It has been 11 years since the Society of Pension Professionals (SPP) published its Vision 2020 paper and, while it’s impossible to predict the future, the 2012 edition turned out to be quite prescient – at least in one respect. That concerned the observation that UK defined benefit (DB) pension schemes’ collective demand for index-linked gilts substantially outstripped the available domestic supply.
This demand-supply imbalance led the SPP to expect sustained upward pressure on index-linked gilt values, and corresponding downward pressure on yields, over the decade ahead (which proved right).
Vision 2030 has been published at a rather different time for financial markets and UK DB schemes. With yields higher, many schemes’ funding positions have surged from deficit to surplus.
Even on the most prudent bases, and trustees and corporate sponsors have been accelerated along their journey plans, finding themselves ready (earlier than expected) to consider fully securing their scheme’s liabilities with a bulk annuity insurer.
And so, as we look ahead to the next decade for these schemes, and particularly the challenges to navigate investing their £1trn+ of assets, the importance of running a resilient portfolio which is able to withstand market dislocation has gained prominence.
Accordingly, a key theme of the 2020 paper is also a key theme of the 2030 vintage – whether the way in which schemes manage their inflation exposure (through recalibrating their conventional and index-linked gilt holdings) is potentially susceptible to inflation expectations moving in the opposite direction from their upward trajectory of the past 12 months.
The explanation for the concern the paper identifies in relation to inflation is technical, but boils down to the fact that, because pension schemes’ inflation-linked liabilities typically carry a floor of zero, trustees will not want to be holding index-linked gilts at a time when markets are expecting a period of deflation and, if schemes are seeking to offload their unwanted linkers into a thin market with weak sentiment at around the same time, the hallmarks for systemic risk would seem to be present.
Managing illiquid asset allocations is the second key challenge that our Vision 2030 paper identifies for DB schemes, particularly where their endgame is full buyout with an insurer.
While schemes, insurers and their advisers are actively innovating to find solutions to the problems (for premium payment) posed by outsized illiquid allocations, an inopportune illiquid allocation can, at best, complicate a transaction and, at worst, hold a scheme back from achieving its objectives.
No commentary on the years ahead for UK DB schemes could ignore the ineluctable – and sharply accelerating – growth of the buyout market, so we devote time in our paper to considering the differences in regulation and investment approach for insurance companies compared with DB pension scheme trustees when it comes to decisions around investing assets held to back liabilities and maintaining appropriate capital buffers against downside risk.
But there are some warning signals here too, with Andrew Bailey, governor of the Bank of England, noting that the buyout boom could expose the insurance sector to “larger and more concentrated exposures to similar types of risks” which could potentially impact the capacity of surviving insurers to take on the back-book of a failed insurer.
It is for a similar reason that Charlotte Gerken, the PRA’s director for insurance supervision, has called for “moderation” amongst bulk annuity insurers, saying they should balance short-term incentives with the need for “long-term and enduring financial strength”.
In that context, the paper considers the availability of the Financial Services Compensation Scheme (FSCS) and identifies its potential vulnerability to a change in the applicable PRA rulebook and its status as an unfunded lifeboat with recourse only to levies on the insurance industry, both of which mean that, in a crisis scenario, the full availability of FSCS support could be dependent on political sentiment.
Stepping back, Vision 2030 surveys a different landscape for UK DB schemes than in 2012, with schemes generally in much stronger funding positions and running lower risk portfolios.
This has brought the endgame within reach for many over the next decade but, with that, comes a different set of investment challenges to manage and some important strategic questions to answer around the merits of buyout versus run-on.
Simon Daniel is deputy chair of the Society of Pension Professionals’ investment committee.