Balancing liquidity and flexibility: a DB de-risking dilemma

As transfers out of UK Defined Benefit (DB) pension schemes reach record levels, John Dewey assesses the implications for pension schemes with alternative income allocations.

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More than £21 billion pounds flowed out of UK DB schemes in 2017, almost three times the level seen the previous year, as members chose to switch out of schemes promising guaranteed future income.1 With low interest rates resulting in high transfer values, many pension savers chose to take cash lump sums right away rather than wait for benefits.   

The unexpectedly large flows have implications for those advising and managing asset allocation decisions, many of whom have been looking to step up allocations to alternative income assets for diversification and yield benefits. In this Q&A, John Dewey looks at the implications of including illiquid assets in portfolios that are being tested in unexpected ways.   

How are the recent pension freedom changes in the UK changing DB schemes overall approach to cashflow management? Does including illiquid alternative income assets in DB schemes restrict their ability to meet unexpected cashflows?

Although pension funds can calculate their expected liability cashflows for 100 years, in reality the quantum of cashflow payable is variable. The variability is much greater for non-pensioner members than for the pensioners, given the choices available to them. Options for non-pensioners range from transferring benefits to an alternative pension arrangement, taking early retirement or exchanging a proportion of a pension for cash. These options will change the individual cashflow profile for that member, and there is data available to help ascertain the likelihood of each.

But regulatory developments can change behaviour quite materially. The UK’s recent pensions changes have given members much greater flexibility on how they receive their retirement proceeds, and they are using it. More unretired members of DB schemes are choosing to take cash lump sums rather than keep the rights to future income streams. And of course, that has an impact on portfolio rebalancing and future asset allocation decisions.

Will having illiquid alternative income assets in DB schemes restrict their ability to meet unexpected cashflows? And will it limit their freedom in changing their investment strategy?

Pension schemes typically revisit their investment strategy every few years to check that the asset allocation is still appropriate to deliver the ultimate objective. Changes in the funding position, sponsor covenant and market outlook can mean that the investment strategy is altered. 

Where assets are illiquid, changing allocations can be difficult to implement swiftly, as there can be fewer opportunities to sell assets to other market participants, or assets may need to be sold at a discounted price. However, even the more generous allocations to alternative income assets tend not to exceed 10 per cent. A pension scheme would therefore still expect to have over 90 per cent of its assets available to meet unexpected cashflows, re-balance to a new strategy or transfer to an insurer.

What are the implications for schemes wishing to transfer illiquid assets to an insurer as part of a derisking strategy?

Where the ultimate objective is an insurance-based solution, pension schemes have increasingly been undertaking a series of pensioner buy-in transactions, en route to a buy-out strategy; this allows risk to be managed in stages over time and increases the likelihood of achieving the target outcome. If assets are invested in illiquid alternative income assets, there are often concerns about transferability to an insurer, agreeing valuations and being a forced seller.

However, alternative income assets deliver a high degree of ongoing cashflow through regular coupons and amortising assets can increase the pace of cash generation, helping provide liquidity. Furthermore, given the demand for long-dated assets from insurers, there are shorter-dated illiquid opportunities (with maturities of between five to ten years, for example) which can offer higher yield premia. The capital from these maturing assets is regularly available as well, providing liquidity to meet unexpected cashflows, or it can be transferred as part of an insurance transaction.

On this last point, while the appetite from insurers for these assets will vary, some may be willing to accept alternative income assets as payment. This will be particularly the case if the asset manager has experience in originating insurance assets, as there may be benefit from having a common approach to credit evaluation and pricing. The key challenge, however, will be in negotiating an agreeable price.

Find more in Aviva Investors Alternative Income Study 2018, based on the views of 250 investment decision-makers at pension schemes and insurers across Europe.


1 Source: Financial Conduct Authority, cited in the Financial Times on 28 August 2018 

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