Text on screen: How to invest for run on. Joe Rattenbury, Senior Solution Designer at Insight
Hi, I'm Joe Rattenbury and I work as a Senior Solution Designer at Insight.
It's nice to be able to give this talk about how to invest for run on.
Because the reason I'm able to do so is because UK DB schemes are in such a great place.
We find ourselves in a position with the aggregate funding levels, which a decade ago was over £200 billion in deficit and now over £200 billion in surplus on a key PPF funding level measure.
And underlying that on the same basis, almost three quarters of schemes and now in surplus, with over a third fully funded on a more prudent buy out measure.
And while this means some schemes remain in deficit, the average deficit size is only £17 million, whereas the average surplus is almost four times as large.
Put simply, it's great that so many schemes are in a position where they have more money than they know what to do with.
I'm sure we all wish that we personally faced the same issue.
The big question that follows from having too much money is what should we do with it?
Should it bypass existing stakeholders of the pension scheme and be given to the shareholders of insurance companies?
Perhaps DB pension funds have been such a nightmare for sponsors over time that they'll jump at the opportunity to be rid of it.
Or should the lion's share go to the sponsor and their shareholders, given they've paid huge deficit repair contributions for the last couple of decades, that would mean they get back some of what they've paid in now that the scheme is so much better funded.
On the flip side, we should remember the DB trust has set up for paying benefits to members, many of whom have received below inflation increases over recent years.
Should we try and find a way to improve the lives of these members?
And then a question of can broader society benefit with a lower return hurdle given strong funding?
Do DB schemes now have the freedom to have a bigger impact on sustainability and responsible investment?
And then for each of these, there's a question of whether to release surplus early, versus using it to create more value over time, which will come on to later.
We recognize the right solution will vary depending on individual circumstances, but it's worth remembering that for a long time, many felt they had no choice but to ensure once they could afford to do so.
And that's something that has changed.
And part of what is helping to support that change has been pension reform, which has spanned across the last conservative and current labour governments.
It was kicked off with Jeremy Hunts Mansion House speech nearly three years ago and we've since had consultations and then legislation which will bring in new surplus release regime and new trustee powers to facilitate this.
Hopefully next year will be when we have a clearer picture of what this surplus release framework will look like in practice, first with guidance and then full regulations being effective.
So starting to feel like the finish line is just about in sight, or at least in perspective of the fast moving world of pensions.
And while we approach the finish line, one important consideration for trustees and sponsors is that all else being equal, time is on your side and the cost of insurance falls as schemes for mature.
Shown on the left hand side, you can see this is a function of shortening duration and a higher proportion of scheme members being pensioners, which has reduces uncertainty and thus results in more predictable cash flows for insurers.
In addition, as investment performance delivers an actuarial prudence unwinds, even with fairly modest return targets, surpluses can grow substantially over time, as illustrated by the chart on the right.
My main takeaway from this is there's no need for pension schemes to be racing towards the exit.
The door is wide open, but this isn't like an action movie where we are rushing to get through a rapidly closing door.
Instead, the gap just seems to be getting wider and wider.
And this means schemes can afford to wait.
They can wait to see how the government proposals and regulatory framework for run on pans out and they can wait to see how that impacts the relative merits to the possible answers to the question who owns the surplus?
Given this potential upside, a key question for the industry is how can we create a supportive environment such that members and sponsors are the ones that benefit?
A critical part of that for trustees is the strength of sponsor, which acts as the primary insurance mechanism for the scheme if deficits emerge.
It's only if the sponsor were to default and the scheme is underfunded that the PPF provides a secondary layer of protection, but crucially is currently less than 100%.
And no trustee wants to be in a position where looking back in hindsight, members received less than what could have been secured earlier.
And so I think what is ending up happening at present is when a position where credit analyst looked at the sponsors of UK DB pension schemes and assessed how many would default over the next 10 years, it'd probably look like the top illustration here.
Yet trustees of each scheme feel the need to behave as if there's a high likelihood it could be theirs that does shown below this.
Results in structural risk aversion from pension schemes often incentivized to take the safest option as penalties only occur when they deviate from that.
And that's where if the government wants to proactively encourage schemes to run on and keep holding gilts, increasing the PPF protection to 100% would help immensely.
A higher universal level of protection in the event of sponsor default would help to put trustees minds at rest.
And given that PPFs funding position is at record highs, we think this would be affordable if universal.
The funding code helps to mitigate the associated moral hazard risks.
Without this, it'll rely on frameworks being put in place on a scheme by scheme basis to avoid the structural risk aversion.
And on that front, the good news is that choice is growing in terms of end game options, and choice can only be good.
On one end of the spectrum, schemes can continue with business as usual, keep the scheme running, perhaps supported by assets in escrow to help provide security.
On the other end, schemes can hand over the keys to the insurers via buy out, which may be in time where all schemes ultimately end up in the future as they shrink and become subscale.
But between these two, we have a whole host of options.
We've seen the launch of consolidators, some of which like Clara see themselves as the bridge to buyout.
Other options, retain the link to the sponsor that improve covenant strength such as via third party capital through a capital back journey plan.
And of course, we are continuing to see innovation.
I thought the reason Aberdeen and Stagecoach deal was particularly interesting.
This was a case where the pension scheme continued to run on, but the sponsor was switched from Stagecoach to Aberdeen and it felt like everyone was a winner.
Private equity owned Stagecoach got rid off their pension scheme, they had no interest in running.
Members received a benefit uplift above and beyond what would've been achievable via a buyout, and trustees had a sponsor upgrade from Stagecoach to Aberdeen.
And finally, Aberdeen were comfortable with pension scheme risk and made benefit from the surplus too.
With this newfound choice more broadly, it feels like we're starting to see a change in mindset around DB pensions.
For a long time the view of DB pensions was very negative.
They felt like a threat and certainly a cost to sponsors and a risk to members if schemes were unable to pay their pensions in full.
Investment risk was often a necessity to keep that cost affordable as schemes sought to take that risk off the table as funding levels improved.
But we're now in a position where many schemes are not just fully funded, but they have surpluses and those surpluses can act as a buffer.
And what a buffer allows is more latitude in relation to investment risk taking, opening up the chance to increase exposure to assets that may drive further out performance and therefore deliver more value to the relevant stakeholders without material increase in the chance of future deficits emerging.
Now, what could this look like in practice?
Now, this is purely illustrative, but consider a scheme that's fully funded on a buyout basis or around 105% funded on a low dependency one that chooses to run on.
Now that surplus on the low dependency basis can act as a buffer to facilitate a slightly higher degree of investment risk taking, if desired, that can be used to generate additional surplus over time.
In this framework, any surplus above a certain amount can be potentially released with a split and mechanism agreed in advance between the trustee and sponsor.
And if funding level falls materially, then there'll be the potential for sponsor contributions if deemed necessary to get back up to 100%.
Now, there are lots of variations to this.
Some of that buffer could be in escrow rather than within the scheme itself.
Different thresholds may be more appropriate for different schemes and of course the surplus for lease guidance and regulation will help clarify some of these points.
But the principle of using a buffer to drive future growth will be a consistent theme.
So what does this all mean for investment strategy?
The key point is that schemes that want to run on want to be able to do this with confidence, and this confidence can be delivered through the successful implementation in 3 key areas.
The first is knowing your destination, getting alignment on the strategy between all stakeholders.
The second is ensuring the right level of sponsor support for your strategy, and finally, how to get there safely.
Strong risk management that can ensure you have good control over the range of possible outcomes.
To delve down a bit more on that third one, we want a strategy that delivers protection against as many adverse outcomes as you can, including areas that may have not been previously given as much focus such as longevity.
To give confidence the choice to run on is worthwhile.
One returns with a high degree Of certainty and finally choosing to run on gives you more time and opens up new investment opportunities that have a longer time horizon.
So how do we achieve that?
Perhaps unsurprisingly, the investment toolkit to deliver this a strikingly similar to what schemes have been doing for a long time with a contractual core allocation, both cashflow and value aware, providing the bedrock for this wider strategy.
Some of the areas we've been working on with our clients are; can liability risks be better managed?
For example, extending to hedging longevity risks in a cost effective way or more dynamically managing the risks associated with inflation caps and flaws.
After the scars of 2022, we believe that liquidity waterfalls will remain critical.
Liquid stable funds with strong carry such as ABS, perhaps complimented by absolute return strategies where alpha acts as a diversified source of returns.
And then of course, growth.
As mentioned earlier, in many cases schemes can afford to take more risk, again underwritten by the surplus buffer.
We have seen significant allocations to liquid growth assets, but perhaps with a longer time horizon, less liquid assets could start to play a larger role in portfolios again.
Non-contractual assets such as equities have performed very strongly and may continue to do so.
But I think we can all agree there are risks on the horizon.
Could equities with some downside protection provide the best of both worlds to bring this to life?
Let's take a cashflow view, an example scheme, with liability cash flows going out 40 years.
First, we add the contractual core allocation.
This is focused on investing in credit that matures over the next 10 years, which means you are not a forced seller of assets at adverse time to meet pension payments.
The credit naturally matures and pays you the cash needed.
That manages cashflow risk.
We then need LDI to fill in the gaps in liability coverage, hedging longer dated liabilities, as well as inflation risks and potentially longevity, that secures your liabilities.
And the interaction between these two buckets is shown by the pie chart, which illustrates that collateral resilience can be improved through permitting credit collateralization, meaning the credit can support the liability hedge at times of stress without being a forced seller of assets.
With our cashflow liability and collateral risk manage, we can start to look for opportunities to take affordable risk that may include a range of higher returning contractual growth assets.
And finally, more traditional growth assets such as equities, which for this purpose we've shown invested for 10 years as other assets have bought them time to deliver through the ups and downs of market cycles without being a forced seller.
Now this may not be run on forever.
In this scenario, we initially focused on the first 10 years after which we'll reassess and decide whether to continue running on it retains the flexibility for schemes to change course.
In this example, delivers a significant increase in surplus for £1 billion scheme over 10 years, over £150 million in the median scenario and positive even in the worst historical scenario, in fact, can even afford equities to go to zero and have had no deficit emerge.
To cover in a little more detail some of the strategy considerations we've been discussing with our clients considering run-on, liability hedging needs to make sure this is consistent with your run-on objectives and we encouraging all clients to consider an LDI health check to ensure this is the case.
We have a separate training session on this topic specifically.
And then of course, pension funds running on no longer have a time horizon of a couple of years.
They can make the most of that by seeking to benefit the illiquidity premium, while ensuring investments are consistent with the liquidity and target timeframe as well as the the collateral requirements of the scheme.
Next need to remember, this does not need to be a five and forget strategy.
Investments can be responsive to market conditions and investment opportunities while retaining confidence that you achieve the outcome desired.
This might mean creating more reinvestment opportunities when spreads are tight and locking into credit for longer if and when spreads widen.
Finally, which are considered how dynamic discount rates aligning the liabilities with the assets can help improve stability.
If we are holding primarily credit assets on a maturing basis, then if credit spreads widen, our forward-looking expected returns also increase relative to gilts.
Now, the actuary would've already made a sensible allowance for defaults on credit assets, which means the majority of that credit spread increase can be captured in your discount rate accordingly.
And this means a market to market fall in credit assets is offset by broadly corresponding fall in liability values.
What this delivers is lower funding level volatility and a reduced chance of the sponsor needing to pay in contributions for a deficit that's only expected to be transient in nature.
So to wrap up, we're in a world of increased choice.
For trustees, for sponsors, no longer are the end game options, a binary decision between business as usual or buyout.
And that choice is good and we think it can help deliver better outcomes for the stakeholders that matter most.
Members, trustees, the sponsor and wider society.
For schemes running on when designing a surplus release framework, consider how a buffer between the minimum funding level and the surplus release level can be used to facilitate affordable risk taking that delivers more value into the future, noting that this buffer can be inside or outside the scheme or both.
Finally, investing for run-on should be seen as an evolution of existing strategies, not a revolution.
But there are key new areas to consider across both the matching and growth portfolios, which can improve efficiency and increase the confidence that running on will be worthwhile.
If you have any questions on any of the topics covered here, please get in touch with your Insight representative.
