By Hugo James
At a theoretical level it is now well established that the cashflow streams emanating from long-dated assets provide a good match for the liabilities of defined benefit (DB) pension schemes. What is more, the market is increasingly throwing up opportunities for pension schemes to invest in assets that are simple to understand and secure relative to the advantages that they bring. Take ground rents, for example – in a world of negative real returns, a bond secured against a portfolio of ground rents can provide a 30-50 year inflation-linked cashflow with a positive real return that would match deferred pensioner liabilities on a costeffective low-risk basis.
The best way to view the liabilities of DB pension schemes are as very long-dated inflation-linked contracts written with scheme members. It makes sense therefore that the profile of the assets that back these liabilities should be similar. Yet investment strategies used by pension schemes to date mean that this is rarely the case, with the majority turning to liquid assets – equities and corporate bonds – that have shorter durations and lack the benefit of explicit inflation linkage.
Accurate information on assets, liabilities and risk is a starting point to enable a matching investment strategy but sophisticated schemes should go further – employing analytics to stress test their assets and liabilities against different assumptions. That’s not to say the results will make pleasant reading, however, as for many running stresses on interest rates and inflation will typically show a large duration and inflation mismatch. The key to plugging this gap is to exploit the scheme’s liquidity by investing in long-dated, inflation-linked assets that give the scheme the duration and inflation protection it needs at a higher yield than traditional matching assets.
Having this information available is invaluable, but the key is making it available to all decision makers. What is required is a common source of information that can be used by all consultants and advisers – both on the asset and liability side – and that can drive consensus and efficient decision-making. Only then can pension schemes hope to develop well-articulated funding objectives and risk strategies – and, crucially, an investment strategy that is consistent with these.
Having defined a matching investment strategy, it is imperative that schemes then also employ a benchmark that tracks the liability, rather than focusing on share or credit indices. By using a liability-driven benchmark, schemes will be better placed to appraise potential investments in terms of their ability to meet their liabilities and the funding relief they provide compared to traditional matching assets.
There’s no doubt in my mind that the pensions industry is moving towards the endgame, and moving all risk to an insurance company or vehicle should be the aim for all. As such, schemes must consider how their asset portfolio will affect the price of a buyout and the scheme’s ability to lock into and track pricing as it gets closer to a potential deal. Of course, this requires specialist knowledge of the insurance value of assets when deciding on the portfolio – and schemes may have to seek help.
My experience suggests that by delivering insurers a well-matched portfolio with little or no re-investment risk, pension schemes can reduce their buyout premiums since these assets will be consistent with the strategies and opportunities that insurers are also seeking to exploit. So, if buyout is the end destination, utilising liquidity in long-dated assets may be a sensible first step.
Hugo James is chief executive at PensionsFirst Capital
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