With the majority of defined benefit (DB) pension schemes closed to further accrual, one chapter of the UK’s pensions history is gradually closing. Indeed, the number of people enjoying a guaranteed retirement income backed by a corporate sponsor is shrinking.
Pension scheme liabilities have been weighing heavily upon corporate balance sheets and most sponsors would like to see the back of them sooner rather than later. But the process will take time. In the meantime, trustees are being charged with ensuring that scheme members still receive what they are entitled to. A difficult balancing act.
More than 70% of schemes are looking to de-risk – that is to pass the responsibility of paying their former employees’ pensions to an insurer – within the next 10 years. Some are more ambitious, with 39% aiming to achieve this within the next five years, says Mercer.
Yet with the events of the past few years showing how quickly conditions can change, a key question for many DB scheme trustees is: how do they manage their final years? With central banks on the verge of introducing monetary tightening and bond markets being historically volatile, the de-risking process has become less predictable.
For instance, rising gilt yields have been good news for fixed income heavy investment portfolios. For the first time in more than a decade, final salary pension schemes have been consistently in surplus during the past year, according to the Pension Protection Fund (PPF). By the end of February, DB schemes in the PPF universe booked a solid aggregate surplus of £133bn, giving them a funding ratio of 109%. In contrast, just two years ago, the aggregate deficit stood at £124.6bn, meaning that final salary schemes were only 93% funded.
This stark improvement is, of course, driven by the marginal rise in gilt yields combined with relatively favourable asset price valuations. But experienced trustees know that the pendulum could easily swing to the other side.
Another threat is a potential rise in inflation, which could wreak havoc on fixed income heavy portfolios. Granted, the majority of mature DB schemes have hedged most of their inflation and interest rate risk, but 70% of plans are not fully covered, according to Mercer’s latest de-risking survey.
A good year
With DB balance sheets at generally favourable levels, now might be a good time to grasp some opportunities to de-risk more of their liabilities. It is no wonder then, that insurance companies are predicting a strong year for buyouts.
But are trustees following suit? Buyout providers are optimistic that they will. Rohit Mathur, head of international reinsurance business at Prudential Retirement Strategies, believes that the market will continue to grow. “All indications are pointing to a strong 2022,” he says. “It’s early in the year but consultants are predicting a similar market to last year, perhaps even a little bit higher at between £30bn to £40bn worth of PRT buy-in and buyout deals. Looking at the pipeline, that is a realistic assumption.”
But the flow of transactions in the bulk annuity market has slowed somewhat. Following the record years of 2018 and 2019, where transactions worth in excess of £40bn were booked, growth slowed to £30bn in 2020 and £28bn last year, according to Barnett Waddingham.
Mathur believes that 2022 could be the year where a number of larger retirement funds pursue buyout transactions, chiefly because UK schemes are much further along their journey and bond market volatility offers a chance to lock in favourable rates.
“Volatility could also mean that there may be more opportune times in the market where pricing becomes more attractive. We saw that in 2020,” he says. “Again, the key is, are you ready to transact, have you done your homework?”
Dinesh Visavadia, director at Independent Trustee Services, agrees. “Credit spreads have widened. That gives a real good opportunity for many schemes and pushes them towards the buyout or buy-in region. “They are now within touching distance of that,” he adds. “That is an unusual situation to have within the corporate setting.”
But the flipside of volatility is a dent in investment returns and stark swings in asset valuations for schemes that may be further away from a buyout scenario and are not fully hedged. The onus is now on the trustee to form a plan to manage those liabilities, says Alan Pickering, president of BESTrustees.“There is tremendous pressure on sponsors with a legacy DB scheme to try and take advantage of either risk transfer or the various forms of consolidation that are coming onto the market.”
For those schemes, bond market volatility can be stressful, says Kevin Wesbroom, a professional trustee at Capital Cranfield. “One month we are talking about £57m in liabilities and the next month it is £67m. That is pretty scary.
“Last month interest rates changed by 30 basis points in just one day,” he adds. “Those are the sort of things that lead you to believe that if you want to get anywhere near a buyout, you want to fully hedge your interest rate and inflation exposures.
“Realistically, for schemes that are not fully hedged, buyout has moved a bit further away, unless you have a benign sponsor who is prepared to put more money in. I do not see many sponsors doing that in the current environment,” Wesbroom says.
Another way to cover the shortfall might be by increasing the investment return targets in the liability-driven investing (LDI) portfolio, Pickering says. “Schemes that are a little further away from a buyout may be reviewing their asset allocation and looking at the leverage within that LDI portfolio to decide whether there are other near cash assets that might provide a little extra return and could get them even closer to their destination more quickly.”
Pickering believes that there are now opportunities to move from the cash element within the LDI portfolio to credit or near cash with varying degrees of longevity. “Obviously, you have to avoid an expensive round trip. You would not want certain asset classes that you could not get in and out of within a few months because of costs. But these are opportunities to bring forward the time when you can affect a risk transfer,” Pickering adds.
In Pickering’s experience, schemes looking to position their portfolio for a buyout would not necessarily have to mirror the portfolio of the insurer. “It is rare for schemes these days to transfer in specie. You might want to mirror what the insurer will be doing, but there is no guarantee that the insurer will take your assets in specie,” he says, adding that liquidity and avoiding high entry and exit costs should be the key priority. “The aim is to get the sweet spot between the premium from going slightly away from cash without increasing the round trip,” Pickering says.
For Visavadia, a key problem with planning a buyout deal is the opaqueness of pricing. “My biggest concern is that I can understand what markets are doing and where my investments are going but I just do not understand the pricing mechanisms insurance companies have. It is a dark world and there is no transparency around it,” he says. “It is not clear whether I need to hold 100% or 110% of my technical provisions because the price changes almost every week and we cannot track it in any meaningful way,” Visavadia stresses.
“Another problem is that as schemes are better funded, the supply-demand equation changes, and as demand for buyouts goes up, the price goes up and that might mean that none of us can afford it. The opaqueness of the pricing of buyout deals is really uncomfortable,” he adds.
But a buyout is by no means the only option on the cards, and it is the most expensive way to deal with outstanding liabilities, as most trustees are well aware. They have to target the most prudent funding level, factoring in the insurance premium they would have to pay for disposing of their liabilities.
And trustees, by nature, have to be frugal. Their priority has to be the financial interest of scheme members, rather than that of the sponsor or insurance company. This means that on the journey towards the endgame, the home-made sandwich, also known as self-sufficiency, still trumps the slightly more expensive prepacked meal deal, also known as buyouts. Almost half (44%) of pension schemes are planning for self-sufficiency, compared to 34% for a buyout meal deal, according to Mercer.
Perhaps more importantly, the share of those planning to pick up their lunch along the way, also known as technical provisions, has dropped to 22% from 34% in three years, according to Mercer’s latest de-risking survey. One explanation for slowing growth is the emergence of pension consolidators such as The Pension Superfund, Clara and, more recently, the master trust jointly launched by Abrdn and XPS Pensions. Visavadia, Wesbroom and Pickering admit that this pooled lunch, to stick with the sandwich metaphor, is now an option on their clients’ agenda.
“We need to start thinking about the endgame differently,” Visavadia says. “As trustees, there are choices available to us and consolidators are one possible option. Not everybody is going to aim for a buyout. We need to keep an open mind, especially when employers are seeing buyouts as quite an expensive proposition.”
Regardless of which de-risking option trustees choose, the defining factor remains that the current market environment might bring the end of the DB scheme era forward, Pickering predicts. “DB schemes that are already closed to further accrual will want to transfer as quickly as possible, particularly those with overseas parents,” he says. “At one time, US employers did not like the idea of journey planning, they just wanted their assets to sweat. Whereas now, they increasingly find that by hanging onto a closed DB scheme, they are carrying an unrewarded risk.”