55%) of their equity assets in this class on average compared to 25% for larger schemes (2015: 29%). Generally, a more geographically diversified investment portfolio is likely to lead to lower volatility in asset values. Since 31 March 2016, UK equities have underperformed overseas equities by circa 9% and many analysts expect continued volatility resulting from the UK’s EU exit negotiations. As a result, small schemes’ funding positions are more greatly impacted by this underperformance.
Smallest schemes face the highest sponsor insolvency risk
The very smallest schemes (less than 100 members) tend to have sponsoring employers with the highest insolvency probabilities. The average insolvency probability is around double that of the group containing the largest schemes (by number of members). Therefore, if anything, we should see smaller schemes taking a more conservative approach to managing risk.
What’s holding smaller schemes back?
Historically, smaller schemes have had very limited access to the necessary advice and solutions. Many perceive this still to be the case. While it is true that there are still many consultancy firms who do not have the required skill set to assist these trustees on sophisticated strategies, there are advisers providing such services and solutions to this market.
Indeed, there are some great examples of how the market is evolving for smaller schemes:
- Liability-Driven Investment (LDI) was once the preserve of large schemes; pooled LDI funds have opened this avenue for well advised smaller schemes.
- Integrated administration, valuation and investment software enables trustees of smaller scheme to monitor, manage and remove risk much more effectively.
- Incentive exercises can now be delivered in a far more cost-effective way for smaller schemes.
- Increased sophistication in the preparation of small schemes before approaching the bulk annuity market – this has increased insurers’ appetites for small schemes.
- Independent employer covenant advice tailored to the needs of small schemes.
In short, trustees of smaller schemes shouldn’t accept that solutions are out of their reach. If their current advisers aren’t open to exploring more sophisticated solutions, trustees of smaller schemes shouldn’t be afraid of looking elsewhere. There is a danger that if they do not, the imbalance of risk between larger and smaller scheme will only become more acute.
However, do trustees of small schemes feel equipped to identify and handle more complex solutions? Around 90% of trustees of large schemes manage a formal risk register and have a formal training plan – this compares to circa 60% for small schemes (Source: Capita 2016 Insight report). Therefore, care is needed to ensure that trustees of small schemes are properly prepared to use more complex de-risking tools - this may be achieved through thorough scheme journey planning – agreeing a plan of action for the scheme between the trustees and employer.
Without question, larger schemes will continue to have access to the most complex solutions. However, it is incumbent upon advisors and trustees of smaller schemes to explore, understand and implement solutions that were once the preserve of the largest pension schemes so that they too can benefit from innovation and solutions in the industry.
This article was first published by Pensions World.