Boris Mikhailov and Matthew Graham look at the benefits and risks for pension schemes targeting self-sufficiency.
3 minute read
By targeting a corporate pension buyout, schemes have the certainty of a clear finish line – a time when all assets and liabilities are transferred to an insurer through the purchase of bulk annuities. But for those targeting self-sufficiency, it is more akin to the scene in Forrest Gump in which the lead character, played memorably by Tom Hanks, decides to go for a run and then keeps running.
Self-sufficiency assumes the pension scheme will remain robust enough to keep running across a longer funding horizon until the last pension payment is made to the last surviving member. Importantly, this journey must be taken without additional sponsor contributions, hence the term ‘self-sufficiency’.
According to Mercer’s 2018 European Asset Allocation Survey, self-sufficiency is the aim for 38 per cent of the UK’s defined benefit pension schemes. In general, the actual funding level is set at a modest premium over the cost of funding liabilities with low risk assets such as government bonds. The Mercer survey, however, also revealed that around 56 per cent of schemes are cashflow negative, while half of those currently in the black are at risk of falling into the cashflow negative category within five years. So how can schemes that are either cashflow negative or at risk of being so also plan for a self-sufficient future?
Planning for the future
The de-risking journey is crucial. And regulation is putting more pressure on schemes to be cautious, with the Department for Work and Pensions, for example, outlining in a 2018 white paper that investment objectives should be linked to long-term goals, such as self-sufficiency or buyout.
In asset allocation, the challenge is to find investments that meet cashflow needs while helping to close deficits or build a stronger buffer. In this regard, traditional barbell approaches combining a growth bucket with a liability-driven investing (LDI) portfolio may prove inadequate. As pension schemes mature, they need income to pay member benefits and can become cashflow negative in the short term, even if long-term investment targets are on track.
This is less of an issue in benign markets; however, sequencing risk could become a factor in tougher conditions. Forced into selling assets to generate cashflows, a scheme will essentially be locking in losses, increasing portfolio volatility and putting more pressure on the remaining assets to bridge shortfalls. The investment time horizon also shortens, leaving less scope to invest in the growth assets needed to improve funding levels.
To mitigate this, a growing number of schemes are turning to cashflow-driven investment (CDI), which is designed to capture a more consistent and predictable income stream that is less reliant on short-term market movements. While such strategies may not offer as much upside when markets thrive, they are more likely to provide predictable cashflows and protection against sequencing risks.
Managing non-investment risk
As schemes reduce investment risk, they will likely confront the potential size of non-investment risks such as covenant and longevity. These, too, can throw funding levels off track.
Covenant risk – the risk a pension scheme sponsor is unable or unwilling to provide financial support – is increasing. In the UK, the rate of failure among companies climbed to 12.2 per cent in 2017, compared to 9.7 per cent five years earlier, according to the Office of National Statistics. More recently, household names with DB schemes that collapsed in 2018 included facilities management and construction company Carillion, and retailers Toys ‘R’ Us and House of Fraser. Brexit and a slowing economy may have contributed to this trend, but long-term structural shifts – such as digital disruption of the retail sector – are other factors.
One way of addressing any unexpected corporate actions or inaccuracies in liability assumptions would be to build a stronger funding buffer or add contingent assets. Another option is to purchase surety bonds during periods when covenant risk is heightened. Traditionally used in the construction industry, surety bonds help ensure a certain level of contributions is made in case the sponsor doesn’t fulfil its funding obligations.
Longevity risk, the risk that schemes have wrongly predicted the lifespans of their members, also can impact funding levels. For example, adding longevity risk to a typical diversified-credit portfolio targeting Gilts + 0.5 per cent per annum (typical for self-sufficiency) could increase the level of funding ratio at risk to about 4.7 per cent from 2.6 per cent, according to Redington. Schemes can target a higher (or lower) funding level depending on the most recent longevity assumptions. They can also turn to insurance solutions such as longevity swaps.
Keep on running?
Having a game plan for managing exogenous risks early in the de-risking journey could help pave a smoother self-sufficiency path. External shocks that materialise further down the road may prove more difficult to recover from for two main reasons. First, there would be less investable assets to put to work as schemes mature. Second, the sponsor could become financially weaker – or, in the extreme, has gone out of business.
In the event ‘self-sufficiency’ turns out not to be an end in itself, but a stepping stone until the resources needed to run the scheme outweigh the cost of a buyout, schemes can still benefit. A portfolio of assets that can match cashflows to liabilities having considered investment, covenant and longevity risks will be well-positioned to target a buyout. As in the movie, even Forrest Gump had to stop running at some point.