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14 February 2023

Turbulent weather ahead for DB schemes

This article was first published by Pensions Expert on 3 February 2023

We live in a world right now that seems fraught with risks.

How persistent will inflation be? What level of geopolitical disharmony will persist as we look to Russia, and further east to China? Will climate change itself lead to further failed states and mass-migrations? The list of things about which we can worry is legion.

It was Donald Rumsfeld who spoke about “known knowns, known unknowns, and unknown unknowns”.

I initially laughed at this apparent gobbledygook. But after Russia’s invasion of Ukraine, and then the great gilt market rout of September 2022, we are (or should be) humble about our ability to forecast the future – the unknown unknowns – with insight and accuracy.

The outlook does not look pretty. There are adverse winds in the economy and the geopolitical environment is stormy.

In doing so, horizon scanning, scenario planning and stress testing are all critical elements of building resilience.

Some will have forecast a number of these events. A few may have put them on a list of “possible events to which we should give serious consideration”.

Three years ago, we were – we thought – in a low-risk era. Bond yields were super low and equity prices were sky-high. And then we were hit by Covid-19. With hindsight we can say that December 2019 was a very risky time; all those unknown unknowns.

Current scenario

Fast forward to the present and we find ourselves in a high-inflation and low-growth pocket. It is tough to break out of a wage-price spiral, as those with memories of the 1970s will attest.

It would be bold to suggest that a recession can be avoided, and some would argue that equity markets are overoptimistic about this eventuality.

On top of this, we must layer the longer-term challenges that come from lacklustre world trade – impacting both growth and inflation negatively – and the costs of funding the global energy transition the world so desperately needs.

While equity prices have fallen, they have not reached the point where we can expect them to deliver super-normal returns in the future.

Bond yields are higher – and so their returns will be greater if they are held to maturity – but given the long-term inflation challenges, they are not obviously “cheap” either. Corporate bonds on the other hand seem to offer rather better prospects, with credit spreads pretty wide relative to history.

So, what does this mean for pension funds? Well, defined benefit pension funds make very long-term promises.

We must honour our commitments to our members, and these stretch many decades into the future. These commitments are not of the “we’ll pay if things go well” variety.

Our members’ DB pensions are guaranteed and paid to them and their beneficiaries over decades of retirement. But we have big advantages relative to, say, a bank, in that we also have decades to earn a return on the sums entrusted to us. I could go to my bank and withdraw my savings today if I wanted. For this reason, a bank cannot commit the majority of its assets for the long term but must invest cautiously.

By contrast, a pension fund can invest significant sums for the very long term, for there can be no “run” on a pension fund. But it does need a high degree of confidence that it can pay its members’ promised pensions when they fall due.

Don’t try to forecast the weather

When it comes to a pension fund’s approach to investing, this speaks to the importance of balance, diversification and resilience. The job of those tasked with managing the investments of a pension fund is not to try to forecast the weather.

We do not seek to predict with precision the geopolitical and economic outlook, and then place all our chips in such a way that we will look like heroes if our forecasts come good. There are too many unknown unknowns – even if we could guess the answers to all the known unknowns.

Rather, we must build portfolios that will thrive in the most plausible weather and survive almost all that the elements could throw at us. We must have a balanced and diversified portfolio so that we are resilient.

I say “almost all” because there could, of course, be storms out there that may do irreparable damage to us all.

Last year saw some very turbulent weather. The Universities Superannuation Scheme has been able to navigate it by virtue of the resilience of the scheme, the scenarios we have considered, and our ability to take a very long-term (and global) view.

The outlook does not look pretty. There are adverse winds in the economy and the geopolitical environment is stormy. Bonds are clearly better value than they were not long ago, while equity markets do not look particularly enticing.

But the USS is well funded, well diversified, and we still have the heft of the universities behind us.

We are well set to withstand the storms that may blow, and to capitalise on the clement weather when it sets in. Of course, those unknown unknowns are still out there, and some of them might even bring good news.

Simon Pilcher is Chief Executive of USS Investment Management