Recent research has demonstrated the extent to which small pension schemes underperform larger schemes. There are a number of reasons for this. Small schemes are usually unable, for instance, to gain ready access to the same investment opportunities enjoyed by their larger peers.
But really the difference between large and small schemes is the latter’s lack of time. Without the resources to build in-house teams and to meet regularly, we believe small schemes should focus their (limited) time on the things that make the biggest difference. Four stand out.
1 – Governance
Governance is about the time required to understand and manage something, or about the money required for someone to do that on your behalf. For small schemes that are likely to be time and money constrained, this poses a big problem.
How do you meet the objective whilst keeping within governance (time/cost) ‘budget’?
For us, trustees should only implement something that (a) makes a material difference and (b) doesn’t have a high governance cost. For example, a 5% allocation to a complex active manager is an immaterial allocation and likely to be hard to govern, so probably not worth doing.
On the other hand implementing LDI makes a material difference to the scheme, and so the challenge is how to do so with as little governance as possible (more on this below).
As a collective trustee boards in the UK have immense experience. Governance and decision making can be made easier by tapping into this – whether it is through a professional trustee or through trustee networks. There is no point reinventing the wheel when you don’t have time to do so.
2 – Funding
The funding and valuation process can be a lengthy process for most trustees. For schemes with limited time this needs to be limited – it should not be a process that takes over a year. The reality of the pension scheme maths is that investment has to do the heavy lifting; spending time negotiating what is potentially not a hugely significant amount in the overall equation seems like a waste of time. Sure, you should always make sure you can get the money you are owed from the sponsor but the importance of spending time on this should be weighed up against how important it is in achieving the overall goal of paying benefits.
3 – Investment
Investment is the main tool for all pension schemes to grow their assets enough to pay benefits. As such this should be where most trustees spend their time. Saying that, I am a strong believer in the 90-10 rule – i.e. small schemes should aim to do a handful of things that can achieve 90% of the
benefits of a complex strategy but with 10% of the cost (monetary or governance). These things have to include a strategy that:
- Has LDI (or the ability to do so if the trustees want to take a view on interest rates)
- Targets the right level of return – this is the heavy lifting
- Protects in some way from market falls – schemes do not have the time to recover from shocks like they used to
4 – Longevity
Aside from poor investment returns, longevity is the risk most likely to knock small schemes off track.
This is fundamentally because small schemes have fewer members and therefore do not have “longevity diversity”. Put another way there are not enough members of enough variation to make “average” longevity useful. Practically this means that as a small scheme matures it becomes increasingly exposed to whether specific members (those with large benefits for example) live or die. There will be a point where this is the dominant risk.
Protecting against this is difficult. Some schemes may be using prudent mortality assumptions but this is still not a guarantee of protection. Alternatively an insurance policy may be an option but it is likely the cost of this will also reflect this diversity risk.
In my view the only likely way to manage this risk is through longevity risk sharing with other schemes.
Mark Davies, Managing Director at River and Mercantile Derivatives
For more information, or to register for the Small Scheme Summit 2017 click here.