The world today looks very different to how it did in 2020, when David Fairs, head of policy at The Pensions Regulator (TPR), introduced his proposals to secure the funding status of defined benefit (DB) schemes.
Back then, record low interest rates were a pressing concern, inflation was low and the world was yet to hear of Covid-19. Two years on, inflation has hit double-digits in the UK and the global economy has been brought to a grinding halt by a pandemic. There is now a bigger risk of sponsor default. At the
same time, rising gilt yields have completely changed estimates of the present value of liabilities and most DB schemes report a surplus.
Over the course of just two years, the funding ratio of schemes in the Pension Protection Fund’s (PPF) universe jumped to more than 110% from around 70%. As of July, schemes collectively sat on a surplus of more than £250bn, according to the PPF. This is despite a significant drop in the assets they hold, from almost £1.8bn in 2020 to around £1.6bn two years later, due to a rapid fall in s179 liabilities.
And there is another factor to consider: more than 80% of final salary schemes are cashflow negative and in the next 10 years, 98% will no longer receive contributions, according to Mercer.
This means that investment strategies will have to navigate capital preservation and cashflow management strategies. At the same time, schemes that are still open manage significant assets, from USS and Railpen to the local government pension scheme pools.
Stronger balance sheets may have accelerated the endgame for many DB schemes, but investment returns are harder than ever to predict. This raises the question: how should DB schemes approach de-risking?
The death of DB?
The stated aim of TPR’s new funding rules is to strike a balance between ensuring that final salary scheme members – some 10 million of them across the UK – receive their benefits in full, whilst ensuring that sponsors can afford to sustain the pension. The regulator also has to tread a careful balance between achieving some form of consistency of measuring funding standards without being too prescriptive.
Enter a second DB funding consultation, which launched in July to address the question of securing retirement incomes without bankrupting sponsors. Many readers will be aware that when the regulator launched its DB Funding Code consultation in 2020, it was criticised, particularly over the suggestion of a “fast track” approach to assessing funding standards in an attempt to simplify the process.
Though perhaps not intended by the regulator, the word “fast track” does not invoke positive connotations for many trustees, raising the question: fast track to where? The regulator found itself being accused of pushing forward the prospect of buyouts and, by extension, the death of DB schemes.
This criticism stuck throughout the introduction of the Pensions Schemes Act last year, where the requirement of “low dependency” for mature schemes had a mixed response. In a nutshell, the regulator expects schemes to be invested in lower risk investments by the time they reach maturity.
The regulator elaborated on this with the draft consultation on the DB funding rules, which launched in July and are set to close this month [October]. Again, the industry was up in arms and David Robbins, senior consultant at Willis Towers Watson, summed up why feelings were strong: “Today’s draft funding regulations formally resurrect the idea that deficits should be cleared as quickly as the employer can reasonably afford, after this was dropped it 2014,” he said.
Consultants, industry experts and trustees warn that this focus on low dependency could have the opposite effect. Charles Cowling, Mercer’s chief actuary, warns that the regulations are set to accelerate the endgame of British DB schemes over the next 10 to 15 years and research by pension consultant Lane Clark & Peacock (LCP) warns that this requirement could bankrupt hundreds of final salary scheme sponsors.
Chicken and egg
While the regulator does not specify which assets schemes should invest in, it defines low dependency as “sufficient assets invested in a low dependency investment strategy to provide for accrued pension rights and is not expected to need further employer contributions”. For better or worse, schemes seem to have taken that as following a liability-driven investment (LDI) strategy, whereby assets are invested in fixed income and hedged against inflation, interest rate and longevity risks to meet the present value of liabilities.
Some 73% of DB funds employ an LDI strategy, according to Mercer, LCP estimates that the value of schemes embracing the strategy is as high as 80%. This concerns particularly medium-sized schemes with assets between €50m and €2.5bn (£44m-£219bn), while larger DB plans often do not use them as they remain open.
But the focus on low dependency is set to accelerate the trend towards investing in LDI assets, warns Con Keating. “The new funding regulations, the portfolios that everybody is going to be forced into, are LDI portfolios, and that would be a disastrous mistake,” he said.
“The funding regulations say that you have to be invested in a low dependency portfolio. This means, people will have to sell their growth assets to buy inflation linked and conventional gilts. Depending on their holdings, let’s say 450 billion at an excess return of 4%, multiply that by 450 billion and the differential is significant,” he adds.
Mercers Charles Cowling agrees. “The draft proposals would force the sale of £500bn of return-seeking assets, the majority being required before 2040,” he says. This is based on an assumption that DB schemes in the PPF universe collectively hold £500bn in return-seeking assets.
Cowling also warns that this could see some £200bn of liabilities added to the balance sheets of employers responsible for DB schemes during the next 10 to 15 years. This estimate is based on the difference between the cost of pension scheme liabilities already accounted for compared to the cost of securing benefits with an insurer. It also includes the prediction that the new rules could bring forward the date that trustees and sponsors are forced to transfer pension scheme liabilities to an insurer.
But for Dan Mikulsis, partner and lead investment adviser at LCP, it is far from clear that DB schemes are required to sell all their return-seeking assets. “One issue with the commentary around it is that there aren’t enough details in the public domain yet and there is now an information vacuum which the industry has filled with educated guesses with a bias towards negative thoughts, because they make the headlines,” he says.
Mikulsis adds that in the absence of detailed information, the most detailed reference to asset allocation is the regulator’s 2020 guide to the DB funding consultation, which implies a 20% exposure to growth assets, even at significant maturity.
“Everyone is jumping to this conclusion that they are going to be forced to sell growth assets, but that is not necessarily the case. If the regulator decides that they are going to be happy with 20% that might even do the opposite, it could even be that schemes were able to take a bit more risk than they thought at
significant maturity. But most schemes are on a path to de-risk quite a lot,” he says.
To put this into context, mature schemes, defined by the PPF as those with 75% to 100% of liabilities are related to current pensioners, are less than 10% invested in equities. The same goes for schemes with a lower level of covenant strength. Only 13% of those schemes are invested in equities, compared to
17% for schemes with a strong covenant, according to Mercer. Mikulsis says that critics might be getting the chain of causality wrong. “De-risking has happened for the past 10 years, not because anyone has regulated it but because people decided that it was the right course of action,” he adds.
So the debate around DB de-risking being stuck in a chicken and egg loop, with proponents and advocates arguing whether regulatory pressures or market conditions were the driving factor in pushing investors into LDI portfolios.
But perhaps the crux here is a different question, should investors continue to allocate in to LDI portfolios given that market circumstances have changed dramatically?
Bond markets have been on a rollercoaster over the past year but overall, a sharp rise in gilt yields has benefited DB schemes. This was accelerated by the new government introducing price caps on energy and announcing other fiscal measures, which could lead to additional gilt issuance of £250bn during the next two years.
Yields on long-dated gilts have now been pushed to their highest levels in 20 years, a trend which will again drive down the present value of DB liabilities and accelerate investment returns for schemes invested in UK long-dated bonds.
But there are also counteracting factors, which critics of LDI strategies are keen to point out. One is that linkers, the primary tool DB schemes use for protection against inflation risk, prove to be costly in a rising rate environment. With the price of linkers being inversely related to real yields and closely correlated to inflation expectations, an environment of rising rates and falling inflation expectations means that linkers are likely to incur significant losses.
It is yet too early to assess how this has affected DB schemes with LDI strategies so far but Keating estimates that they would have incurred billions of losses as a result of the double whammy of rising rates and lower inflation expectations.
LCP’s Mikulskis counters this criticism making the point that LDI has performed as expected this year. “Linkers have gone down but that goes back to the mirror image concept of any hedging strategy. The whole point of LDI was supposed to be to perform a mirror image of what liabilities are doing and it has done exactly that, though the moves have certainly been very fast,” he says.
But linkers aside, there are other challenges for LDI investors. One problem is that inflation is set to hit fixed income assets much harder than equities. And with UK inflation forecasts ranging from a conservative 13% by the Bank of England, to 22% according to Goldman Sachs, central bank rates are widely expected to exceed 4% by next year. But DB schemes that have already bought into linkers with a long maturity are now locked into duration risks.
Investors might also struggle with UK inflation rising at a much faster pace than in Europe and the US. This means that Tips – US inflation-linked debt – offer insufficient protection from UK price rises.
Other factors to consider are the volatility and liquidity risks that come with LDI strategies. One key element of such strategies is that the remaining interest rate, inflation and longevity risks would be hedged by derivatives, with the more secure bond assets used as collateral. This meant that many DB
schemes have built up significant leverage. USS, for example, reports that more than half of its assets (56.4%) are matched against its liabilities, at a net leverage of 27.4%.
If LDI strategies were entirely implemented through derivatives, the combined volume of collateral calls could be as high as £380bn, former Columbia Threadneedle fund manager Toby Nangle told the Financial Times.
Such levels of leverage must be painful to navigate when bond markets are facing huge swings, resulting in large scale collateral calls on the liabilities they used to hedge their liabilities.
Consultants and investment partners working with DB schemes have confirmed that these collateral calls are hitting schemes hard, with some, particularly those in pooled LDI strategies, forced to sell their growth assets to meet margin calls.
Advocates of LDI strategies would counter this with the fact that the damages made to a scheme’s assets have been offset by the sharp fall in liabilities. Because the calculation of liabilities is so sensitive to the slightest upward movement in gilt yields, at this point few questions are being asked about losses on the asset side.
Where proponents and advocates of LDI agree is that improvements in the funding status of DB schemes have dramatically accelerated the endgame for many final salary schemes. And this is why the debate on the DB Funding Code is so hard to resolve. It touches the core of the UK pensions provision. DB
schemes are winding up faster than expected and while defined contribution (DC) schemes have expanded the reach of pension provision, the actual retirement income they offer risks being insufficient to sustain people throughout retirement.
Meanwhile, longevity continues to increase. This means that the responsibility of paying members benefits does not disappear, but it shifts from UK companies who sponsor final salary schemes to insurers, consolidators and DC scheme providers.
[This article was written at the end of August any opinions quoted reflect the information available at the time.]