What is lurking in your blind spot when you make DB pension strategy decisions?
Pensions & benefits Investment DB pensions Risk Strategic journey planning
Making decisions involves using the information available to you and weighing up the relevant factors. The question we’re posing here is whether considering systems could lead you to a different decision, which ultimately boils down to whether your DB pension schemes’ outcomes are affected by systems (spoiler: they are), making them a relevant factor.
In this article, I’ll discuss how:
- Your DB pension scheme is part of, and reliant on, a number of key systems – you are exposed to this whether you like it or not.
- Those systems are being challenged and are changing in new and faster ways – some of which could cause you serious problems in the near future, or even already.
- Considering this within your decision-making is vital to an effective and joined up pension strategy.
I’ll also cover some of the types of actions a systems mindset might lead you to consider.
Considering systems
If you’re reading this, there’s a good chance that you make or assist with strategic decisions about at least one DB pension scheme on a reasonably regular basis. Some of these decisions probably do consider the wider systems to which the scheme is exposed, but equally there are probably some decisions that don’t.
So, what do we actually mean by considering systems?
My dad always lets the bus pull out in front of him. His view is that a public transport system that runs on time will be more used as it is seen as more reliable. Therefore, while his journey might be 30 seconds slower today, the confidence in public transport will lead more people to use it, and there will generally be fewer cars on the road and he’ll have generally faster journeys. You might not agree with his position (we call this siding with my mum), but it’s a good example of thinking about the wider system rather than just your role in it. If you drive your car on the roads, you and the bus are part of the same system, even if you’re never going to get on the bus yourself.
Applying this same logic to DB pension schemes, we could consider the gilts crisis, and in particular how investing in LDI has changed as a result. As an individual scheme, it benefits you to run more leverage in your LDI portfolio because it frees up more of your assets for other things, and as a result LDI funds ran with what we might now consider a lot of leverage. As part of its Financial Stability and Stress Test results in late 2018, the Bank of England commented on the level of leverage being used by pension funds and the sudden liquidity demands it could create.
This scenario the Bank of England were warning of needed yield movements larger than any we’d really seen before, and so most schemes considered it too unlikely a scenario to worry about and continued to focus on their own objectives. Schemes made sensible scheme-level decisions, but assumed the system would continue to behave as it had done before. No one thought too hard about what would actually happen in this extreme outlier case.
If we’d seen ahead to what we know today, and what we were going to experience in the pensions industry in late 2022, we might have acted differently. LDI now runs with lower leverage, and specific collateral requirements, both of which reduce its efficiency at a scheme level, but better protect the pensions system itself.
This example shows how, if we’re not careful, decisions are made assuming that systems stay static over time, or that our expectations about their evolution are correct. Decisions often assume systems will always continue to function as they have done and as they are intended to, which is not the case. You will not have perfect foresight of what can or will change, and forecasting can only tell you so much, but using this as an excuse to do nothing will leave you vulnerable to changes or failures – the systems changes and systems failures that directly influence the pensions outcomes of your members.
Systems-level factors
When we worry about what might go wrong with systems, we often refer to these factors as systemic risks, but we shouldn’t forget the potential upsides when we think about how systems change can materialise. For example, you’ve probably heard of megatrends, as it has become a bit of a buzzword in recent times. Megatrends are transformative themes with profound impacts on society, the economy, the environment – they have impacts on multiple systems. They represent significant shifts that will shape how the world works in future, and therefore they are a driving source of systemic risks, but they are also a major source of opportunities. We refer to these risks and opportunities collectively as systems-level factors.
It’s easy to see these factors as future issues, but a lot of these changes are already happening and problems could materialise at any time. You could, rightly, argue that there have always been challenges to systems, and that systems have always been changing, but the sheer speed of some of these changes now (and the ways they interact) is causing much larger impacts. That matters because your scheme is exposed.
Crucially, these impacts will play out within your members’ lifetimes. I think it’s reasonable to argue that trustees should be focused on ensuring members get all the benefits they’ve been promised – even if they are paid by someone else, such as an insurer. A trustee’s job is not just about seeing a scheme through to a buy-out.
This is why thinking about the bigger picture matters, especially when you’re making big strategic decisions that will have consequences for years down the line.
The systems in the videos below, and others that we could cover, are a part of that bigger picture that underpins the outcomes your scheme aims to deliver. Making decisions without recognition of that is not properly accounting for all material relevant factors.
Making decisions with systems in mind: two examples for a DB scheme
Imagine you have a surplus sharing arrangement between trustees and sponsor, for example as part of improving DB member benefits. Your surplus release threshold is likely based on a reasonably prudent basis that considers investment risk, longevity risk, sponsor covenant, and your ability to change endgame in the future. This is a good start and a common way to think about such an arrangement.
But does your basis sufficiently allow for how the systems that underpin these factors are changing? Is it making assumptions about risk and return that are anchored in past experience? If a major systemic risk event happens, it’s unlikely that the impacts will be confined to one of these factors, and you could find yourself with a nightmare triple whammy:
- Your assets have fallen in value,
- Your ultimate funding target or buy-out pricing has increased,
- The sponsor is no longer able to plug the gap.
It’s not enough to worry about this after it becomes a problem. Your assumptions, and therefore your decision, should sufficiently consider all the material factors.
We can also take a step back and think about endgame more generally for a DB scheme. You will have a good idea of the risks you’re choosing to take on when you decide on a particular endgame. However, your view of the relative importance of the risks might change if you think more deeply about the different exposures to systems change. For example:
- Your sponsor might be particularly well-placed to benefit from AI or be a provider of climate solutions, but could simultaneously be at particular risk from physical climate risks or particularly sensitive to the health of the wider economy.
- An insurer will be exposed to the same system changes, and although the solvency regime for the insurance industry is widely considered to be strong, it’s not wholly immune to these risks.
Having weighed up the security offered by the different endgames, you may still decide that (for example) insurance is the best option, but you may think harder before cutting your sponsor link.
The key is that this change of mindset won’t necessarily change your decision, but taking into account, and documenting, this wider spectrum of risks and opportunities is a better decision-making process. If, in the future, the endgame you’ve chosen encounters a problem, showing that you considered that possibility, weighed it up against the other options, and made a robust decision protects you as the decision maker, even if hindsight suggests it wasn’t the best choice.
Adopting a 'systems thinking' approach in practice
This decision-making approach is part of a wider 'systems thinking' mindset. To help you make decisions in this way, you could:
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This includes their interdependencies, your dependencies on them, and identifying signals that can help you track how the key issues are changing over time. As with any decision, ensuring you have the right expertise available is an important starting point.
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Adding a governance mechanism that reminds you to consider systemic risks and megatrends each time you make a major decision can ensure that no decision slips through the cracks, and that the thinking behind decisions are better documented.
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Linking decisions together across your scheme is important. You should avoid siloes of decision making and ensure everyone involved in the scheme is working towards the same goals. That means not leaving it to a single committee to think about systems.
Taking actions to address the risks
Once you have this systems mindset, there are some potential actions that you may take. For example, contingency planning: having a plan for the extreme scenarios, not just hoping that the past will be a good guide for the future. This allows you to be on the front foot if such an event does occur.
Scenario analysis is another example, but this means thinking a little bigger than modelling a 10% asset shock! I’m sure many readers will have considered the impact of geopolitics and tariffs in recent times, and the impacts this has on economies and therefore assets, but have you considered whether you can still pay members if the tensions escalate and international trade collapses? Do you know?
Ignoring my own advice and thinking of the past for a second, we could consider the banking system crises the UK has experienced in recent times. If we have another Northern Rock scenario, potentially that extends to multiple banks, are you confident that you could continue to pay all of your members in a timely manner?
This kind of wargaming for scenarios and contingency plans can open up your strategic blind spots and show you decision angles that you may not have realised are important. I would encourage you to discuss these questions with your trustee boards and consider whether you’re happy with the answers or whether they will keep you up at night. If it’s at all the latter, it’s not too late to get started.
We have been developing an action framework that can help you work through these questions and decide on actions that are useful and proportionate for your scheme.
My final word
This is my one ask of you as a reader looking for a takeaway: apply systems thinking to your strategic decisions.
You won’t make a different decision every single time, but where you do, it will be a decision that is more resilient because it better accounts for your scheme's dependencies on systems.
Making decisions involves using the information available to you and weighing up the relevant factors. The systems in the world around us, and the ways they are changing, are most definitely relevant factors.
Learn more about systems, their interconnectedness and their impact on pension schemes
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Cat Drummond - Insurance
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Amlan Roy - Geopolitics, trade and investments
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Anais Caldwell-Jones - Global debt and financing
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Andy Bradley - Energy system
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Catrin Treharne - UK public health/NHS
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Claire Jones - Climate change
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Gavin Smith - Pension risk transfer
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Jon Forsyth - UK policy and regulation
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Lee Ann Steadman - Global medicine and pandemics
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Shyam Gharial - Agriculture/food
