Expert view: A new solution for the pension deficit

Pension deficits have become something of a hot topic for all sectors in recent years.

Charity pension schemes' equity holdings have recovered from the bear market of 2001 to 2002, but some of the main drivers of funding deficits - higher life expectancy and a fall in interest rates (against which pension liabilities are calculated) - remain in place.

In response, many sponsors in the private sector have topped up their pension schemes. However, few charities have the financial means to follow suit.

Charities are also conscious that their primary duty is to fulfil their charitable objectives - and use of funds for any other purpose is a sensitive issue.

At the same time, regulatory considerations and charities' historically paternal approach to employment mean they need to ensure adequate pension provision for their staff.

There are no easy answers to this dilemma, other than ensuring that charity pension schemes are managed in the best possible manner. One of the best solutions is to use a liability-driven investment approach (known as LDI).

Simply put, this means setting schemes' investment strategies by reference to their liabilities, which equate to all of their members' future pension payments.

This is a departure from the traditional approach, whereby performance is measured against a peer group or market benchmarks. The principle is that each scheme has a different liability profile, reflecting the different age and career profiles of its members.

A scheme with mostly young members can often afford to take considerably more investment risk than a scheme whose members are largely retired.

A peer or market benchmark will leave most schemes with a potentially costly mismatch between their investment strategies and their liabilities.

By putting their future pension payments or liabilities at the heart of their investment decisions, schemes can avoid such a discrepancy and ensure the biggest potential return for the risk they are able and willing to take.

LDI investing is not a panacea for all charity pension issues, but it does create the right framework for discussion with employees, management and the pension regulator.

KEY POINTS

  • Liability-driven investment takes into account the scheme's liabilities, rather than benchmarking against others
  • Schemes with young staff can carry more risk than those with mostly retired members

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