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Crisis or opportunity for DB pension schemes?

Crisis or opportunity for DB pension schemes?
(Bloomberg/AFP/Getty Images)

The events of last week will have concerned many stakeholders of defined benefit pension schemes.

The sharp spike in interest rates following the chancellor's "mini" Budget pushed many schemes into the eye of the storm, which could have been disastrous for some had the Bank of England not stepped in.

Concerns will relate not only to the security of member benefits but also to DB schemes’ use of and risks embedded in liability-driven investment strategies – paradoxically, the very structures put in place by many schemes to improve risk management.

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However, it would be wrong to assume that all schemes will have been badly impacted by recent events. Indeed, many will have seen an improvement in their funding positions because of rising gilt yields, enabling them to reduce risks and create greater certainty for members.

So, what is the rationale behind LDI, what went wrong and what, if anything, needs to change?

To answer these questions, it is useful to look back at the history of DB schemes and what drove the use of LDI.

The rationale behind LDI

DB schemes are designed to pay out benefits to members based on a formula relating to length of service and salary. It is possible therefore to estimate the projected outgoings many years into the future. With these estimates, schemes could hold government bonds such that the income and maturity proceeds matched the projected benefit outflows.

As long as the estimated projections are reasonably accurate, this is a relatively low-risk way of making good on the member benefit promise.

However, in the early days when DB schemes were set up, they were operated in a manner akin to with-profit funds. 

The core benefit was often a fixed pension without any inflation linkage with the contributions and investment strategy (typically with a heavy equity bias) designed to create an asset pool that would cover the benefits plus discretionary pension increases.

However, if the asset returns fell short, the discretionary benefit increases would not be given, so members effectively bore the investment risk with the employer only covering the cost if the assets fell short of that needed for the core benefits.

Over time, various forms of pension inflation linkage were forced on DB schemes. This resulted in the investment risk being moved from members to the employer (and is a key reason behind the demise of DB schemes).

Further, legislative changes also encouraged most DB schemes to assess how well funded they were by comparing the market value of the assets with the capitalised value of the future benefit payments using a discount rate linked to gilt yields (this ratio it typically referred to as the funding level).