Every job comes with its own natural rhythm: a series of milestones mark out the way ahead, providing focus for our efforts. For some, working life is divided into relatively short segments: the sports stars who must “take it one game at a time”, the teachers given three academic terms to drum the curriculum into each cohort of children. Others work towards multi-year goals: the politicians timing their initiatives with an eye on the next election, or the corporate managers currently polishing their “2025 Visions” in their home office.
Towards the far end of this spectrum, we pension professionals – pensions managers, HR specialists, trustees, advisers – find ourselves. We may not be quite so far-sighted as the futurologists (many of us will be familiar with Aubrey De Grey, advocate of super-longevity) or science fiction writers (Isaac Asimov’s Foundation series features a protagonist saving the world using a form of actuarial science). But there are few other jobs where thinking about the next 10 years, 20 years, or longer is part of the everyday.
Does the nature of what we do for a living make us better long-term thinkers? Our jobs require us to understand the slow-yet-powerful forces, measured over decades, that shape our world, and take practical action in anticipation of the potential ramifications. So I think the answer to the question would be “yes”.
But we need to be clear what this actually means. For me, it is important to point out that thinking long term does not equate to acting slowly. Rather, it is a matter of knowing where you are trying to get to, and making regular course adjustments to keep things heading in the right direction.
For a good (and topical) example of taking practical action in the face of uncertain long-term forces, we can look to the increasingly popular Cashflow Driven Investment (CDI) strategy. This involves investing in a range of income streams to meet a scheme’s cashflow demands, reducing the need to sell assets at prevailing prices in order to pay members. Schemes adopting CDI strategies typically expect to run off liabilities in this low-risk manner for some years before buying out, with some planning to do so indefinitely.
A CDI strategy serves as a good illustration of the relationship between taking near-term action and achieving a long-term goal. It is by no means a set-and-forget strategy. Those of us involved in running CDI mandates are often bemused (to put it lightly) by the suggestion that there is relatively little to do when, in practice, we are busy juggling the cashflows into and out of the scheme, dealing with the inevitable downgrades, defaults and impairments, reinvesting excess money, improving income diversification with new issues, updating hedges, and identifying opportunities for insurance transactions.
The timeframe for running a CDI strategy and for holding onto income generating assets means that long-term forces affecting the assets and liabilities must remain front of mind. To illustrate this in practical terms, we will consider two such forces in more detail: climate change and inflation.
Amongst the statistics illustrating the daunting scale of the climate change challenge, this one stands out: to help limit the worst impacts of global warming, not only do we need to make the reduction in carbon emissions caused by the recent lockdown permanent, but we need to maintain the same rate of reduction year after year. This presents a daunting task indeed, given our societal tendency to focus on the short term - like the young child who, unable to see beyond instant gratification, fails the famous Stanford Marshmallow Experiment by taking the proffered confectionery. To achieve the near-impossible will require significant developments across a number of areas including government policy, technological advancement and society as a whole. Institutional investors, wielding perhaps the only power comparable to the forces of the planet itself (aka money!), also have an important role to play.
Pensions professionals will be especially motivated by the knowledge that their funds will still be making payments to members whilst the full implications of climate change are unfolding. Some will have already studied the phenomenon in some numerical detail, for example in the projections of asset performance under various temperature rise scenarios. In the coming months, schemes will move beyond analysis and predictions to take concrete action in the following areas:
| Action | Description |
|---|---|
| Incorporating the wider impact of investments into portfolio design | In effect, the societal and environmental impact (both positive and negative) becomes a third key “pillar” of investment, alongside risk and return. |
| Developing a carbon journey plan | Analogous to the more familiar journey plan for building up assets, this sets out the desired pattern for reducing portfolio carbon footprint systematically over time. |
| Complying with a raft of new regulations | The requirements of the Task Force on Climate-Related Financial Disclosures (TCFD) is an early example. |
In the specific context of a CDI mandate, this kind of thinking may result in:
Price inflation exerts a strong influence on the value of benefits promised to pension scheme members. It also has a notable tendency for causing “unintended consequences” for pensions, for example:
| Phenomenon | Consequence |
|---|---|
| Successive legislation requiring guaranteed inflation proofing for pensions | DB pensions become less affordable, contributing towards the trend for scheme closure. |
| Switch from RPI to CPI as reference index for pension increases / index-linked gilts | Funding improvement or deterioration, depending on the nature of a scheme’s assets and liabilities. |
| Triple-lock rule for state pension increases “distorted” by COVID-19 experience | Outsized earnings inflation results in “windfall” for pensioners, at the expense of wider public spending. |
Looking ahead, following years of stability, the future outlook for inflation appears rather less certain, with strong inflationary and disinflationary forces pitted against each other:
Note that, in the above picture, “climate transition” can act as a possible force in either direction, depending on the actions that global governments take in tackling climate change, the overall impact on input prices (e.g. energy, water) and output requirements (e.g. waste treatment), and how this feeds into the supply and demand for goods and services (e.g. a fall in agricultural yields may drive up food prices).
Our central view is that, whilst the inflationary forces are more likely to win out over the next year or two, over the longer term the disinflationary forces are more likely to prevail. That said, when strong forces act in opposite directions, the outcome can be volatile - doubly so if exacerbated by policy misjudgement.
A sensible first step is to understand whether high or low inflation is a good or bad thing for an individual scheme.
How all this translates into running a pension scheme is a notoriously tricky question, especially when one starts to consider the interaction between inflation and interest rates. A sensible first step is to understand whether high or low inflation is a good or bad thing for an individual scheme. This may sound rather obvious, but in practice the answer can be very different depending on the precise scheme provisions for benefit increase caps and floors, and the way in which the assets held may behave in different environments.
There is normally no real reason for a pension scheme to be exposed to the uncertainties around future inflation, the consensus being that this is an “unrewarded” risk that can and should be removed. There is therefore an increasing trend for hedging away inflation exposure, by holding more inflationary assets and by using derivative instruments (e.g. inflation swaps as part of a LDI programme). As it is neither easy nor cheap to have assets that replicate exactly a scheme’s pension increase rules, the hedging tends to be broad brush, meaning that continuous oversight of the programme is required, especially with an eye on the possibility of a sudden shift to a higher or lower inflationary environment.
Looking again through the lens of CDI, mitigating future inflation uncertainty can involve:
So, back to the original question: are pension professionals better long-term thinkers? In our day jobs, we certainly spend more time grappling with long-term phenomena (of which the above are noted examples) on a practical basis than most people. That said, there is little available evidence on whether this long-termism extends to our non-working life. Are we better at booking flights in advance when the fare is cheap? Do we tend to prefer fixed or variable rate mortgages? Do we look after our health, or save for our own retirement, more enthusiastically than the average person? I would love to hear your examples!
