Could your low dependency strategy stand up to Trump’s tariffs?

The pensions and insurance paradox

At the start of my career advising Defined Benefit (DB) pensions schemes on investment, the conventional wisdom was the more return (and risk) you pursued in your investment strategy, the less money you needed to meet your pension obligations. The logic was the higher expected return did more of the heavy lifting for you, so you needed less money. This was at direct odds with the insurance world, where the more risk you took, the larger the buffer you needed to hold if it all went wrong. Either one was right and the other was wrong, or they existed in parallel universes where different rules apply.

In a way they did exist in different universes as the regulatory landscape was fundamentally different. As was the nature of the different promises made to the member and policyholder respectively. Ultimately regulations define the rules of the game, so in a way determine the reality. Who’s to say which is right?

Well, there is some evidence to say that the insurance approach to risk management has historically worked better than DB pensions. You only need to look at the uptake of the respective lifeboats, Pension Protection Fund (PPF) and Financial Assistance Scheme for pensions and Financial Services Compensation Scheme (FSCS) for pension annuity insurance. The PPF currently supports 292,000 ex-members of pension schemes that failed without sufficient assets to fully meet members’ benefits, plus a further 192,000 supported by the Financial Assistance Scheme because their sponsors had gone bust before the PPF was set up in 2005. The FSCS serves the same role for insured pension annuities but hasn’t yet had to put its hand in its pocket to support members of failed pension annuity insurers, as there haven’t been any. Not a like for like comparison you may say, and you may be right, but there’s some truth in there somewhere. 

The advent of low dependency

Thankfully, in the pensions industry we’ve come a long way. The rules have changed and the requirement which since last year is baked into regulation, is to be fully funded on a low dependency basis once a scheme is significantly mature.  This should address the fundamental difference between the pensions world and insurance in terms of security of benefits. Getting it right for pensions in the end.

Or perhaps not.

The “bounce-back” test

In the Pensions Regulator’s (TPR’s)  funding code, published in November 2024, the requirement for testing that your scheme is fully funded on low dependency involves stressing your intended low risk investment strategy and testing if you can get back to fully funded with a certain time frame. I’m going to call this the “bounce back test”. This sounds great in theory, but there’s a snag...

When put into practice, higher risk strategies generally perform better in a bounce-back test than low risk strategies. There are several contributors to this but the most prominent is that in most cases, higher returning strategies are expected to disproportionately outperform liabilities compared to lower returning strategies.

Here’s why: Investment risk is broadly proportional to the amount of expected outperformance above risk free interest rate.   For example, the riskiness of a strategy that is expected to deliver gilts plus 2% is roughly double the risk of a strategy targeting gilts plus 1%. But if you have a liability discount rate, let’s say in line with the regulator’s fast track low dependency basis of Gilts + 0.5%, your Gilts + 2% investment strategy outperforms by 1.5%, compared to a Gilts + 1% strategy, which will only outperform by 0.5%. So if you double the risk, you triple the expected outperformance in this example.

Given the initial stress event in the test is defined by the amount of risk, which has doubled, the higher risk strategy appears to be superior in bouncing back, as it will be expected to recover to fully funded in a shorter time period given the disproportionality higher outperformance. This is like swimming upstream, if you can swim twice as fast you’ll get to the finish in less than half the time. Swim slow enough and you don’t progress at all.

Resilience is in the eye of the beholder

In ts final code, presumably in response to feedback on the test from the draft code, TPR removed the requirement to use their specific resilience test, instead letting pension schemes decide the resilience test for themselves. This test was a 1 in 6, 1 year downside combined with required bounce back to full funding within 6 years. Crucially though TPR still requires non-fast track schemes to prove the concept of being able to bounce back as the sole measure of resilience beyond other requirements of being 90% hedged and sufficiently liquid. But I’m not convinced these criteria are sufficient to ensure a strategy is actually resilient. In theory any magnitude of risk is acceptable as long as the ratio of return for risk is sufficient. The sky’s the limit!

It leaves a huge question mark as to how big an acceptable downside outcome is, and should a downside event materialise, you’ll have to persevere with that higher risk strategy to have any hope of getting back to full funding.

What’s the answer?

What is needed is an objective way of setting a maximum absolute level of downside risk alongside the bounce-back. So you need at least two separate tests when checking your low dependency investment allocation is a genuine low dependency solution.

Fortunately our industry has a great record for taking matters into its own hands and introducing necessary safeguards. Look at the LDI response in Autumn 2022, the market moved to an arrangement within a few weeks, that the regulators then largely emulated over the following months.  Given that TPR has left the door open for pension schemes to choose their own tests, my hope is that the industry will take it upon themselves to construct strategies that are genuinely resilient. 

As one of my clients - with a long standing low dependency strategy - put it following the tariff market falls, “I guess this is the reason we stayed away from equities - thank goodness”.