UK pension funds should consider nine dimensions as they move to derisk
- Trustees should avoid certainty in forecasts ahead of de-risking
- There is insufficient supply of matching assets
- Credit diversification can help but is expensive
- A holistic view of liquidity is essential
Many UK defined benefit (DB) pension funds are entering the endgame. The continued closure of schemes, ageing membership, the transfer activity – all these factors are forcing trustees and investment committees to start managing the runoff phase.
What lies ahead is unexplored territory, because the UK has raced ahead of counterparts with the maturation of its pensions.
Investment strategies are evolving accordingly. Physical bond allocations are increasing, and as they do, hedging in LDI programmes is shifting towards physical bonds and the credit markets.
Navigating through the final chapters throws up questions and trade-offs. There is no one-size-fits-all solution and what suits one fund may not be appropriate for another.
However, as many UK pensions begin to take tangible steps along their de-risking journey, there are nine dimensions that should come into consideration.
First, there is the so-called ‘jelly on blancmange’ effect to consider, or the intrinsic messiness to the runoff period. Endgame investing dictates more precision in matching the liabilities, but precision can be confounded by inherent uncertainty. Cash flow projections are educated estimates rather than forecasts, given the long-term nature of the pension promise, the uncertainty of demographics, members’ ability to exercise options in how and when they take their benefits, and the propensity for legal changes to impact what benefits are taken.
In this context, retaining flexibility is important. Trustees will need to make refined judgements about the trade-offs between precision in matching and uncertainty in the liabilities.
Second, trustees contend with incomplete markets. Even if you could forecast the liabilities with certainty, the instruments available to match those liabilities do not give complete coverage, or are limited. The majority of a bond’s cash flow is in redemption, so you need bonds (or, better, zero-coupon bonds) maturing in each future year, bought in the appropriate amount to match your projected outflows. Compromises need to be made around how any gaps can be filled with synthetic instruments, such as funded swaps.
The ‘yield illusion’ is another factor to grapple with. Defaults and downgrades open a gap between quoted headline and the captured yield in the market. The matching credit portfolio needs to reflect this, adjusting yields for default risk. Portfolio construction and management can reduce the gap.
This can be done through judiciously selecting credits to hold until maturity, being vigilant in monitoring that credit and intervening to manage any deterioration in quality. This is active management to minimise losses.
Fourth is concentrated credit risks. Credit risk is idiosyncratic and event-driven. Endgame investors matching liabilities with credit will need to diversify and cap their exposure to any single credit.
A fifth consideration is capacity limits. The sterling credit market is £372bn (€418bn). UK defined benefit liabilities exceed £2trn, although some project that those liabilities will fall to less than £1trn in 10 years due to runoff. Nonetheless, the sterling credit market is not big enough to match the UK pension liability. This challenge can be overcome by investing beyond the UK and, in particular, in the US credit markets. This does introduce currency management challenges.
Sixth, pensions in the endgame need to diversify beyond credit risk. Expanding the portfolio outside the UK brings a wide range of debt markets beyond corporate credit, offering diversification opportunities. Liquidity, structured credit and leverage risk premia can diversify credit risk and present opportunities to add incremental yield to the portfolio and enhance risk-adjusted returns.
Seventh, sourcing inflation. Credit and securitised debt are nominal markets. There are small pockets of inflation-linked corporate credit from, for example, the utility sector, but the capacity is limited. Pension funds need to source inflation protection through derivatives or build up reserves. Few, if any, will be able to afford to buy index-linked Gilts to match their liabilities. Collateralising and managing the inflation hedging programme will remain integral.
Real assets are an eighth consideration. Although credit will be centre stage of any endgame strategy, most plans will need to target a higher return than credit can provide alone – particularly if there is a funding shortfall relative to self-sufficiency. Trustees are long accustomed to balancing the need to stabilise the funding level with the need to deliver a return. They will have to continue to walk that tightrope and now must add the need to service runoff cash flow, as well. For these reasons, real asset are increasingly in demand.
The ninth is managing liquidity. Putting all of the above together, a liquidity management challenge becomes apparent. An endgame strategy will entail allocations to less-liquid assets, and also require collateralisation of inflation and duration completion overlays, and of currency hedging programmes. A holistic view of the liquidity needs, with centralised oversight, will be essential to minimise cash drag and leakage.
Endgame strategies require customisation and refined trade-offs as trustees steer their ship into port. Trustees will need to work with their investment managers to inform those trade-offs with real-time insights and customised investment portfolios. No path will be predictable or the same, but these considerations can help pensions as they wind up.
Sorca Kelly-Scholte is head of pensions solutions and advisory, EMEA, at JP Morgan Asset Management
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