UK DB Index– the calm before the storm?
31 Jul 2017 - Estimated reading time: 10 minutes
While recent indicators suggest the majority of schemes are affordable to their sponsors, we believe the status quo is leaving too much to chance. Our analysis shows there’s a better approach.
Despite some recent recovery, the outlook remains uncertain. As the market adapts to a post-Brexit world, schemes should prepare for the possible storms ahead. Now is the time to explore alternative capital efficient strategies which will perform better in a low yield environment and allow you to achieve your long term goal with more certainty.
The DB Universe
As equity markets have rallied post Brexit and Trump, the chart below shows how the aggregate funding deficit for UK DB has shown signs of recovery in recent months, reducing by c.£200bn since September 2016.
However, deficits alone don’t guide schemes to strategies that improve outcomes for pensioners. To give a fuller perspective, we’ve developed our UK DB index, monitoring UK DB across three key components focused on paying the pensions promised:
- Chance of success: what’s the likelihood of your strategy paying members pensions in full?
- Level of risk: how bad could it get if things don’t go to plan?
- Member security: given covenant risk, how secure are members’ pensions?
DB universe's current strategy1
It is clear there’s still significant and unnecessary risk of benefit loss. Schemes are looking through a narrow filter of deficits and discount rates rather than taking a genuinely integrated approach to risk management, and it’s the members who are paying the price.
Choppy waters ahead?
Despite market signals suggesting we could be entering a period of relative calm, the market outlook remains uncertain.
- The signals from economic indicators have been mixed. Business survey data continue to point strongly to sustained momentum in the global economy, however official economic releases have been more subdued.
- Investors have tended to put a favourable gloss on developments. Bonds have been relatively resilient as investors there focus on faltering inflation and disappointing US growth. Equity investors emphasise the revival in global profits and upbeat corporate sentiment. Can they both be right for long?
- The outlook for interest rates is less favourable than it has been in many years. Markets have benefited from “lower for longer” interest rates for many years now: will “low for long” be enough?
- Valuations on risk assets are stretched. Equities and credit markets have done well in recent years even though the economic background has not been particularly supportive. Could devaluation overwhelm improving fundamentals if economic conditions improve? If they don’t, can valuations continue to offset fundamental disappointments?
Inevitably there will be choppy waters ahead - we must proceed with caution and not leave the security of members’ benefits to chance.
Braving the storm
We’ve applied an alternative approach to the UK DB universe to demonstrate how outcomes can be materially improved. We’ve extended the existing cash commitment and reduced the growth asset risk, replacing it with a portfolio of income generating credit.
As you can see below, our fully integrated strategy improves DB schemes’ chance of success from 66% to 85%, importantly with no further strain on the sponsor for extra cash commitments today. Member security is improved by exploring lower risk, longer term asset and contribution strategies that have less propensity for bad outcomes.
This is just one alternative strategy that maintains affordability for sponsors, reduces cash uncertainty and improves the security of UK DB members’ benefits. The optimal investment and contribution strategy to maximise benefit security will of course be scheme and sponsor specific. Our fully integrated 3D approach allows schemes to explore the full range of strategies available to them covering investment, contributions and long-term covenant risk to help them get the best outcome for their specific circumstances.
In the current period of calm and recovery, now is the time to revisit your strategy with a key question in mind - is your scheme in the best possible position to navigate the storm ahead?
1Based on £40bn p.a. cash commitment, typical 8 year recovery plan and 50% growth assets.
2Based on £40bn p.a. cash commitment, recovery plan extended to 2037, 50% growth assets exchanged for a portfolio of income generating credit.