Things are seldom what they seem

The sponsors of the UK’s 5,500 defined benefit pension schemes are more exposed to a stock market crash than in any year since 2008.

That’s one of the – perhaps surprising – implications of new figures released by the PPF and Pensions Regulator.

The Purple Book, produced every year since 2006 by the Pensions Regulator and PPF, tracks a number of key statistics on the UK’s defined benefit pension schemes.

The story on the face of the figures in the 2017 Purple Book is the one you might expect: progressive reductions in the proportion of pension scheme assets invested in equities. The Purple Book shows that equity allocations have fallen year-on-year, from over 60% of assets in 2006 to under 30% of assets in 2017. At the same time, holdings in bonds have doubled, as a proportion of assets, from 28% to 56%.

These percentages tell one story – the one we expect to hear – one of progressive de-risking. But the percentages alone tell only part of the overall narrative. 

The pound-note figures tell some different stories.

Back in 2006, the Purple Book figures suggested that UK pension schemes held about ￡470 billion in equities. That holding dipped to around ￡360 billion in the depths of the credit crunch in 2009, but then rose strongly – topping ￡425 billion in 2015 and reaching nearly ￡450 billion in 2017.

At the same time, pension scheme trustees have increasingly sought out other sources of return. In 2017, pension schemes held around ￡100 billion in hedge funds. Back in 2006, the Purple Book did not show any investments in hedge funds[i]. 

In total, UK pension schemes now hold some ￡550 billion across equities and hedge funds: ￡40 billion more, it seems, than in any previous version of the Purple Book. The higher holdings in these return-seeking assets means that the deficits in the UK pension schemes, and the contributions potentially payable by the sponsors of those schemes, are more susceptible to a fall in stock markets than has been the case in the past. A 20% fall in the values of growth assets could increase pension scheme deficits – and the contributions required from employers – by over ￡100 billion.

Looked at in pound-note terms, then, pension schemes hold more than ever in growth assets, and are more exposed than ever to the risk of falls in the values of those assets. So have our pension schemes de-risked at all?

So what is going on?

One of the other key stories from the Purple Book helps to tie these two, seemingly conflicting, messages together: the total amount of money held in the UK’s defined benefit pension schemes has doubled from around ￡770 billion in 2006 to over ￡1,540 billion in 2017.

Return-seeking assets have increased over the period, but now represent a smaller part of a very much greater whole.

The growth in assets is startling in itself, but it also highlights two other key stories to which we need to pay heed.

Bonds galore?

When we look at it in pound note terms, the amount held in bonds has not just doubled: it has nearly quadrupled. UK pension schemes held just under ￡220 billion in bonds in 2006; in 2017 that figure is around ￡860 billion. Back in 2006, pension schemes held less than ￡75 billion in index-linked bonds – that figure has increased fivefold to ￡380 billion. The Purple Book asset breakdown doesn’t show it, but it’s likely that many of these “bonds” are actually LDI holdings intended to reduce interest rate and inflation risks.

These are big numbers, but what makes them even more startling is when you realise there only are ￡630 billion of index-linked gilts in existence[ii]. 

UK defined benefit pension schemes’ holdings in index-linked bonds are equivalent to around 60% of the UK Government’s entire issuance of index-linked gilts. Much of what’s left is in the hands of banks and insurance companies, who have their own reasons for holding such gilts. If pension schemes want to buy more, where – and at what price – will they find them?

Are we nearly there yet?

My final story, linked to the last, is even more alarming.

Despite that doubling of pension scheme assets, the PPF estimates that the aggregate buy-out deficit across UK pension schemes has increased from ￡500 billion to ￡740 billion. Overall buy-out liabilities have hit a new high at nearly ￡2,300 billion.

In spite of all the contributions paid, the asset returns achieved, the gilts bought, the UK’s pension schemes (as a whole) are now further from being able to buy out their benefits than they were in 2006. If buy-out is our goal then, over the past decade, it seems we have gone backward not forward.

Many schemes are, of course, in a much stronger position. There are good opportunities to settle benefits for those schemes able to take advantage of them. Many have already taken those opportunities – the PPF estimates around ￡80bn of bulk annuities (buy-in or buy-out) have been bought since 2006.

But even in its best year, the buy-out market has only taken on ￡13 billion of pension liabilities. At that rate, it will take many decades for the buy-out market to dent the ￡2,300 billion of liabilities in the UK defined benefit pension market.

As you look at that ￡2,300 billion mountain of liabilities, as you look at the experience of the past decade, as you look at the growth of deficits, as you look at the capacity of the buy-out market, as you look at the short supply even of suitable gilts, you do have to ask if many of us might just be chasing rainbows.

Where do we go from here?

The reality, of course, is that the schemes are in a wide range of different positions. For some, buy-out is not just an aspiration, but could become reality this year. Others are not so lucky, but still find themselves in surplus and wondering how to protect that position, and what their next step should be. Many, though, find themselves behind their chosen path, with deficits staying stubbornly high. 

As the credit cycle matures, and easing turns to tightening, schemes need to reassess where they stand and the risks they face. They need to make sure their goals are realistic and achievable – too ambitious a goal may be doomed to fail. Employers, who ultimately bear the cost and the risk, should be closely involved in those discussions.

We may think we’ve de-risked. In some respects we have, but we’re taking more risk than ever on return-seeking assets: it only feels as if that risk has reduced because the pie is so much bigger. 

For UK PLC, the ￡ figures have far more real-world relevance, as those are what drive the debates on cold, hard cash. Trustees need to look at what an increase in cash contributions would mean for the employer. They need to make sure they aren’t betting money the employer can’t stand to lose. We need to understand the shape and structure of risk and take a joined up perspective across assets, liabilities and covenants, not just in percentage “funding level” terms, but in ￡ terms as well.

Perhaps, if we can do all that, we will stand a better chance of providing the ten and a half million members of the schemes with the benefits they expect to receive.

[i] Asset values and descriptions reflect those in the 2017 Purple Book, which depends in turn on data submitted by pension schemes through their annual scheme returns. Some of the apparent changes in asset allocation reflect changes in data collection – for instance, the PPF did not request separate data on hedge funds until the 2009 Purple Book reporting cycle.

[ii] Source: DMO quarterly gilt report Q3 2017