FirstGroup’s John Chilman, keynote speaker at CEO’s breakfast briefing in January, explained why pensions directors should expect the unexpected and maintain a holistic perspective on risk.
Toward the end of January at The Ritz in London, UK, CEO hosted a particularly topical breakfast briefing with a keynote speech from John Chilman, group pensions director of FirstGroup, trustee of the one of the biggest pensions funds in the UK - the Railways Pension Scheme - and chairman of its investment committee.
After a great breakfast, Chilman delved into how FirstGroup puts into place an ongoing strategy to manage the risks associated with pension schemes. His wealth of experience provided valuable food for thought, especially in the wake of the financial crisis, which he claimed has shown the importance of understanding pension risk.
The price of uncertainty
Uncertainty has seeped into all aspects of business since the global economy crashed; the pensions industry is no exception. With equity prices falling sharply and other risk types like longevity and inflation remaining intractable, the risks of running an employee pension scheme seem greater than ever.
Finance directors could be forgiven for skirting over their pension exposure at a time when protecting the rest of their balance sheets seems so pressing. But with pension liability as important and as dangerous as any other form of corporate risk, that may be unwise.
For every piece of negative news in the pensions industry, a company's finances are badly affected. A 25% swing the wrong way can wipe out a firm's entire market capitalisation. And that's why delivering an effective de-risking strategy requires so much thought, with three areas of particular significance: measurement, evaluation and management.
The complexity of risk management
For a man so well regarded in the pensions business, John Chilman was surprisingly honest about the complexity of risk management. In many cases, he suggested, there's a danger that model assumptions prove unrealistic, failing to account for volatility, liquidity risk and other black swan events.
"For me, risk is more than just a combination of models," he said. "When you're looking at risk and trying to quantify it, the times where it matters the most are times of financial crisis and disaster. But this is precisely when the models that worked so well in the past suddenly fail. What will happen if the euro crisis affects the UK? What will it do to the global economy? These are factors that need to run throughout the design of your scheme and governance process. I'm not going to throw cold water over everybody's risk model but this is how you need to measure it."
Not all risks types are bad. Without at least some element of risk involved in a given venture, the idea of return would barely figure. That's why trustees invest in equities; they understand the return will be better than a standard safe harbour asset like government gilts. But it still raises questions.
"Can you cope with the short-term volatility to get what you believe will be a long-term game?" Chilman asked. "And how long is that game? When your pension scheme has a three-year valuation, and when you have a corporate sponsor valuing the scheme on an annual basis, these things can trip you up before the expected return from the assets comes through."
Chilman stressed the benefits of what he called a holistic perspective on risk, thinking "not just from within the box of the pension scheme but putting it together with other risks, asking how they play across one another and work together". As an employee of FirstGroup, Chilman understands the possibility of wider corporate risk. Over half of its business and revenue comes from the US, which gives it a natural hedge from dollar-dominated currencies.
Fortunately, the industry has been strong on innovation over the past few years, and a range of de-risking strategies are now available to the market.
"There are a lot of things you can play with," Chilman said. "Some people choose to reduce the generosity of their benefit design, but tweaking pensions has become much more difficult. I think investment is another key area where the more enlightened schemes have already acted."
It's well known in the pensions business that having a mixture of assets in a portfolio can avoid unnecessary risk exposure. But even with a diversified pension, many companies have suffered recently. According to Chilman, there are two ways of overcoming that: acting sooner, and showing more dynamism in asset allocation and decision-making.
"If you or I saw the stock market go down, we'd think there was an opportunity to buy some shares," Chilman said. "Alternatively, if the stock market climbs, that would be a sensible time to sell. Compare that with putting an equal amount each month in stocks, property, fixed income and so forth. It's just not as dynamic. I'm not saying it's necessary to play the markets every day; it's just about taking a larger, macroeconomic view."
Many of the bigger schemes already take this approach to asset management. In Chilman's own case, with the rail scheme, it's meant hundreds of millions of pounds of improvement in asset performance.
Aside from dynamic investment, pension providers need to look at their balance sheet liabilities. And that's where consultants can be useful. The range of de-risking strategies available has grown dramatically as the markets fluctuate.
"With enhanced transfer values we can incentivise people to take their benefits elsewhere. I've done the job of tidying up my own individual pension arrangements, aggregating them particularly when I think there's a risk with leaving them where they are. So I don't have them set upon my past employers any more. I think enhanced value transfers are really very valuable.
"Pension increase exchanges are also important. Instead of your pension going up by RPI every year, you can take an immediately uplifted pension, but without an increase thereafter. And I think as long as you're giving fair value, that should work."
The de-risking market also offers buy-ins and longevity swaps depending on where a company is and how big an issue they find themselves in. A £100m corporate with a £5m pension scheme won't have too many problems, but a £1bn corporate with a £4bn pension scheme clearly will. For Chilman, it's about assessing where one stands as a company and acting as soon as possible.
"My advice would be to think about them early, and then consult and negotiate with your trustees," he said. "Because if you don't, by the time you've made a decision, everybody else will be trying to as well. And that will mean the bandwidth of consultancies is low, capital will be limited in the market and there may be nothing left available."
Understanding underlying liabilities and acting quickly to remove them has become a pressing need for corporates today. The ongoing volatility in financial markets has made running pension schemes more hazardous than ever. As Chilman stressed, ignoring it could be costly.