The need for return engines, whether to deal with these risks or to help plug funding gaps where they remain, is particularly pertinent as decumulation erodes the assets of more defined benefit schemes. As Steve Aukett cohead of solution design within the Financial Solutions Group at Insight Investment says: “Schemes that are cashflow negative face a problem if returns are not generated consistently. If the assets underperform the liabilities, the problem gets harder as a smaller asset pool has to generate greater returns. These schemes should place a greater value on assets that have a higher certainty of outcome, such as fixed income and credit, which are contractual obligations with fixed maturities and investors are higher in the capital structure than equity holders.”
Certainty of outcome is also important in providing much needed capital protection against valuation anomalies. Where a return engine is more unconstrained in nature, and are therefore able to invest in a broader opportunity set, they can also avoid bubbles in some sectors.
High yield, for example, has become so popular in recent years, prices are looking increasingly rich. Bank of America Merrill Lynch estimated the total size of the global high yield bond market to be $1.2trn at the end of March.
The over-reliance of large credit funds on the primary market, has allowed investment banks to dictate prices in favour of the issuers. In contrast, a reduction in demand for senior secured loans, which share many attributes with high yield, including their tendency to be low-duration, makes them relatively more attractive.
Although de-risking into LDI strategies provides much needed relief for trustees and sponsors, the job is far from done. Other risks remain, which are harder to hedge or are largely ignored, but can materially impact scheme liabilities. The need for a return engine to hedge against those risks cannot be underestimated, especially for schemes in decumulation.
As Invesco Perpetual’s Batty concludes: “Schemes need an investment vehicle alongside their LDI strategy to cover risks that aren’t hedged, including wage inflation and increased longevity. It is important that any vehicle provides a smooth return profile with capital preservation qualities.”
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