In the midst of the COVID-19 shock, Felix Mantz from Lincoln Pensions and Joachim Sudre from Aviva Investors explore how defined benefit pension schemes should plan their journey towards an end game and adopt a more holistic approach to risk.
We are experiencing a truly unprecedented event in financial markets and for society as a whole. The extreme measures introduced to mitigate the spread of COVID-19 have been detrimental to economic activity across the globe, and it is not yet clear what the longer-term damage will be. Indeed, many otherwise viable businesses are already fighting for survival. For defined benefit (DB) pension schemes, this once again thrusts into sharp focus the issues of both covenant and investment risk, just as many may have been daring to contemplate a brighter future.
First steps
From a trustee’s perspective, it makes sense to aim to reduce reliance on the sponsor as swiftly as possible by reaching their end game target. The importance of this has been brutally highlighted by COVID-19: while exceptional COVID-19 measures are supportive, financial health is on everyone’s mind.
But what immediate actions can trustees take before planning their end game?
- Augment covenant support. For example, if there is material value that exists outside participating employers, access can be formalised through a guarantee. Alternatively, negative pledges or security can be sought to ensure value is not lost to other stakeholders.
- Ensure DB scheme members are treated fairly relative to other stakeholders. Leading up to the COVID-19 outbreak, a number of companies had been distributing more in dividends than they have paid in deficit repair contributions, potentially treating shareholders preferentially. The need for fair treatment also extends to other stakeholders, such as creditors, who might seek additional security or early repayment – especially in times of corporate distress.
- Monitor the key risk relationships in an integrated way (see Figure 1). With the activities of many companies slowed or stalled by COVID-19, answers to questions like ‘Are key contributions affordable?’ may not be immediately obvious. Agreeing an information sharing protocol with the sponsor can help the flow of proportionate, timely information.
- Contingency plan for scenarios where risk relationships become unbalanced. Setting out expectations from all parties and unilateral trustee actions is a helpful starting point, before looking to pre-agree actions with the sponsor.
Figure 1: Monitor what matters
Planning the journey
Designing a route that ensures scheme members receive the benefits to which they are entitled takes detailed planning, and a comprehensive understanding of the risks that need to be managed along the way.
Covenants can therefore help with understanding:
Step One: Which target is right?
Some risks – like interest rate or longevity – can be managed; others, e.g. related to data security or the changing climate, are much more difficult to contain. For example, the EU’s General Data Protection Regulation has increased the scale of potential fines for mishandling of data to four per cent of annual global turnover or €20 million.
With such risks in mind, ask whether the sponsor will still reliably provide support until the last pensioner has been paid out. A low dependency end game target may be appropriate if this is likely and residual risks are covered – however, in many cases, buy-out or consolidation might be preferable.
Step Two: When is it necessary to reach the target?
In volatile industries or industries facing cliff-edge risks (e.g. with specific intellectual property due to run-off), trustees should consider reaching the end game target sooner. Scheme maturity is also an important consideration, as mature schemes are less able to recover from investment shocks themselves (and are therefore more reliant on future sponsor support).
Step Three: How to get there
Affordability and risk capacity shape the combination of contributions and investment returns needed to reach the target. These should be varied over time, based on the outlook for the sponsor; reflecting this necessarily becomes more uncertain the longer the time horizon. Managing investment risk is especially important for schemes where the sponsor has limited scope to make additional contributions.
Figure 2: Gauging risk appetite: How much investment risk can the sponsor support?
Managing investment risks along the way
When it comes to managing investment risk, schemes have, for a long time, been focused on a traditional asset-liability framework. In terms of strategic asset allocation, that involves the segregation of the assets into two ‘buckets’: a matching bucket and a growth bucket. The goal of the matching bucket is to hedge the scheme’s liabilities and in doing so, minimise funding level volatility. The intention with the growth bucket is to allocate to riskier assets, in the hope of generating the investment returns necessary to improve the funding level. However, during times of high volatility, such as during the current crisis, these riskier assets can have a significant negative impact on the funding status.
A number of better funded schemes have turned to a CDI investing approach to help mitigate the downside risk
Over the last few years, a number of better funded schemes have turned to a cash-flow driven investing (CDI) approach to help mitigate this downside risk, while also addressing the challenges posed by cash flow negativity. This approach involves structuring a portfolio of income generating assets to match, within tolerances, the anticipated future benefit payments from a scheme. Such a low-risk approach may not be suitable for everyone but, where funding levels permit, it can help improve the certainty of achieving the desired outcome, as illustrated in Figure 3 below:
Figure 3: Contrasting outcome ranges from a traditional growth/matching strategy and a CDI approach
In practice, CDI means building a portfolio of high-quality investment-grade debt and debt-like assets that, after allowing for expected defaults, is designed to meet benefit payments, hedge liability risk and generate the required returns. Liability-driven investing (LDI) is often used as part of the strategy to fill in any remaining gaps between the asset and liability risk profiles.
In addition to liquid assets that can generate predictable income, a variety of alternative income assets can be considered for CDI strategies. Opportunities with high predictability and security of income can provide similar characteristics to public debt, while potentially generating higher returns and lower risk through enhanced portfolio diversification.
These include:
- Infrastructure debt
- Real estate debt
- Private corporate debt
- Real estate long income
- Unlevered infrastructure equity
Ultimately, the suitability of a given asset or asset class for a CDI strategy is likely to depend on the specific profile and risk appetite of the pension scheme in question.
Strategic actions for secure income seekers in times of market stress
Those seeking to pursue a CDI strategy have a number of strategic actions at their disposal, depending on their current situation and objectives.
They include:
Addressing scheme governance
Having appropriate governance structures in place can allow timely reactions in periods of market stress. For example, it might be helpful to ensure managers’ mandates are structured to give breadth and flexibility, so schemes are able to take advantage of market opportunities, as they arise.
Releasing cash from LDI
Falling yields can result in decreasing leverage within LDI strategies. Pension schemes that have adopted an overlay approach within their LDI programme, using derivatives to create their desired hedge, can use this opportunity to ‘re-leverage’ their LDI portfolios and extract cash in order to buy high-quality credit (or other assets) instead. This approach would avoid selling growth assets and potentially crystallising losses.
Hedging RPI, waiting for CPI
With the current consultation for proposed changes to the measurement of inflation in the UK underway, pension schemes need to assess their CPI vs. RPI liability split. While we can expect most will have an RPI exposure, the picture is still fragmented and may vary widely. A good example is the Pension Protection Fund, which has 100 per cent of its liabilities linked to CPI.
Some trustees may be nervous hedging inflation now, given that RPI could be lower if the reform happens. However, on balance, long-dated inflation is currently materially cheaper than it has been for a while, so hedging to reduce risk remains a viable option. The appeal of this will primarily depend on each scheme’s individual position and risk appetite.
Preparing for real asset deployment
As in previous crises, there will inevitably be investment opportunities that arise out of the present uncertainty. For now, public market spreads have widened faster than their private market equivalents, which tend to lag in terms of pricing, and illiquidity premia typically associated with private assets have been eroded. However, for patient investors, private markets may offer future opportunities at higher yields and more favourable risk-return characteristics than at present.
Ultimately, being prepared for real asset deployment will mean being able to take advantage of premia and diversification benefits, as and when opportunities arise.
Reducing sponsor reliance
Managing the de-risking journey effectively requires understanding risks holistically; COVID-19 highlights this with its material impact on both investments and sponsor health and is likely to force many schemes to extend the timeframe of their journey plan.
Trustees have access to a wide range of tools to address the risk of insufficient covenant support in the short term, but the best long-term protection is ultimately offered by managing scheme risks to a point of low or no covenant reliance.
Investment opportunities continue to exist and tactical responses could add value
In the meantime, investment opportunities continue to exist and tactical responses, implemented quickly and efficiently, could add value. Developments in both public and private markets are likely to provide opportunities for attractive entry points for long-term investors like DB pension schemes.
While assessments on the depth or duration of the current crisis cannot be made with precision, we can expect the de-risking trend to continue as schemes look to reduce sponsor reliance. In which case, advisers and managers of DB schemes should, more than ever, work in an aligned way with trustees to identify suitable solutions to manage covenant and investment risks in both the short and long term.
