Ian McKnight, long standing CIO of the Royal Mail Pension scheme tells Mona Dohle about running a scheme whose assets are more than five times larger than the sponsors’ market cap and how the scheme tries to address intergenerational inequalities.
The Royal Mail Pension Plan is divided in three sections – Post Office, Royal Mail and Defined Benefit Cash Balance Scheme. Why the need for such a structure?
The Royal Mail Pension Plan looks after the old Royal Mail’s defined benefit (DB) scheme, also called the 2012 section, and the Defined Benefit Cash Balance Scheme (DBCBS), which was launched in 2018 when the old DB scheme closed to future accrual. In addition, we oversee the legacy Post Office section, which is still part of the Royal Mail Pension Plan, albeit a separate section [Post Office is owned by the government, whereas Royal Mail is publicly listed].
The DB and DBCBS sections are legally the same plan but are notionally divided in liability and asset terms. There is no blurring here, but there are benefits to being in the same legal “pot”, not least via economies of scale. That is why we have a structure that might seem strange at first sight.
Your scheme stands out for another reason. Not only have you been in surplus for eight years, but your assets have grown by £1bn in the past 12 months. How did you weather the first storm of the pandemic so well?
A large part of it was due to the early introduction of interest rate and inflation hedging strategies as well as the strong performance of our return seeking portfolio. Given that, in essence, we are hedging the majority of the interest rate and inflation exposure imparted by its (very long dated) liabilities, if you imagine it as a split between return seeking and liability matching, the matching bit of the portfolio was geared [using swaps and gilt repo] to hedge the value of the return seeking exposure as well.
That swap effectively means that instead of having a gilts benchmark, the return-seeking assets need to outperform cash plus a margin to improve the plan’s funding position. So, instead of the return seeking bit trying to beat the liabilities, like the gilt-plus benchmark many pension schemes use, it needs to beat cash because you swapped your linkers into cash.
If you generate positive returns above the cash [liabilities and discount rate] you will increase and improve your funding level. And that’s what happened. On our return seeking assets, we had an investment return target over the period of cash-plus around 3.5% [this varied over the period]. When the return-seeking assets were at their largest, we were achieving double that but with pretty much half the risk. As we de-risked significantly during 2019, this “good news” was locked down to a meaningful degree.
That is just on the return seeking side of our portfolio. In an absolute sense, the total plan delivered 13% per annum, because of the hedge doing 16% pa. Combined, these contributions resulted in the asset growth and strong funding position you are referring to.
You would not get that kind of return from a lot of hedge funds.
Yes, it sounds like the best hedge fund in the world, but I can assure you it isn’t run like a hedge fund. The plan is managed in a very tight risk-controlled way. For the return seeking assets, volatility was 2.8%, which is low for a “risk” portfolio. We also outperformed equities, if you consider that listed equities are typically modelled at 18%, this shows how low risk the plan’s portfolio is. The Sharpe ratio, the return over cash per unit of risk, was 3 for a while.
Anything over 0.5 is phenomenal, anything over 1 is dreamland. A Sharpe ratio of more than 2 means that you are in fantasy world. To achieve a Sharpe ratio of 3 was like nothing I had ever seen. Since inception, our Sharpe ratio is currently around 2, and that is staggeringly good. We are very pleased with how the programme has gone.
That is why it has been so successful. We had a great hedging strategy and a gold dust portfolio that just kept giving as it has evolved over the past eight years. It is also important to remember that markets were forgiving and whatever asset you were in went up, to varying degrees. But to manage that out-turn in such a risk-controlled way is something I am proud of.
Remember the scale: Royal Mail’s market capitalisation is today just over £3bn and since its flotation its profits each year have been a few hundred million pounds.
We oversee pension assets for the group of the order of £14bn. If we had put that all into shares which then dropped by their standard deviation of 18% you would almost have lost the market value of the entire business.
We would not be getting any Christmas parcels next year…
Quite. That is why risk management is such a crucial part of a scheme like ours, which is much larger in scale than its sponsoring business.
How has your broader asset allocation strategy played into the performance?
As mentioned earlier, for the old Royal Mail section, more than 80% of the assets are in the hedging portfolio, which includes gilts and collateral backing the hedge. The rest is in this cash-plus return seeking portfolio. As it is, because we are effectively fully funded, we do not necessarily need massive amounts of return in future. Of course, being fully funded also means that we can afford to take a modest level of risk to get better returns for our members, but we remain on a de-risking journey.
There are two options when you get to that. You can do what the Post Office did and say we have such a healthy surplus that we will seek an insurance deal that gets rid of not just the interest rate and inflation risks but also the mortality risk.
But there is always a cost attached to pursuing this option and for the Royal Mail section these costs could be high as it is an immature scheme, which only stopped accruing in 2018. Most defined benefit schemes only have pensioners to buyout, which are relatively cheaper. In the case of deferred members, such as those in the old Royal Mail section you are talking about double the insurance costs.
The alternative is to manage the assets on a self-sufficiency basis like an insurer would and keep that premium for yourself. What then also happens is that the basis on which insurers price this deferred maturing pension liability reduces over time. So, for us it may be cheaper to wait. However, such ultimate de-risking decisions are considered frequently by our trustee board with input from the sponsor. It is quite a luxurious position to be in, to be concerned about insurance pricing.
For the 12 months to June, our hedging assets for the Royal Mail section increased by 21%, that is £10bn-plus two. Our return seeking assets over that period were pretty much flat, slightly down even. Overall, after fees, assets grew by 17% to the end of June. That was driven entirely by the reduction in the real yield from -2.1 to -2.5, so it is simply the noise of the interest hedge going up and down. We can go plus and minus £1bn in short order, with the assets going up, but so do the liabilities and therefore the funding position is largely immune to the movements in long-dated interest rates. But the return seeking is what makes the difference to your real surplus or deficit. Since 2012, our return seeking portfolio has achieved 6% per annum [time weighted] on 2.9% volatility. As we de-risked significantly during 2019, the money-weighted return achieved would be greater than this.
How was your portfolio positioned going into this year?
The Royal Mail’s DB section has been largely de-risked. We took all the equity exposure out last year, turning a third (£1bn) of it into cash. So, on a money-weighted basis it has done tremendously well.
We went into the year holding quite a lot of absolute return funds [e.g. macro hedge funds], very short duration on credit, private debt and property. We also have some pseudo-hedging assets in infrastructure debt, but they sit somewhere in between the return seeking and hedging element of the portfolio. So, we were effectively long cash and macro funds, which included some of our best performing portfolios, two places where you wanted to be and underweight on the place where you didn’t want to be in the first quarter: the liquid stock market. Similarly, when listed equity markets started picking up we did not get any of that, but bonds and the absolute return assets performed well too in that period, so it has been a decent year. We are restructuring our portfolio and over the next few years will be moving further towards self-sufficiency.
The new DBCBS section, which manages around £1bn, is much more ambitious in terms of seeking returns. Its purpose is to generate these lump sums, which it tries to increase each year. For its first 12 months it gave the inflation-plus increase. But the DBCBS section of the portfolio has a higher equity exposure, bearing in mind that this is a big risk, there is a cap on the amount of risk we can take, and the target return is set out in its trust deed.
That sounds different from a DC scheme.
It is. DBCBS is totally different to the DC scheme, in that the pension lump sum which scheme members accrue each year is guaranteed. If we achieved an inflation-plus increase, which we did this year, then they will also get that increase to the lump sum they receive upon retirement. The design of it is clever, a bit like a with-profits fund without a terminal bonus, but remains underwritten by the sponsor and not left to its own devices.
It is ambitious in what it is trying to achieve, so we have to be smart about it. Given that it only has between 10% to 15% of equity exposure, it needs other assets to provide returns too. So, we went into the year overweight cash and hedge funds. When everything sold off, we had lots of dry powder to invest in cheap high-yielding assets, equities and other opportunistic investments, reducing the cash as we did so and benefitting from the subsequent rallies in markets. It was nice timing with hindsight; we could not have been much better positioned for what ultimately happened.
I remember writing my annual review to my trustees saying that we were expecting a tank in 2020, perhaps around the US election. But then, of course, the pandemic came and we were already [inadvertently] positioned for it. It was a good call that markets were looking for a short-term correction, but you are only as good as the next call.
In the old section we hold a lot of private debt, private equity and real estate. The portfolio is broadly diversified by vintage and asset type. It was impossible to re-create this “Rolls Royce” alternatives portfolio in the new section at that scale because it had no assets when it was first launched. What we did do was to unitise the old book of DB assets – which we coincidentally wanted to sell as part of our de-risking, set up a fair pricing mechanism and re-allocated assets into the new section. So, the new section gets the great benefit of the economies of scale that we have and the established vintage diversity of a more mature private markets programme.
So, this offers the new DBCBS section access to a broader spectrum of assets than a DC scheme?
Yes, and it is not just limited to illiquids, equities and debt are pooled, too. This is especially helpful for property investments. In the old section, we owned buildings directly. It started off with the Post Office section where we bought direct real estate funds.
If we were a typical UK pension scheme with one of the main asset consultants, we would have been guided into a pooled fund, which is the worst way of accessing property in my view. We use consultants under an “open architecture” model. For property, you want to either own it yourself or have a private markets fund which self-liquidates. So, for the DBCBS section, we unitised the funds we wanted so that the new section’s property allocation is well diversified from its first investment. It could not in all reality have practically done that independently.
And the composition of the new section’s portfolio looks different from your old Royal Mail section. It must have been like starting with a clean slate.
That’s right, it has different objectives – as mentioned earlier it has a higher return target than the old closed section. For the first few months, we invested in proxies. I just bought some lower risk diversified funds, but as the money came in we bought things that we thought were cheap and attractive. Now it is a robust portfolio and I am happy with where it is. We still have lots of dry powder coming in and have invested swiftly in some interesting new ideas as a result of the market dislocations caused by Coronavirus.
You also do not have a charge cap?
There is no charge cap for the Royal Mail or DBCBS sections, although the average fees for both are low [not least for the largely de-risked Royal Mail section]. I am hoping that the company, the union and their advisers successfully lobby government to enable structures which accommodate performance fees and a more realistic charge cap for their new CDC scheme, which would enable better access to the opportunities presented by the private markets, especially for a brand new, open and long-term investor – as CDC would be.
Porting over assets from a DB scheme to a less mature scheme could make sense for a lot of other DB schemes. Do any other final salary scheme plan to establish something similar?
I am not aware of any, but it would make sense. Our pool has an open architecture fiduciary approach. We are in-house, we are not a fiduciary manager in legal terms, but we piece together the advice to support it. This is bespoke to us. You cannot get that set-up anywhere else.
We should all take on a job as a postie then?
You are right. They have a remarkable pension plan, they might not know how good it is until they retire but good luck to them – we’re doing our best for our postal workers.
As sponsor, Royal Mail is unique in the UK pensions industry in being the only business to attempt the transition to a CDC structure. What led to such a move?
In 2018, against a background of historically low interest rates, it became clear that the Royal Mail’s defined benefit pension scheme would be unaffordable for the business to continue to support in its current form and so was closed to further accrual.
CDC, of course, was not legislated for in 2018. So, Royal Mail, supported by the Communication Workers’ Union, lobbied the government to initiate legislation to allow for such a scheme, which proved successful. The legislation necessary to allow CDC schemes to be set up in the UK has now reached the final stages of its journey through Parliament, and we expect it to be on the statute book in the near future.
While Royal Mail waited for this legislation it set up a new section of the Royal Mail Pension Plan. This took the form of a defined benefit cash balance scheme (DBCBS), which provides a lump sum upon retirement for its members.
Within the old DB scheme, members have an income at retirement and could “commute” up to 25% of the value of that pension to a lump sum, which most members tend to do. The new DBCBS accrual provides some (or possibly all) of this lump sum on retirement, which reduces the need for members to commute as much of their retirement income. The lump sum is guaranteed at the point of accrual, and depending on the performance of the DBCBS assets, the level of this guarantee can be increased each year.
Royal Mail also offered employees in the defined contribution scheme [the scheme for new joiners since 2008 and separate from Royal Mail Pension Plan] the option to transfer to the new DBCBS once they had completed a qualifying service period. Once CDC is launched, the goal is that all employees should be in a position to receive an equally attractive pension accrual.
The CDC launch process has been delayed by the challenges facing the Pensions Bill. Guy Opperman pledged that the bill would be law by 2020, what does this mean for the Royal Mail’s plans for a CDC scheme?
Of course, the Royal Mail Pension trustee, whom I work for, will continue to manage the Royal Mail and DBCBS sections however long it takes for the new CDC scheme to be launched. We know that Royal Mail wants the necessary legislation in place as soon as possible, so that it can launch its CDC scheme as soon as it is practicalthereafter.
At this point the Company’s intention is that the DBCBS scheme should cease new accrual, and DC scheme [of which, ironically, I am a member myself], will largely be wound down and members will receive their future accrual via the CDC scheme. The old DB section will stay as it is in asset terms, but the members who are still employed in the business will have their future pension accrual provided in the new scheme along with anybody else who joins the company.
Do you think other DB schemes might follow suit?
There are not many left, and many are in the public sector. One can only speculate whether the government might take a view that as people are paying for council tax rises and watching their services fall because that money is going into a black hole in their pension funds, that they might take a look at it. Purely from a social and personal point of view, it would be wonderful if everybody in the country could join the benefits of a scheme like that.
I should note that DC schemes can and do also provide a good pension, if you can get the contribution levels right. The single biggest factor is how much people put into their pensions each year but of course there is reliance on how the investments their scheme fare during their lives. I am optimistic that CDC has the potential to address some of those intergenerational injustices.