Schemes must proactively prepare for major delays in risk transfers
Demand for risk transfers among UK defined benefit (DB) pension schemes is booming, with record buyout volumes expected in the coming years. Around one in five schemes are already fully funded on a buyout basis, and anecdotal evidence suggests this could be far higher given favourable market moves in recent months.
This is a success for the trustees of those schemes and good news for sponsors. However, as we have previously warned, there is a burgeoning mismatch between supply and demand for deals, which is rapidly threatening to overwhelm market capacity. Today, there are only a limited number of bulk purchase annuity players in operation.
They face a list of supply constraints including the capital required to underwrite deals, the limited pool of suitable assets for cashflow-matching liabilities, and the administrative resource required to price and enact these complex transactions.
While the technicalities of buy-ins and buyouts are different, the teams working on those deals are the same, so it is as much a question of human resource as capital availability – further narrowing the line-up of potential buyers.
With the hurdles to new entrants both lengthy and costly, additional capacity in the market is unlikely to be forthcoming.
Combine this with the challenges for schemes themselves – cleaning member data, overallocation to long-dated and illiquid assets, and so on – and it is clear that there are major hurdles to buyouts happening at the pace and scale required by the market. This means that schemes must proactively prepare for major delays.
Risks to schemes
Essentially, what we have here is a multi-year queue for buyout completion, so our message to trustees is simple: make sure you’re ready in case ‘Plan A’ fails.
There are multiple risks of not acting now. Chief among them is that schemes’ investment strategies may no longer be optimised to the appropriate time horizon.
For example, if they were expecting to transact within the next year but a realistic timeline is now closer to five years, they will probably need to rethink their asset allocation to maintain their current funding position, and there is the risk of a significant cumulative drag on returns if they don’t. Part of this is the possibility of major market movements in the meantime.
In the event of an economic downturn more severe than expected, riskier assets (including illiquids) could sell off, undoing some of the funding progress of the past year. If yields and spreads reverse their recent upward trend, insurers will also need more capital to take on new liabilities, which may reduce their appetite for deals or make the cost of buyout untenable again for many schemes.
The current environment is good for insurers and conducive to deals, but this too puts pressure on schemes in the buyout queue.
In the last few months alone, we have seen a spate of high profile and large (even jumbo) schemes either transact or in advanced talks of transactions. Large deals could take an insurer out of the market for some time as in some cases one transfer can be equivalent to the entire amount underwritten in previous years.
How to construct a ‘Plan B’
With these and other risks in mind, schemes need to consider a ‘Plan B’. This means reconsidering their investment strategy to ensure that they remain (or become) buyout-friendly, and improve or maintain their desired funding level.
For trustees, three factors are key.
First, de-risking: many schemes will have de-risked before and throughout the liability-driven investments (LDI) crisis by reducing exposure to equities and riskier bond investments into investment grade credit. However, de-risking isn’t always about asset allocation, particularly when much of that work is already done – deleveraging or even unleveraging LDI portfolios can be an option for well-funded schemes, ensuring their end game journey is not derailed.
Second, liquidity: although the immediate squeeze from the Gilts crisis may have subsided, overexposure to illiquid assets and higher funding requirements from LDI portfolios may still burden schemes. They may want to consider how they can best rotate or roll-off their illiquid allocations into liquid income-generating equivalents.
Finally, consider the basics: continuing with the ongoing needs of each scheme by abiding by regulations, picking the best managers for each role and paying pension cashflows as they fall due are as important today as they were pre LDI crisis, if not more so.
‘Plan B’ in practice
There are multiple ways to meet any one of these objectives but, in our view, the most effective and holistic way to achieve a cohesive ‘Plan B’ is by allocating to credit through cashflow driven investment (CDI) strategies. DB allocations to CDI strategies have been growing for some time as schemes have shifted emphasis from funding levels to paying member benefits.
With schemes increasingly likely to find themselves in buyout limbo, however, CDI can play a vital role in overcoming the risks trustees face as they prepare for an extended delay. Indeed, credit serves many purposes – including hedging, rates, buyout pricing, responsible investment, growth, resilience to risk, and liquidity – that specifically speak to schemes’ ‘Plan B’ considerations.
While many schemes have been de-risking into and throughout the LDI crisis by switching from equities or other growth assets into bonds, a further way to de-risk could be through de-leveraging LDI portfolios, where schemes are able to do this.
This removes the risks of the leverage-induced crunch seen in 2022.
Credit can play an important role here, with longer-dated credit taking up some of the interest-rate hedging burden. It can also offer funding-level protection in severe economic downturns, especially if funding levels are calculated on a discounted asset basis as opposed to a ‘Gilts plus spread’ basis.
Liquidity and construction
Schemes seeking buyout will need good liquidity to appeal to insurers and credit, as demonstrated in the LDI crisis, is a proven source. But schemes need to ensure their manager can access that liquidity, as well as offer trading expertise, to maximise the benefits of credit and enhance their attractiveness to buyout providers in future.
Likewise, constructing an appropriate portfolio needs careful consideration. A strong track record of ‘cashflow matching’ liabilities will help to solidify a scheme’s current position and appeal to insurers analysing scheme assets.
Knowing what insurers want is key. This means considering factors such as cashflow matching, callability features within bonds, and the maturity of bonds.
Schemes must, however, be able to source the assets (particularly primaries) as well as identify them. There are limited long-term credits and managers need the scale and trading capabilities to compete for them.
Back to basics
Evolving regulation and insurer requirements offer trustees a further opportunity to stand out from the competition. How capital-intensive assets are from a solvency perspective is a key consideration and can directly impact risk transfer pricing.
Responsible investment is another crucial factor. The requirements on trustees relating to Task Force on Climate-related Financial Disclosures (TCFD)reporting has increased materially, and with the Taskforce on Nature-related Financial Disclosures (TNFD) framework being finalised in September, it is only likely to grow.
As insurers ramp up their climate commitments amid a backdrop of tightening regulation, assets with strong ESG credentials will be more attractive. Climate integration is therefore key.
Schemes must be on top of forthcoming regulation and well positioned to transfer credits when needed to avoid being knocked further down the buyout queue. As the transfer backlog gets longer, schemes simply cannot afford to wait to act.
In our view, credit provides the best asset to construct the type of ‘Plan B’ portfolio they need. But in a febrile market where there are elevated risks of downgrades and defaults, it has never been more important that schemes choose the right manager to help them navigate the long journey to buyout.
Rob Price is a senior portfolio manager at AXA Investment Managers