Riskier Pension Investments Have UK Watchdog Group on Alert

The search for yield amid low interest rates and a low return environment has led some UK pension plans to seek out riskier and more illiquid investments to earn their targeted return.

The Pensions Regulator (TPR), the UK’s watchdog for work-based pension plans, has published a report on leverage and liquidity to better understand the potential risks for defined benefit pensions, and to help inform the Bank of England’s Financial Stability Report.

In its 2018 Financial Stability Report, the Bank of England’s Financial Policy Committee (FPC) presented its assessment of risks from leverage in the non-bank financial system. It said that the use of leverage by non-bank financial institutions could support financial market functioning. It also said, however, that “it can also expose non-banks to greater losses and sudden demands for liquidity, which can give rise to financial stability risks.”

The FPC said that the Bank of England would work with TPR to enhance the monitoring of possible systemic risks that might arise.

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The regulator’s preliminary analysis shows many plans are well-diversified and aware of the risks that can come from leverage and liquidity. But it also shows some plans are pursuing riskier investment strategies in search of extra returns, which TPR said could be damaging in the event of adverse economic shocks.

“We believe that some of these strategies introduce additional risks which may not be adequately rewarded, and which may amplify market impacts in the event of adverse shocks,” Fred Berry, TPR’s head of investment consultancy, said in a release. “We also believe that some of the longer term illiquid investments may not adequately allow for the risks that climate change may introduce.”

One of the key finding of the report was that the pension plans surveyed held £244 billion within pooled investment holdings, 33% of which was in equities, and 22% of which was in credit. Bonds accounted for 60% of all plan assets, half of which were inflation-linked government bonds.

Interest rate swaps were held by 62% of plans, and accounted for 43% of all leveraged investments, and swaps accounted for 66% of derivative contracts outstanding. The report also found that 45% of all plans had increased their use of leverage during the last five years, and 23% had increased their use of leverage in the last 12 months.

The survey covered 137 of the UK’s largest 400 defined benefit pension plans, which had combined assets worth nearly £700 billion.

“We believe that some of the survey data shows a potential for concentrations of risk within individual plans,” Berry said. “We will analyze the survey responses in more detail and consider how we can use the findings to help trustees to improve their risk management practices further.”

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Tags: Bank of England, Fred Berry, low interest rates, low return environment, The Pensions Regulator, TPR, Yield

The Texas Employees Retirement System (ERS) faces a “strong possibility” of becoming completely insolvent in 40 years if it does not work to correct issues facing the fund, according to an actuarial valuation report commissioned with reviewing the system’s health.

“The current financial outlook for ERS is very poor. It is important to understand that the currently scheduled contributions are not expected to accumulate sufficient assets in order to pay all of the currently scheduled benefits when due. Based on current expectations and assumptions, ERS is projected to remain solvent until the year 2075,” the report, prepared by GRS Retirement Consulting, stated.

“However, based on volatility in the financial markets, there is a strong possibility that ERS will become insolvent in a 30- to 40-year timeframe, which is within the current generation of members. Contributions must materially increase in the next legislative session to secure the benefits for current members.”

The report studied the volatile effects of the market and concluded that given current volatility projections, there is a 40% chance that the pension can become insolvent by 2060, and a 25% chance of becoming insolvent by 2050.

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“Given this outlook, we recommend the legislature increase the contribution rates to ERS,” the report said. “Each successive biennium that ERS receives the currently scheduled contribution rates, the unfunded actuarial accrued liability is projected to increase by approximately $1.0 billion.” The state contributes 9.5% of gross payroll, agencies contribute 0.5%, and system members contribute 9.5% of their salaries towards the pension.

The legislature was considering appropriating $150 million to ERS in a previous session, but the funds were used for other priorities, such as public education spending and property tax relief.

“Addressing the pension liabilities now will cost the state much less than if it waits to do it later,” ERS spokeswoman Mary Jane Wardlow said, according to the Statesman. She attributed “past market volatility and insufficient contributions to the fund” for the pension’s declining health. The pension’s assets are expected to return 7.5% per year.

If the pension goes bust, the ERS’ funding will have to revert to a “pay-as-you-go” status, which would mandate the legislative appropriation for ERS to immediately quadruple, the report warns.

The fund earlier this year took initiative to configure its strategic asset allocation, altering the parameters under which many of its private markets allocations must adhere to.