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Why does volatility matter and how can pension schemes manage it better?

In order to understand the impact of volatility on a portfolio we have to start by looking at what’s in it and, more importantly, how the investments behave in different market situations. Historically, portfolios of equities and bonds were considered diversified. Consider though, that both equities and bonds are both negatively impacted by high inflation. Do they give that portfolio any real protection?

What does diversification really look like?

Diversification is easy to understand as a concept but hard to deliver in reality.

When setting a diversified investment strategy, trustees should move away from statistical diversification and instead think about how their portfolio would stand up to a series of real life scenarios – both bad and good. Only when outcomes are tolerable in all these scenarios will the investments be truly diversified.

Is there a trade-off for pension schemes when it comes to volatility?

Most trustees face asymmetry when it comes to volatility – the downside risk is more damaging than the corresponding upside risk is rewarding. That means the first priority needs to be to get enough return with a level of downside risk they can live with. Controlling downside risk doesn’t mean that trustees can’t be alert to the opportunities volatility offers. Volatility is an inherent aspect of markets that can either be harnessed in its own right or present opportunities to enter or exit investments at an attractive time.

How can trustees better manage their exposure to volatility?

Getting the right balance of risk and return can be challenging for trustees. There are often tensions between the desire to make the investments work as hard as possible (leading to lower sponsor contributions if achieved) and the desire to limit the extent to which volatility can blow funding plans off course. Fortunately, if trustees are willing and able to use a wide range of tools, it is usually possible to have some of your cake and eat it!

However, this can be difficult for some schemes to do directly because it often relies on being active in markets and using a range of sophisticated investment tools. This adds complexity to the investment strategy and can increase the overall governance burden.

One option which really helps here is delegation – employing an investment manager (or managers) who can manage volatility on your behalf. This can come in many guises, ranging from sophisticated strategies designed to benefit from or control volatility to relatively simple instructions to implement pre-agreed triggers set by trustees. It’s increasingly common for schemes to use several of these, with the balance determined by their individual views on costs, markets and ability to tolerate risk.

Surely long-term investment horizons protect many schemes from short-term movements?
For most schemes, the honest answer is no. If your timeframe is infinite or your covenant indestructible, you can arguably afford to think of volatility as ‘noise’, but how many UK defined benefit schemes can say this? Particularly as schemes mature and start paying out more than they get in, a period of adverse volatility can permanently destroy their ability to meet the benefits as they fall due.

The majority of trustees and companies have to think about the long term as a series of triennial periods – i.e. from valuation to valuation. Adverse volatility can lead to increased deficits and difficult decisions around contribution levels in the short term.

It’s a perfect example of integrated risk management at work – trustees need to be comfortable that their covenant and funding plans support the level of volatility they are taking. If the answer is no, speak to your advisers about what you could do differently.