An excellent – if very specialist, article! The author is Legal & General’s John Towney. You can read the original here
A few years ago, I worked at a very special and unique place called Redington where I had the privilege of advising a handful of multi billion pound defined benefit pension trustee boards on their investment and risk management policies. It was a multifaceted job that involved helping these boards define their funding objectives and then implement asset allocation strategies that balanced their return requirements against risk tolerances and liquidity constraints. While the job required good analytical and communication skills, the one exam question that I felt I needed to answer each and every board meeting was whether what I was recommending would deliver the highest risk adjusted returns to the pension scheme.
For most asset classes, this is a straightforward question to answer. When assessing different investments and how they can fit together in a portfolio, investment consultants will often look to a measure called the Sharpe Ratio. Rather than looking at return only, the Sharpe Ratio compares return to risk in order to help investors understand both the upside and downside of an investment. For example, most investors assume that equities will generate higher returns than bonds, but this is only half of the story. Equities can also be expected to decline by more in unfavourable markets and therefore carry more risk. The Sharpe Ratio takes account of both return and risk and by doing so, enables investors to assess investment opportunities in risk adjusted terms and build more efficient portfolios to target the highest returns for a certain amount of risk.
End game management is not a pie chart and asset allocation decision
When a pension scheme is in deficit, as most are today, the question that trustees are typically looking to answer is what is the most efficient portfolio in terms of risk adjusted returns for a given funding objective, time horizon and level of contributions agreed with the sponsor. As the scheme’s funding level improves, however, the picture begins to change and the decisions that trustees need to make become more nuanced and multi-dimensional. End game management is about protecting, rather than improving, the scheme’s funding level while still delivering on the obligation to pay member benefits. In practical terms, this is more complex than commonly assumed.
End game management is what insurance companies do
When a pension scheme has reached its funding objective, concepts like the Sharpe Ratio become less relevant. Rather than generating returns in excess of the liabilities, the focus for trustees will shift to achieving other objectives, such as:
- Sourcing assets that will produce the cash flows required to meet member benefits as and when they fall due;
- Managing a precise hedging programme and ensuring that there is always adequate collateral to support it; and
- Provisioning for reinvestment, expense, regulatory and other unknown risks.
In other words, managing an end game portfolio begins to look and feel a lot like what insurance companies do, namely sourcing complex assets, matching cash flows, managing basis risk, stressing collateral availability and provisioning for unanticipated risks, and all of this must be done when the trustees’ and sponsoring company’s tolerance for knocks to the scheme’s funding level (or solvency, to use an insurance company term) is greatly reduced.
Self-sufficiency versus buyout
Many trustee boards simply do not have the resources or the governance structure to run this kind of portfolio where the margin for error is zero, while most sponsoring companies have little appetite for increased complexity and expense at this stage of the journey. Rather, both trustees and sponsoring companies typically want to get the pension scheme into a de-risked position where it can run-off without further reliance on the sponsor covenant. For these reasons, a large number of schemes are simply targeting a buyout with an insurance company as their end game objective, but others, particularly larger schemes, are targeting what they commonly refer to as “self-sufficiency”.
Self-sufficiency means different things to different schemes, but it generally is defined as having the following characteristics:
- The scheme is fully funded on a conservative basis (e.g., liabilities valued at Gilts + 0.25%);
- It no longer requires deficit repair contributions from the sponsoring company;
- It has managed down interest rate, inflation and potentially longevity risk;
- It is invested in a portfolio of conservative investments that generate the cash flows the trustees need to pay member benefits as they fall due; and
- The trustees are able to pay out member benefits without a deterioration in the scheme’s funding level.
When thinking through these objectives and what they entail, increasing numbers of trustee boards are deciding to partner with an insurance company, even if their ultimate objective is self-sufficiency rather than buyout.
Do-it-yourself versus outsourcing to an insurer
It is these dynamics that have been driving the growing trend for pension schemes to purchase buy-in policies, often to back some or all of the pensioners in payment, as they manage their journey to self-sufficiency. In these arrangements, a scheme will often exchange gilts (a “matching asset”) for a buy-in policy (a “perfectly matching asset”) and essentially outsource the management of the end game portfolio to an insurance company, thereby freeing up the trustee board to focus on the investment strategy backing the active and deferred members.
Buy-ins offer attractive investment characteristics regardless of the end game objective
For many trustee boards, this is a tidy arrangement that suits their governance bandwidth, but coming back to our original question of how does it stack up in investment terms, a buy-in also has an attractive risk and return profile.
Let’s first look at return. A buy-in is a perfectly matching asset and does not have any excess return, per se, but an alternative way to assess its return is to consider what it would cost a scheme to obtain the same protections on a do-it-yourself self-sufficiency basis and to answer this question, it is helpful to consider what a buy-in provides:
- Perfect cash flow match: a buy-in policy covering the in-payment pensions will pay the scheme the exact cash flows it needs to meet its payroll;
- Longevity protection: a buy-in protects the scheme against the risk that members live longer than expected and the scheme has to pay pensions longer than expected;
- Perfect inflation hedge: a buy-in provides a perfect inflation hedge, including any caps and floors that the benefit structure may include as well as any CPI links;
- Credit and covenant enhancement: a buy-in is backed by the Financial Services Compensation Scheme (FSCS) which is an additional protection beyond the sponsor covenant and PPF backstop at the scheme level.
Most pension schemes would need to generate on the order of 0.75% of excess return to get the longevity, inflation and other protections that a buy-in provides. For those schemes that have a weak sponsoring company, the trustees may place an even higher value on the FSCS protection that comes with a buy-in.
For a pension scheme that has set a self-sufficiency target of Gilts +0.25%, the trustees would then need to generate Gilts +1% to replicate the buy-in and to support the 0.25% spread in the liability discount rate. This hurdle rate on a do-it-yourself self-sufficiency basis may be even higher when the trustees take account of the expenses, such as lawyer and investment management fees, associated with running their self-sufficiency portfolio. In today’s market, it may be possible to generate these kinds of returns with gilts and corporate bonds only, but the scheme may find itself in a position of not having enough gilt collateral to support the hedging programme in times of stress. Therefore it is likely the scheme would still need some exposure to risky assets (e.g., a 10% allocation to equities) to strike the right balance between return and liquidity which also means that the scheme would still carry downside and mark-to-market risk, whereas with a buy-in, all of these risks are outsourced to the insurance company.
But, what is the trade-off? While a buy-in is a perfectly matched asset that enables the trustee board to transfer investment, inflation and longevity risk, this transfer comes in exchange for counterparty risk to the insurance company. This counterparty risk, however, is mitigated by the FSCS protection covering the policy and it can be reduced further through a collateral agreement with the insurance provider, albeit this might come at an additional cost. The end result is that the trustees will have secured their members’ benefits in a very robust way through a buy-in, as the scheme will hold an asset with FSCS protection, will potentially hold collateral and will still have the sponsor covenant and PPF backstop – and all the while will have transferred the investment, inflation and longevity risk of meeting member benefits to a regulated insurance company.
Insurance solutions are not just end game strategies
The ‘so-what’ of all of this is that an often overlooked aspect of insurance solutions is that they do indeed offer attractive risk and return characteristics and can play an important role in an investment portfolio even if the trustees’ ultimate objective is not full buyout. The issue, however, for many schemes is affordability, but for those schemes that have excess gilts, a transition into a buy-in is often an attractive investment proposition. In addition, as schemes continue to make progress with their journey plans and funding levels improve, insurance solutions are an effective way to “bank” gains and protect funding levels going forward. Insurers, meanwhile, are working hard to increase affordability and help pension schemes transact at earlier stages in their journeys, particularly through new asset and reinsurance strategies. All of this means that the lines between insurance solutions and the investments traditionally used by pension schemes are beginning to blur and the pension risk transfer market is shifting from one that only involved a once-and-for-all decision for a trustee board to a more dynamic market that offers trustees greater choice and certainty in securing their members’ benefits.