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Pension schemes will confront a different set of challenges as they mature, not least around cashflows. How these problems are managed now will affect the financial health of the schemes far into the future.
No two pension schemes are alike, and their paths towards delivering on their promises to members may not be either. Today, buy-ins, buy-outs and self-sufficiency are all distinct objectives.
Yet as closed pension schemes mature, many face common challenges: cash flows become more pertinent as income is needed to pay member benefits; if markets falter, these schemes may have less time to recover; and similarly, their fates become more dependent on factors outside their control, such as members’ expected lifespans and the health of their sponsors.
At our October UK institutional conference, ‘Adapting to thrive – inspiring future outcomes,’ we considered three paths that may help pension schemes to address these issues as they approach the endgame. (See the table below.)
Three strategies for defined benefit pension schemes
Source: Aviva Investors, October 2018
Each has its merits and drawbacks. As we weighed the options through the lens of a hypothetical case study of the £1.2 billion Widget Pension Scheme, we made the following assumptions about the Widget scheme:
- The asset allocation is divided with 30 per cent in an LDI portfolio designed to hedge 100 per cent of the assets, 30 per cent equities, 30 per cent buy-and-maintain credit and 10 per cent real estate long income.
- Funding level is 80 per cent.
- Sponsor contributions are £30 million per annum for five years.
- Scheme is closed to new members and accrual.
The trustees of the Widget scheme are targeting fully-funded status in ten years, based on a government bond basis, a measure that assumes the scheme’s liabilities can be funded with existing assets by buying government bonds. As the scheme matures, trustees wanted to reduce risk and are changing the portfolio’s return target to gilts +150bps per annum from gilts +175bps per annum. A major concern is their sponsor covenant, which could deteriorate over the next few years if Brexit impacts the company’s ability to make its annual contribution.
With lowered targeted returns, increased sponsor covenant risk and higher cash flow requirements, the Widget scheme could benefit from implementing cashflow driven investing (CDI). One way of targeting a more predictable cashflow stream and therefore reduce their reliance on the sponsor is by increasing exposure to high-quality public and private debt, at the expense of public equities. While such a strategy is not likely to generate equity-like returns, it still can provide some growth potential while reducing downside risks. (See the chart below.)
In search of certain outcomes
Comparison of CDI versus a reduced equity allocation approach
Source: Aviva Investors, October 2018, for illustration purpose only
However, capital deployment in private markets could take time. Assets are less liquid, and the competition for deals is rising with investor demand. Extensive resources are needed to find, structure and monitor private assets, and a robust risk management framework is a must. Private debt strategies also take time to deploy, so an early start could be crucial to meet investment outcomes.
For others who are concerned about equity risks but may not wish to invest in private markets, multi-asset strategies with an absolute return benchmark may make more sense. In the case of the Widget scheme, about 30 per cent of the investment portfolio is invested in equities. Following ten years of positive equity market returns, trustees are concerned that more volatile markets could damage the scheme’s funding level. A 20% drop in equities, for example, could lead to a deterioration of 4.8 per cent in the funding level. This increases the risk of forced selling to meet cashflow needs, but more importantly may compound the funding shortfall if the scheme is cashflow negative.
Absolute return strategies that focus on a specific outcome may help to smooth returns during periods of heightened volatility, but investors also have been concerned over the underperformance of many strategies relative to equities. Some may use leverage and long-short positioning to target returns that are independent of market directions. Others follow long-only diversified growth process or are dependent on managed hedging programmes. In practice, investors need to be clear how each – or a combination of the above – can be tailored to meet their goals.
To have the best chances of delivering a targeted outcome, investors need to consider the following:
- Does the asset manager have the analytical framework to identify opportunities and mispricing in a disciplined way?
- Does the asset manager have dedicated resources to monitor these frameworks, propose action and then execute it in a cost-efficient manner?
- Does the asset manager have the accountability and governance structure to ensure that the board can oversee and justify their investment decisions?
Both absolute return and CDI strategies address investment risks, which is rightly the focus for trustees. But harm to the health of the pension scheme also could be from other causes such as the sponsor covenant and/or longevity risks. For example, the Widget scheme’s sponsor could fail to make part or all of the expected £150 million contribution over the next five years due to the impact of Brexit on the company’s profitability. Equally longevity assumptions could be out, causing a surplus or shortfall of £100 million or more over a ten-year time horizon, based on assumptions that are in line with the level of prudence that insurers currently use. Without adequate considerations of these external risks, trustees may find that their endgame will not actually end where they thought it would.
Insurance solutions can help to reduce uncertainties that are not market-related. For example, surety bonds could provide an effective way of managing covenant risks and at the same time, potentially offset some or all of the cost of the Pension Protection Fund levy. Other insurance-based solutions including longevity pass-through structures can effectively help schemes to remove longevity risk. While these solutions can be a quick way to reduce big-picture risks, they require additional costs, specialist expertise and adequate governance.
Nevertheless, during October’s conference, 28 per cent of the attendees said they would explore insurance solutions to reduce endgame risks. The winning option, however, was CDI with 51 per cent of the votes, and the remainder chose to focus on the absolute return strategy for the growth portfolio as the most urgent option in the current environment. What is clear is each pension fund will have its own challenges and, more importantly, its own views and opinions as to how to solve them. Only by having a crisper picture of how far they are from the end goals can trustees plan their journey with more precision.
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at 17 October 2018. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this document, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment.
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