Introduction

2020 was a year that halted the world in its tracks, and one that will no doubt end up in the textbooks of future students. Many of us entered the metaphorical trenches of our home workplace and went into defence mode. 2021 was arguably a year of false dawns and, for pension schemes, trustees continued to see meeting agendas jam-packed in a bid to achieve the right balance of managing risk , taking opportunities, and completing compliance tasks.

2022 will undoubtedly present its own challenges and opportunities for DB scheme investments. In this short note, I’ve pulled together the three main meeting agenda “must haves” for trustees this year, to ensure they continue to achieve that balance of risk, opportunity and compliance!

Agenda Item 1: Market headwinds and tailwinds

There will undoubtedly be market head and tail winds over the coming year that will present risks to manage and opportunities to take advantage of. It won’t come as a surprise that the key market factors that I think need careful consideration are inflation and interest rates.

We’ve seen the overall level of inflation rise in 2021. The shape of the curve has changed too, with shorterdated inflation rising considerably more than its medium- and long-dated equivalents. While there is still a threat of ongoing supply scarcity and labour shortages, and the full effects of the disruption caused by the pandemic remains with us, inflation continues to be something that should not be ignored.

And when inflation is something to be carefully considered, so too must interest rates and central banks’ response to the inflation coming through in markets. Indeed, we’ve already seen interest rates rise in 2021, with indications that future rises in rates are to be expected in 2022. The question that I would therefore pose trustees is

"Do you fully understand how the different potential outcomes for inflation and interest rates could impact your assets and ultimately your funding position?"

What can trustees do to be proactive and position themselves to take advantage of the opportunities created by, and manage the risks associated with, rising rates and/or inflation? Here are some key talking points to get you started:

• Review hedging arrangements – has there been unintentional drift in your hedge ratios, or is there an opportunity to lock in a gain?
• Stress test collateral sufficiency – does the headroom remain sufficient? Is there a plan in place to source additional collateral if required?
• Reassess liquidity / cashflow policies – how robust are your policies under stressed conditions? What is plan B?
• Consider impact on credit assets – has the cashflow profile of your floating-rate assets been affected? Has there been a deterioration in the credit quality of your corporate bonds?
• Reassess strategic plans – is your long term strategy still appropriate? Are there plans in place for disciplined rebalancing and de-risking to lock in gains?

Agenda Item 2: The role of illiquid assets

At the risk of stating the obvious, one of the considerations when deciding whether to invest in illiquid assets is the lock-up period, that is, the period of time before you get your money back. For most schemes, this hasn’t really been the deciding factor on whether to invest in illiquids as schemes’ investment horizons have typically been longer than the lock-up period.

However, despite the unprecedented couple of years that we’ve had, funding positions for many DB schemes have improved and at the same time, there has been a reduction in recovery plan timeframes amid the continued maturing of DB scheme liabilities.

For many, this combination has brought potential end-game targets closer and into sharper focus. Against this backdrop, the role of illiquid assets in a scheme’s investment strategy will need attention, and preferably in advance of it becoming a potential blocker to future strategic decision-making.

In practice, this means that the potential lock-up period for a particular illiquid opportunity rises up the pecking order of deciding factors. Not because the attractiveness of the illiquid opportunities has diminished, but due to the potential change to the speed at which the future needs of schemes’ investment and funding strategies are changing.

The questions that I would therefore pose trustees are:

• To what extent is the return from an illiquid investment required now and in the future?
• To what extent is the cashflow distribution profile of an illiquid investment aligned to the evolution of your scheme’s needs?
• What appetite is there to take on the risk that the constraints of an illiquid investment may prevent otherwise desirable future risk-management decisions being taken?

What can trustees do to be proactive and position themselves to take advantage of the opportunities that are presented by illiquid investments, while also retaining the desired degree of flexibility in the investment strategy over the medium-to-longer term? We suggest trustees consider the following points:

• Review the liquidity profile of existing assets against long-term plans
• Understand the current run-off profile of existing assets and:
  • if reinvesting in illiquid assets, then include the lock-up period in the selection process (and understand any extension risks)
  • if not reinvesting in illiquid assets, then consider what to do with the run-off proceeds
• Consider the potential future evolution of the investment strategy

Agenda Item 3: Tackling climate change

Climate risk continues to dominate the media headlines and minds of key decision-makers across the world. Pension schemes, with their trillions of pounds of assets, have an important and influential role to play, not least because of the risk climate change poses to scheme members and their pensions. Regulators are continuing to develop and evolve legislation that will compel pension schemes to take certain actions around climate change.

In addition to the specific regulatory demands that must be met, the questions that I would ask trustees are:

• Are your stewardship activities resulting in quality engagement and focused on outcomes?
• What are your plans to get to Net Zero, and how realistic are they?

Net Zero plan

My plea with setting a Net Zero plan is not to let perfection be the enemy of good. Like stewardship, there is regulation requiring pension schemes to start monitoring and reporting climate metrics (e.g.TCFD requirements), and while data availability might not be as good as we would like, it is improving. As the data continues to grow and develop, it can and should be used to help set, and monitor progress against, Net Zero plans.

That said, a lack of good quality data continues to be one commonly used excuse not to consider setting a Net Zero plan. Another is the fear of being measured against the plan and falling short. This is only natural. So, what can you do to work towards a Net Zero plan?

• Consider what Net Zero might look like for you and your scheme-specific circumstances
• Map out the possible routes to getting there, i.e. make a plan, set shorter-term targets and milestones and don’t worry about failure to meet those targets. It’s better to have made steps towards those targets even if you have fallen short.

Stewardship

It feels different this time. Individuals are making changes, even if it’s just charging points for electric cars popping up on the side of houses in your street. People are taking action without compulsion. Institutional investors are being compelled to take some action, but effective governance requires action beyond that imposed by regulation.

Amid this cascade of positive action, are trustees using their full weight as multi-million-pound investors to engage with fund managers and investee companies? What more could be done to drive change?

With the exception of the very largest schemes, most pension schemes will have delegated engagement activities to their investment managers. However, delegation does not mean abdication, and therefore there is a need to up the ante on stewardship, making it more active – regardless of the extent to which delegation to managers has taken place.

What can trustees do to be proactive and ensure that engagement activities are making a difference? Basically, how can trustees ensure engagement activities are of the highest quality, being meaningful and having a real world impact? Well, it starts with:

• Being clear on what your current engagement policies are, why they have been implemented, and the expected outcomes
• Considering what could be done to improve the policies, their application, and the expected outcomes
• Identifying red lines that align with your beliefs and risk assessments
• Understanding how to extend engagement to those assets that don’t have voting rights

And my point is….

….threefold and quite simple really 1) identify the areas that really matter to the success of your scheme, 2) look beyond the regulatory requirements, and 3) plan ahead; with a wee bit of careful planning there are opportunities out there to be captured!

Please get in touch with myself or your usual Hymans Robertson contact, we’d be delighted to chat to you on any of the topics mentioned in this article.