Four investment questions trustees and sponsors of defined benefit schemes should ask themselves 

After a disruptive few years, trustees and sponsors of defined benefit schemes may gain from asking if their investment arrangements and governance are fit for a new environment.

The first years of this decade have proved particularly disruptive, as pandemic, war and high inflation pave the way for turbulence to come. As 2023 progresses, the world faces a set of risks that feel both eerily familiar and wholly new. Those like high inflation and geopolitical conflict appeared to have been solved over the past few decades. They are now being amplified by newer risks, like unsustainable levels of debt and environmental crisis.

At Mercer, we do not expect a deep global recession in 2023 and our central view is that we think annual inflation rates will fall, while remaining firmly above the 2% targeted by developed world central banks. However, with the geopolitical and financial backdrop of the unwinding of loose monetary policy, there remains significant scope for tail risk and market volatility on both the upside and downside.

Among UK defined benefit pension fund trustees, there’s a prevailing sense of uncertainty. To add to the panoply of risks, 2022’s huge sell-off in gilts following the year’s “mini-Budget” undermined long-held assumptions about the safety of gilts. As trustees reassess their strategic frameworks for the years ahead, there are four key things we believe you should think about in 2023.

1. What are the lessons from past recessions?

We believe that the UK will enter a mild recession in 2023. High inflation, rising interest rates, supply chain bottlenecks and a level of industrial action not seen in decades are undermining economic growth, rhyming with the recessions in the 1970s and 1980s. While financial markets were weak in 2022, as they anticipated recession, they may recover this year in anticipation of the economic rebound to come. That said, many risks remain, not least geopolitical risks. So, what’s worked well for investors in past recessions? The lesson is that different asset classes have performed well prior to and during the initial stages of a recession, ranging across hedge funds, commodities, low volatility equities, emerging markets equities, gilts and credit. What’s more, a range of assets have done well coming out of recessions, including private markets, small cap equities and value equities. "Historically, some of the best vintages in private markets have been during recessions, so the lesson is to maintain commitments, subject to remaining within illiquidity constraints." There are understandable fears about committing capital to illiquid investments while portfolio values are declining, but making steady commitments to diversify vintages is part of the strategic discipline of portfolio management for private assets.

2. What are Biodiversity’s growing risks and opportunities?

2023 looks set to be a critical year for biodiversity, after December 2022’s UN COP 15 biodiversity summit held in Montreal highlighted the urgency of halting a collapse in ecosystems. The focus on biodiversity may cause the value of natural assets related to forestry, farmland and the oceans to be re-evaluated, especially if moves to introduce a market for biodiversity credits prove successful. Notably, The Taskforce on Nature-related Financial Disclosures plans to introduce a risk management framework for organisations to disclose nature-related risks later in the year. "The significance of the Nature Crisis is arguably greater than the related Climate Crisis, though widely under-appreciated, providing an opportunity for investors to consider investments in nature-related real assets, as well as stock market-listed companies focused on conserving nature." There’s also a need for investors to engage with companies to make sure they are managing their nature-related risks responsibly.

3. Has your strategy and journey changed?

In the wake of the UK gilt sell-off triggered by September 2022’s “mini-budget”, LDI strategies may require a review of their governance arrangements.  Following the gilt market shock, The Pensions Regulator has issued guidance to trustees to review liquidity buffers and ensure LDI funds have a yield buffer to withstand a rise in long-term interest rates of 300 to 400 basis points. In our view, trustees should also review collateral waterfalls, indicating where – and how quickly - they would find money to make up any collateral shortfalls if needed. More generally, trustees should think holistically about their overall journey plans. Does reducing risk in your LDI portfolio mean you have to take more risk in another area? Following 2022’s significant rises in fixed income yields, how has your balance sheet changed and are you closer to a buyout? If so, should you adjust your investment strategy accordingly?  Does the current liquidity profile remain appropriate given collateral/buy-out considerations? And how does any revised journey plan fit with The Pension Regulator’s new draft funding code?

4. Is your governance fit for a crisis?

Finally, a lesson from the last few years is that trustees must be organised to act swiftly in case unthinkable events happen. Who would have predicted the COVID-19 pandemic, Russian invasion of Ukraine or the degree of gilt market volatility? What would you do if there was another “black swan” event like a new military conflict, a more dangerous COVID-19 outbreak or a fresh inflation spike? Equally, there could be a “blue bird” event – or outbreak of good news – such as a peaceful resolution to the Ukraine crisis. Trustees need to prepare their governance for a less predictable world, by making it more nimble and efficient. That comes from greater operational efficiency, which can be achieved in a number of ways. There remains a need to prepare portfolios through stress testing.

The landscape is very different from what it was even 12 months ago. Change has been rapid and unpredictable, leaving some defined benefit schemes in a significantly different situation. If you would like an independent assessment of your current investment arrangements and governance structure, we would be happy to help.

Important notices:

This does not constitute an offer or a solicitation of an offer to buy or sell securities, commodities and/or any other financial instruments or products or constitute a solicitation on behalf of any of the investment managers, their affiliates, products or strategies that Mercer may evaluate or recommend.

For the avoidance of doubt, this paper is not formal investment advice to allow any party to transact. Additional advice will be required in advance of entering into any contract. The findings and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes or capital markets discussed. Past performance does not guarantee future results. Mercer’s ratings do not constitute individualised investment advice.

About the author(s)
Nathan Baker
James Lewis
James Brundrett
Matt Scott
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