Defined benefit (DB) pension schemes face numerous challenges on many fronts. The first is regulatory, with two big, interlinked initiatives potentially redefining the world of DB pensions.
The Department for Work and Pensions consultation on the draft Occupational Pension Schemes Regulations 2023 and The Pensions Regulator’s DB Funding Code of Practice look set to change a great deal for DB pensions.
These will shift the impetus of trustees at DB pension schemes to adopt a funding and investment strategy that sets out the ‘endgame’ for their scheme and how they will get there – bringing with it challenges along the way. There are also other potential consequences of which DB schemes will need to be aware. This comes after DB schemes were caught up in the gilt volatility of September and October 2022. What are the lessons for DB schemes from such a tumultuous event? And how should schemes approach liability-driven investment, after it was the forefront of much that occurred?
All of this raises a big question about what the path ahead should look like for DB schemes.
A defined benefit roadmap
September’s gilt volatility had a deep impact on many DB pension schemes. How do you view the affair?
I would like to take a step back, if I may, and look at the whole of last year. Generally, the funding positions of defined benefit pension schemes improved in 2022. By far the biggest influence was the sell-off in real rates. The yield on long dated index-linked gilts has the greatest impact on the value of a pension scheme. If that yield rises, the value of a scheme’s liabilities falls. And that yield climbed by around 3% per annum during 2022, which had a huge impact on liabilities. As a rule of thumb, a 1% per annum increase in yield might lead to a 15% decrease in the value of a scheme’s liabilities. So it is huge.
Now, most defined benefit pension schemes have liability-driven investments (LDI). In its broadest definition, it means considering your liabilities when you invest. A narrower interpretation is achieving real yield exposure through hedging interest rates and inflation. How it typically works is that if your liabilities rise in value, you buy an equivalent asset that roughly goes up by the same amount. If your asset portfolio matches any change in the liabilities, through changes in the yields, then you would be 100% hedged.
Last year, because schemes were less than 100% hedged, liabilities fell further than assets did, so pension scheme funding positions improved, perhaps by 10% or more, on average.
The funding level is the value of assets divided by the value of liabilities with 100% classed as fully funded. Overall, the sell-off in real rates last year was a benefit for most pension schemes.
That is good context, but there were tumultuous events in September and October.
The volatility in September and October was unlike anything seen before in the index- linked gilt market. In a single day, the yield on long-dated gilts jumped more than 70 basis points, which had a huge impact on value.1
If, for example, the duration of these gilts is 30 years, that would have been approximately a 20% shift in the value of their liabilities within a day. We have never seen anything like that before. We had several of these big shifts, in the same direction, on consecutive days.
The largest single day movement prior to September and October, was in the order of 30 to 35 basis points.1 This means that when pension schemes hedge through entering into swap contracts or repurchase contracts with banks, they are locking in a particular rate. If the market rate goes up, then the pension scheme has to post collateral to the bank. If the market rate goes down, the bank has to post collateral to the pension scheme.
For decades the move has mainly been down, so banks posted collateral to pension schemes. But in September and October last year, yields went up a lot and pension schemes needed to post collateral to the banks.
The way these portfolios were generally managed meant that they could stand real rates moves that were significant compared to pre-Autumn-22 market conditions. But during the height of the volatility, the collateral buffers held were equivalent perhaps to only a few days’ worth of movement. The difficulty came when schemes had to find additional collateral to sell quickly. Moreover, no one knew when the increases would end. A scheme may have had enough cash or gilts to withstand a yield rise of 150 basis points, but if it was more than that, they needed to sell other assets to post them as collateral. That is what caused the difficulty. It was a liquidity issue rather than a funding issue.
Within a few days, gilt yields rose 200 basis points. Then, on 28 September, the Bank of England announced it was going to support the market through purchasing gilts up to a certain limit each day. That calmed the market and yields fell considerably. Then they went up. Then they went up again.
The Bank of England then announced that rather than just buying conventional gilts, it would buy index-linked gilts, which calmed the market and yields fell. There were changes at the top of government, calming statements were made and the market settled.
What are your takeaways from the impact on defined benefit schemes’ collateral? If schemes couldn’t find the cash to post, they had to take a risk or reduce their hedge. If that happens – and you only temporarily want to take it off – you likely do it when it is cheap and replace it when it is more expensive. This could cause an element of underperformance. There may also be broader impacts from selling other assets to generate collateral. Looking at the longer-term impact, thinking of LDI portfolios we expect an increase in a scheme’s collateral buffer, especially as the Bank of England’s policy committee had made noises in that direction. And in April, that is what happened when The Pensions Regulator released guidance for a market stress buffer of at least 250 basis points as well as a further Operational Buffer to increase resilience.2
There is also the issue of less leverage in pension schemes. They do not need as much as they had before due to improved funding levels. As funding levels have improved, schemes may choose to have more lower risk investments.
And another big point is governance. If you are a big scheme with a lot of resources then you have people who make sure assets are sold and cash is posted when needed. If you are not, then you need procedures to make sure those people are available if needed. They will have to spend significant amounts of time on these events, should something of the same magnitude happen again.
This is driving consolidation of one sort or another. It could be consolidation in terms of OCIO [outsourced chief investment officer]. Moreover, as an alternative, some schemes are giving LDI managers more assets to manage, so they can access these quickly and directly in times of market stress.
The outcome here could be some form of what we call a collateral waterfall structure. This could be a LDI portfolio supported by cash and something like a short-duration corporate bond or an asset-backed security fund that has daily liquidity. It gives you a bit of return when you don’t need it for collateral, but if you do, you can sell the assets to get cash quickly.
I suspect professional trustees are seeing an increase in interest also.
Is there anything around LDI that should be questioned based on the events of last year?
Pension funds have benefited from LDI during the past two decades. It enabled them to meet their dual objectives of managing their biggest risks at the same time as being able to invest in return-seeking assets that are expected to reduce their funding shortfalls.
Over the long-term, it has been a benefit, but it needs to evolve. As I mentioned, this is along the lines of more collateral, less leverage, more access to other assets and a stronger overarching governance framework, so if there are issues when action needs to be taken quickly, then that can be done.
In this new landscape, DB pension scheme trustees face many tests on many fronts. What are the priority challenges they face?
One comes at this from what we have been discussing: funding levels have improved. There are new funding and investment regulations and the code of practice. At the forefront is the ability to pay contributions to the scheme as and when needed.
We would have thought that with the changes last year it would be time for an investment strategy review for most pension schemes. Our experience is that they are doing this now – with their consultants, their internal teams and with their asset managers.
They may find their asset allocation mix has changed compared with last year. The denominator effect, whereby your LDI portfolio has grown, your liquid risk assets have shrunk, but you have proportionally quite a lot of alternatives and more illiquid assets than maybe you would want according to your asset allocation, perhaps needs to be reviewed in light of your new funding position. What we are seeing, and it is no surprise, is a big appetite for LDI and liquid fixed income. This could be used in that collateral waterfall structure. They are better funded, so need less return and fewer higher return-seeking assets, such as equities.
They can get a lot of what they need from a combination of LDI and fixed income. Government bonds, for example, in short duration, yield 3.5%. Add a bit of investment-grade credit spread on top of that and you are getting up to 5%, which is a considerably higher yield than from short dated credit around a year ago. You can now do a lot with credit that you couldn’t have done in years gone by.
What endgames are DB schemes opting for?
The bulk of pension schemes are still at some stage looking for an annuity buyout, thus transferring their assets and liabilities to an insurer. They have their own resource and many of them are looking to run off their liabilities themselves. There are new entrants looking to come into the market, such as superfunds which have been around a while. So that is a possibility. The assets and liabilities would be transferred from the pension scheme to a superfund which would run them for five to seven years before transferring them to an insurer for an annuity buyout.
The Pensions Regulator looks carefully at the covenant, that link between the pension scheme and sponsoring employer, is broken with the superfund becoming the sponsoring employer.
One thing to add is a variant of that, which is basically the same bridge to buyout methodology but not breaking the link with the sponsor. The capital-backed funding plans seek to do that. The pension scheme will still be attached to the sponsoring employer, but it will be some third party capital that will be used to support any losses in between now and buyout. There is a great deal of interest in that. We are talking to a number of providers and it could well plug a gap. You could well expect to pay a bit more as someone else is providing the risk capital, but you are considerably reducing your downside.
How is inflation and rising interest rates affecting endgames?
Those who are hedged are less concerned. All things being equal, rising rates reduce your liabilities if you are not hedged and the value of your assets go up.
On inflation, a lot of pension fund benefits are linked to it. If inflation goes up that can be a bad thing; that is why many hedge against it. However, if inflation is high then many pension schemes have a cap, so the impact can be more limited. Schemes need to think carefully about how they are impacted. And if there is something that is hard to predict and is potentially damaging, then that would point towards hedging, or substantially hedging.
Then what investment strategy options should DB schemes consider?
It is defined by the funding level and what is happening with the covenant, but more in fixed income, LDI and cashflow matching. Schemes have to consider the endgame objective in the light of the new funding code that would push schemes towards a cashflow matching approach. If you are sufficiently funded to cashflow match you will be largely using bonds (assuming you don’t need an excess return from equities).
Here, it is probably worth talking about bulk annuities. There has been a maximum of £40bn worth of annuities purchased in a year, which is where we are now, and less than 3% of total pension liabilities. A lot of pension schemes are sufficiently funded to buy annuities: so is there the market capacity in insurance to take them? Are there enough people to turn the wheel to make the trades happen? As these are big trades, are there sufficient assets for insurers to invest in? So even though schemes may want to buy out, can they? Perhaps then, it is a sellers’ market – with the sellers being the insurers.
And there is a value loss in pension schemes de-risking up to the point of annuity purchase, but then the insurer re- risking afterwards – what can be done to bridge that?
How influential is ESG over the investment strategy of DB schemes?
It is central to everything we do. ESG and climate risk is investment risk. Stewardship is vitally important and it doesn’t apply just to equities. It can be more challenging with asset classes such as LDI to have a direct impact through portfolio management. However, we take an active role through engaging with the Treasury and DMO on their green bond framework and spending of proceeds. In addition, we engage with our counterparties through our stewardship team on a range of ESG factors.
What is the path ahead for DB schemes?
There are probably a number of categories. The easiest is run off, “stay the course” if you like. Either they are big enough to do that themselves or they join forces with others via OCIO, or fiduciary management through one of the capital-backed funding arrangements.
Then there are those who have targeted a credible path to annuity buyout. They will invest in a mixture of cashflow-matching assets, corporate bonds, illiquid credits and LDI to hedge against the long-term liability risks.
For the ones going to buyout there will be a mixture of corporate bonds and LDI. Watch out for some innovation that will enable them to invest in alternative credits for a longer period, that may even transfer to an insurer. But they will need lots of liquid assets: LDI, cash and some credit when they go to buy annuities.
Then you have a tail who are in a less fortunate position. Their funding levels are not so good and they need to invest in return- seeking assets, equities and alternatives to bridge their funding gap. If there is a covenant gap, they may need to lock down what they have got and get whatever they can. So it will be interesting to see the outlook for DB pensions in the years ahead.
This article was written in partnership with Portfolio Institutional.
