In this article, I refer to some recent analysis by Kempen of the opportunity opening for DB schemes to create surplus, if current gilt yields remain. I support the analysis, though I lament the opportunity cost of a wasted decade when pension schemes invested in instruments with negative real returns
I was drawn to Kempen’s analysis of alternatives to buy-out by its comparison of a capital backed journey plans with Superfunds.
Because Clara is the only superfund , it is what superfunds have come to be. It is a sorry state of affairs that what superfunds have come to be , is so diminished that it has no ambition to run on schemes for more than 10 years. But what is more revealing is that while a superfund is constrained to produce returns between 1.5% and 2.5% above gilts, Kempen’s assumptions for schemes with an additional sponsor are for returns 3.5% to 4.5% higher. That is bold.
For returns as high as Kempen assumes for CSJPs there will need to be a substantial increase in the proportion of a DB’s scheme being return seeking and some heroic assumptions on the returns CSJPs can expect on those assets.
Small wonder that Kempen consider
The key takeaway here is that there is great potential to generate a large amount of surplus within the UK DB pensions market, even after allowing for a continuation in the significant buyout activity of £50 billion per year. This opportunity is overwhelmingly anchored by larger schemes (£500m+).
The opportunity cost of buy-out.
You would have thought, the opportunity being available to most sponsors to take back surplus to und better pensions and/or invest in the company for greater productivity, that there would be considerable demand for capital backed journey plans. There is.
However, no recent CBJPs have been reported since the emergence of schemes from the LDI trauma and one has to ask why. I have to agree with Kempen’s conclusion
The UK’s defined benefit market is huge and is if Kempen’s assumptions are correct, it has the capacity to transform large corporate finances,
The industry finds itself in unique situation which very few would have predicted at the height of the COVID pandemic in 2020. We estimate the surplus as at February 2024 (on a proxy buyout basis) to be in the region of £210bn. Even allowing for a blockbuster decade of buyout activity at £50bn p.a., aggregate surpluses could reach half a trillion pounds across the industry over the next 10 years.
The biggest risk pension schemes face today is “opportunity risk”. The opportunity is to get a share of that £500bn surplus, the risk is failing to do so.
In “comments” over the weekend, John Mather asked whether the imputed deficits that drove the leverage of LDI could be compared with the tactics of advisers frightening savers into pension scams. Pension Oldie’s response deserves more prominence than the comments section.
The answer is that both can be devastating. However as in all scams the individual is left with a feeling of guilt from a feeling of person responsibility.
In the case of LDI the responsibility is shifted to the Trustees and their advisors (also in my view The Pensions Regulator) in encouraging schemes to switch their investments to those with negative real returns. Also the bulk of the losses were and are being borne by the scheme sponsor in deficit contributions that should not have been required.
Also the individual pensioner has lost potential pension prospects (a loss of expectation which he or she may not have recognised) rather than an absolute financial loss. So in spite the vastly increased number of members and pensioners affected, the loss feels remote and hypothetic to the individual even though the effect may not be any less.
For example do the Debenham’s employees who lost their jobs blame it on the £350M reported deficit that has proved to be entirely illusory?
We have thrown away £166 bn in assets by not unwinding LDI in time, let’s not throw away another £500 bn by buying out our DB plans.
There is a need for a label that identifies a regulated adviser.
The losses seem to be sold by unregulated individuals. Transfer of pensions need to be looked at in two transactions
1) The move from DB at 40x promised benefits
2) The subsequent portfolio chosen
Demonising advisers drives beneficiaries away from regulated advice into the arms of crooks. The incidence of victims amongst the 6% advised is very low.
Where the promoters of LDI regulated by the FCA?
An excellent paper from Kempen, not just because of the 44 mentions of risk and guarantees. Risk and return are key aspects of capitalism, but downside risk, think near naked pensioners on a beach stripped of their pensions, democratically dictated the DB funding risk balance. QE and lack of QT just catapulted political expediency and is arguably the bigger problem.
Hopefully the PRA will keep UK insurers’ financial reassurance (regulatory arbitrage) to very low and manageable levels, albeit they can’t control US insurers or the risk of contagion. Avoiding insurers joining highly leveraged banks in the “too big to fail” league would be most welcome.
The worst of the LDI debacle is yet to come.
The TPR appears hopelessly out of date and appears intent on making things considerably worse.
As Con Keating and Iain Clacher demonstrated https://henrytapper.com/2024/04/03/the-video-the-slides-and-the-feedback-on-con-keatings-data-tour-de-force/ the loss of pension scheme assets during the “LDI crisis” manifestation of the problem was considerably greater than the TPR reported mainly because it was using out of date information and that the nearly 1/3 of pension schemes remained in deficit compared with the TPR’s estimate of 8%. Even this was based on the premise that because the gilt yield had increased, the remaining assets of the pension would magically generate double the income each year going forward for the remaining life of the scheme. (The nonsense of “it doesn’t matter that assets have been lost because the “liabilities” have gone down more”).
The overarching responsibility of a DB Pension Scheme is to pay the benefits as they fall due. The cash to pay the pensions, other benefits and administration costs in the year comes from new contributions paid in, the interest and dividends received with any shortfall required to be made up by the sale of the scheme’s investments. The key to the success of the scheme is therefore that it manages to minimise the outflow of the capital assets with the highest yielding assets being retained longest.
When we look at the diminished assets of the pension schemes after the crisis period we find a higher proportion of assets are now in lower cash flow generating classes, such as leveraged LDI funds and stable income generating assets such as property, infrastructure etc. have been sold or are intended to be sold at a discount. The result for closed schemes is an ever increasing deficit or reducing surplus with an increasing requirement to sell further assets and the potential to buy-in or buy-out either with an insurer or a consolidator disappearing ever further into the future. The only alternative being substantially increased deficit contributions from the scheme sponsor until such time as the run-out scheme experience reduces the outgoings to level that can be managed from the investment income and asset sales.
By continuing to focus on its historical valuation data without reference to the post valuation date cash flow position of the Scheme, the TPR is blinding itself to the problem.
There is of course one way to increase the cash flows into the scheme – that is to re-open the scheme to DB benefit accrual. In that way the new contributions from both the employer and employee can be invested in high income earning assets to allow the current pensions to met from the sale of the lower income earning assets. This would permit the gradual improvement in scheme funding and a diminishing need for additional deficit contributions.
Employers should therefore consider the level of DB benefits they can reasonably promise from a given level of contributions (e.g. the proposed auto-enrolment minimum of 12%) taking a prudent but realistic view of the investment return into the long term future the scheme can expect to earn – that should certainly not be based on a volatile historic gilt yield. The resulting defined benefit should then be compared to the pension benefits the same contributions would provide to the employee in the DC alternative.
Fanciful – I think not!
Closed DB schemes could reasonably consider reopening if the covenant is reasonably strong. Where the opposite is true then transfer to a superfund (or similar), de-risking for safe run-on, or buy-in to lock in future income are probably more attractive.
I agree LDI destroyed a lot of value for many, but where I think LDI was useful was in preventing some schemes with weaker sponsors forcing the liquidation of the sponsor whilst the period of low rates was endured. LDI bought the extra time for the scheme to survive to enable it to now consider the various end game options. Yes, assets might well have been higher if LDI had not been used but would the sponsor and scheme have survived long-enough to use them?
I think it was Patrick Head of the Williams F1 team who said “To finish first, you first have to finish”