A sharper focus on the endgame
The UK defined-benefit (DB) pension-scheme landscape is changing. The vast majority of schemes are now closed to new entrants, and an increasing number are also closing to future accrual. As a result, DB pension schemes are maturing.
As these schemes mature and as their average funding position gradually improves, trustees and sponsoring employers are increasingly focusing on the ‘endgame’.
The Pensions Regulator (TPR) has also increased its focus on the endgame. The expectation here is that trustees and employers will set a long-term funding target with a clear strategy for achieving their long-term goals. This involves, recognising how the balance between investment risk, contributions and covenant support may change over time, particularly as schemes mature and their funding position improves.
What are the options for the endgame?
There are essentially three broad endgame options for UK DB pension schemes:
- Buy-in/buyout: transferring liabilities to an insurance company through a buyout, potentially preceded by one or more buy-ins
- Consolidation: transferring liabilities to a commercial consolidator
- Self-sufficiency: a long-term run-off of the pension scheme’s liabilities.
Buy-in/ buyout
- This involves transferring the scheme’s assets and liabilities to an insurance company. In return for a one-off premium payment, the insurance company takes on responsibility for paying pension benefits to the scheme members.
- Following a buyout, the trustees and sponsoring employer have discharged their liability to the scheme, which can then be wound up.
Consolidation
- Consolidation can take many forms, including transfer to a ‘superfund’ (where the link to the existing sponsoring employer is broken) or a ‘mastertrust’ (where the link to the current sponsoring employer is maintained).
- At the time of writing, no superfund transactions have taken place, and the regulatory framework in which superfunds will operate is still to be established. However, superfunds are expected to operate outside of the insurance regulatory framework and, therefore, are not expected to be subject to the same regulatory requirements as insurance companies.
Self-sufficiency
- Self-sufficiency involves the ongoing running of the pension scheme using a low-risk investment strategy within the pensions framework.
- With this approach, the focus is on minimising risk and increasing certainty of outcome. It will typically involve investing like an insurer but without some of the constraints.
The option that is right for your pension scheme will depend on its individual circumstances. This includes the covenant of the existing sponsoring employer and your scheme’s funding positon.
Important investment considerations as you move towards the endgame
Regardless of which endgame option you are heading towards, you should think about the most efficient investment strategy to get you there.
- A greater focus on income and cashflow matching
As schemes progress towards their endgame, there is often a greater focus on removing sequencing risk through cash-flow matching. The appropriate level of precision depends on your ultimate endgame destination and how close you are to getting there. - Cornerstone of investment portfolio is likely to include significant allocation to public debt
With public credit often being managed on a ‘buy & maintain’ basis, the primary focus should be on finding an investment manager with a robust process and a strong record of avoiding downgrades and defaults. - Benefits of incorporating alternative sources of contractual income
Alternative sources of contractual income can include a number of assets, from private debt to long-lease real property. These can offer potential for higher yields and improved portfolio diversification. As these assets are often illiquid, it is important to consider the most appropriate way to access them given your endgame destination and expected timescales to get there. - Revisit your interest rate and inflation hedges
Once you have decided on your endgame destination, it is worth reviewing the risks that remain in your portfolio. As an example, how high are your interest-rate and inflation-hedging levels? Are these expressed as a percentage of your assets, your technical provision liabilities, or your self-sufficiency or buyout liabilities? In addition, it is worth considering how your liability-driven investment strategy interacts with your cash-flow-driven investment strategy. - Ensuring ESG is embedded into your investment framework
A focus on long-term environmental and socioeconomic trends is essential for delivering a successful endgame solution. Environmental, social and governance (ESG) factors are financially material and have an impact corporate performance – especially over this long-term horizon. - Are there benefits of taking a holistic approach to your investment strategy?
Depending on scheme size and endgame destination, taking a holistic endgame investment approach can be beneficial. This involves one team developing the optimal asset allocation. This can include optimising exposure to sectors and risk factors, optimising your exposures to individual credit names, collateral efficiencies and a lower governance burden with clear ownership of responsibilities. - Understanding and monitoring your progress
Given the focus on minimising risk, it is vital to take a holistic view of aggregate cash flows and risk exposures across your entire portfolio. Holistic reporting should cover both the progress of your overall strategy, in addition to your manager’s effectiveness in implementing that strategy. - Embrace or exploit the insurance regime
If you are targeting an insurance company buyout, are there benefits, and can you evolve your investment portfolio to be insurance-friendly (‘Solvency II optimised’)? If you are targeting self-sufficiency and investing like an insurer but outside of the insurance framework, what additional investment opportunities does this present for you?
It is clear that a different approach and skillset is required when targeting an endgame solution. As pension schemes progress through their de-risking journey, the investment focus shifts from investment growth to minimising risk and increasing certainty of outcome. A very specific skillset is required to build and implement appropriate investment portfolios to help pension schemes move towards their endgame.