Endgame investing

Sponsoring a defined benefit pension scheme is a big responsibility. You have to ensure that thousands of members do not run out of money in their retirement. This is why the risk settlement market is booming with almost £44bn worth of such transitions disclosed last year. There are other endgame options, but passing the responsibility […]

July 2022

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Sponsoring a defined benefit pension scheme is a big responsibility. You have to ensure that thousands of members do not run out of money in their retirement. This is why the risk settlement market is booming with almost £44bn worth of such transitions disclosed last year.

There are other endgame options, but passing the responsibility for paying your workforce’s pensions to an insurer is popular.

But it is not easy. You need data, lots of it, and then there are the assets. You need to be invested in what investors want to hold. So reaching your chosen endgame needs work.

This is why we sat down with members of Aon’s risk settlement team and a range of trustees to discuss the issues schemes face when working towards their chosen endgame.

We hope you enjoy this supplement.


Tiziana Perrella
Professional trustee, Dalriada Trustees

Tiziana Perrella is a lead trustee based in Dalriada’s Manchester office. A qualified actuary, she has worked with pension schemes
for 20 years on risk settlement, leading more than 200 buy-ins and buyouts.

Prior to joining Dalriada, Tiziana was a principal consultant within Aon’s Risk Settlement Group, having joined from JLT where she was head of the bulk annuities team.

Melanie Cusack
Client director, PTL Governance

Melanie Cusack became a professional trustee in 2009 after working for consultancies such as Willis Towers Watson.

Today she works with defined benefit schemes on their liability management, risk reduction and endgame planning. Cusack’s work is not limited to pension schemes, as she also helps charities and not-for-profits.

She sits on The Pension Regulator’s Diversity & Inclusion Working Group and is chair of the Winmark Pension Chair Network.

Alan Pickering
President, BESTrustees

Alan Pickering is a trustee of the retirement plan for
plumbers and mechanical engineers as well as for workplace scheme The People’s Pension.

His experience is vast having served as a non-executive director of The Pensions Regulator and as a member of the Occupational Pensions Board.

Pickering is also a former chair of the body that is now known as
the Pensions and Lifetime Savings Association (PLSA).

In 2002, he wrote A Simpler Way to Better Pensions, a government-sponsored report on the industry

Lucy Barron
Partner, head of investment risk settlement. Aon

Lucy Barron brought a 20-year track record of providing strategic advice to pension schemes when she joined Aon in 2017.

Barron leads Aon’s specialist investment advice for schemes preparing for buyout, working closely with the risk settlement team.

In the past three years, her team has helped 128 schemes align their assets for buyout.

Colin Cartwright,
Partner Aon

Colin Cartwright is a partner in Aon’s investment practice.

He is the lead consultant to several defined benefit pension schemes
worth between £100m and £1.5bn.

Cartwright is also a member of the firm’s investment risk settlement team where he helps schemes prepare for buy-in or buyout.

Elizabeth Hartree
Director, LawDeb

Elizabeth Hartree is a trustee with seven
appointments across a range of defined
benefit and defined contribution schemes.
Before becoming a trustee, she was a lawyer
working in private practice and for FTSE100
Hartree is experienced in journey planning
and de-risking, including buy-ins and buyouts.

Charlotte Quarmby
Associate partner, Aon

Charlotte Quarmby is an associate partner in
Aon’s Risk Settlement Group and has advised
schemes on around 60 buy-ins collectively
worth more than £20bn. This has seen her
complete transactions for retirement plans
sponsored by ICI, British American Tobacco
and 3i.Quarmby sits on the management
committee of the Institute and Faculty of
Actuaries’ bulk annuity and longevity swap
member interest group, which is responsible
for driving changes to the industry.

Jo Myerson
Trustee director, Ross Trustees

Jo Myerson spent 12 years as a pensions
lawyer and then as a strategy and policy
adviser at a £26bn scheme before becoming
a trustee. She is Ross Trustees’ restructuring lead working with schemes undergoing
significant change, such as the sponsor being
taken over. Myerson also works on liabilitymanagement, buy-ins, buyouts as well as
complex funding arrangements

Wayne Phelan
Chief executive, Punter Southall Governance Services

Wayne Phelan specialises in investment,
governance and endgame planning. The
chief executive of independent trustee firm
Punter Southall Governance Services started
his trustee career working on direct pension
scheme investment for wealthy individuals. He
continued to work with pension schemes at
consultancy Alexander Clay & Partners. Today
he is chair of several schemes, the largest of
which has £5bn of assets.

The debate

What endgames are pension schemes favouring

Alan Pickering: Most of the schemes I work with are thinking about the traditional route of an insurance buyout. It is a case of ‘when’ not ‘if’, but these days there is more choice.

Any consultant worth their name will sit down and explain the options to sponsors and trustees because we are on this journey together. It is particularly challenging in the not-for-profit sector where the people making governance decisions are probably not pensions literate. It is difficult to engage those people because they see it as a legacy with no HR dividend so they want shot of it. You have to explain that they might damage their employees in
doing that. There is a marketplace out there so choose which bit suits you.

Melanie Cusack: On the legacy point, I’m a trustee of a large charity, which has been self-sufficient for years. When we told them they could remove all risk through buying it out, they said their covenant is vastly superior to any insurer so will leave it here and run it off. There is more to it than getting it off a company’s balance sheet. There are other considerations.

Colin Cartwright: Sponsors are looking at alternative ways to use the pension scheme efficiently on their balance sheet. That could involve captive insurers or funding a defined contribution trust. However, running it themselves is ultimately a steppingstone to buyout. That is more of a ‘when’ rather than a

Charlotte Quarmby: We are seeing clients considering cashflow matching to manage some risks either prior to transitioning to an insurer or consolidator, or when in a state of self-sufficiency. Cashflow matching can be used to create additional returns to either get them to buyout or to generate a buffer, but it needs the right partner to manage it properly.

Pickering: A disadvantage of having a long run-in to the endgame is that wisdom changes. Trustees have decided to invest in what insurers invest in, which was the mantra at one time. But it is important that as we take people along the journey that their hard-earned knowledge does not get stuck in a time warp.

Lucy Barron: Investing like an insurer is a diversified strategy with lots of cashflow matching-type assets, but for most schemes, self-sufficiency ends up being a staging post because people, corporate activity and funding positions change. Some of the assets bought when you were investing like an insurer become a barrier to passing assets to an insurer. So it is worth testing and re-testing what your true endgame is.

When we recently surveyed pension schemes, buyout had overtaken self-sufficiency as the preferred endgame for the first time. But they are just two options. That is the old world and there is now a range of other options to consider. Are your schemes considering the other options, Elizabeth?

Elizabeth Hartree: The traditional insurer-led options still feature heavily, although we are also having conversations about capital-backed journey plans, where the interest is mainly coming from the sponsors. Some clients also want to explore how a single trust for DB and DC could be used to address issues sponsors are concerned about, such as inter-generational unfairness.

Wayne Phelan: There are other influences driving this. Currency is one. Costs can fall dramatically for overseas sponsors. Depending where sterling sits, overnight it can become much cheaper for US-sponsored schemes to go down a traditional route.

Going back to the comment about peoples’ views changing, there is more talk these days about surpluses and what schemes should do with them. Remember, these things will go against you again, so if you have a surplus, spend it as quickly as you can to secure benefits.

I had a client who was fully funded on a buyout basis in 2008, but by the time I was appointed it had fallen to 50%. They had done nothing wrong; it was just where the world was at that time meaning buyout was much cheaper.

Pickering: It is important to have a project plan. The employer and trustee need to ensure that not only do they have the right ducks, but that they have their ducks in the right order. It’s about maximising the efficiency of the DB transfer and then deciding what to do with DC. You need a project plan to ensure that you are not caught unaware further down the track.

Tiziana Perrella: My schemes have a clear vision as to what they need and what they are missing. Scheme data is usually below par as far as the insurers are concerned, which is a big issue. Sometimes your project plans concentrate on those aspects. There are sponsors where the perceived painfulness of the pension scheme – due to its size or a corporate activity that they want to pursue – means they want to get rid of it. If they have to pay to do that, they will pay as much as they can afford.

Then there are schemes that are not quite there but with a little bit of luck, some ageing of the membership and good terms, they will make it in the next three to five years without the sponsor having to write a cheque.

Then there are those who choose to invest in something that could deliver excess returns but the need for liquidity means there has to be a plan to exit less liquid holdings at the right time.

You could split schemes broadly in those categories, but yield increases mean most of my schemes are well funded. There are discussions around surpluses which are not captured because the scheme is mispricing pricing opportunities due to lack of preparation in other areas. As much as a transaction looks affordable, if you take a scheme to an insurer and the data is poor they will not be interested.

Hartree: That can be a challenge for project planning. I love a project plan, but there is a risk that people get too wedded to the timings in them. We have talked about market opportunities due to attractive pricing or assets performing better than expected and there has to be an element of flexibility to be nimble when opportunities arise.

Pickering: I learnt late in life the importance of an expected return on assets to American sponsors. It can often influence the timing of a risk
transfer as they may not want to take a hit to their profit and loss account.

A project plan needs to be sensitive to the non-pension aspects so an employer does not find out late in the day that they will have a lot of explaining to do on Wall Street if their de-risking has an effect on the expected returns.

Cusack: That has been a blocker for some of my clients. We wrote a project plan and had the data ready, but when we confirmed that they understood this will impact the profit and loss, they pulled the pin.

Perrella: That is why a conversation with the sponsor helps. Sometimes they want to buyout when they expect a poor year due to other activities or they have a balancing impact from other items so they do not mind losing out. The dynamics are interesting.

Cartwright: It is an important conversation. There was a scheme I worked with that was fully funded on a buyout basis. In 2018 we engaged with the sponsor but they did not want to get it off the books for a number of reasons. So we took steps to de-risk and match buyout pricing. A lot happened in the two years that followed so we were able to buy the scheme out in February, returning a healthy surplus to the sponsor.

The early engagement helped us to manage the uncertainty. We found out how it met their corporate objectives and aligned the trustees with their investment strategy and planning, giving us time to get out of hedge funds, for instance. It took us three years to buyout, but it met everyone’s objectives
and was driven by the early engagement.

Cusack: A three-year period also gives you an opportunity to deal with the data. Doing benefit specification today lets you know if there are any pieces of paper you need to find so you can take it forward at a pace that suits. There is a misunderstanding that if your funding position is good you can buyout. You can’t if you do not have the right data. The project plan is a way of teasing out the issues, although you may not go with that plan.

Hartree: Sometimes there is an element of an ‘essay crisis’ and people need an impetus to get their ducks in a row.

Jo Myerson: I am a fan of an essay crisis because it is quite effective, it is cost effective – the advisers look at something once and focus on it properly because of the tight timeframe rather than picking it up and putting it down again over a longer period.

Cusack: I agree that it is inefficient if there isn’t some form of pressure. I have a scheme where the benefit spec revealed a lot of errors and we are trying to make sure members are getting the right benefits. Going to buyout within 12 months would be impossible because no insurer would back it.

Pickering: An American company I have been working with wants to transact in December 2022, which is the most benign check date for their profit and loss. I do not mind the sponsor having a deadline of December, but I am not going to allow the administrator to have a deadline in December because they want to go on holiday in the summer. It is no excuse. They have to have their feet held to the fire.

Cusack: The dashboard will help with that. You have to get your data right for the dashboard, so in theory there will be more work on the data.

How are raging inflation and rising interest rates affecting endgames?

Cartwright: Perversely, the market turmoil has been beneficial for some funding levels. Whether that is because schemes hedged the retail price index or that insurer pricing has become more competitive with spreads widening. If you had a proper plan coming into this with an eye on dealing with legacy issues such as liquidity, you have been able to make transactions from the funding gains we have seen this year.

Perrella: I would add that there are old-style fiduciary arrangements for some smaller schemes, particularly where when you try to disinvest you find all sorts of issues with timing and costs. Trustees and sponsors need to be aware of the disinvestment timeline and process. Sometimes people do not fully understand it, which can stop you from moving quickly when you see that it is the right thing to do.

Cartwright: Going back to project planning, there are sensible steps you can take such as letting your custodian know you are planning a transaction or keeping the signatories up to date. That preparation does not sound exciting but it is important.

Barron: For years the focus has been on preparing benefit specs in advance, thinking about the data, but increasingly trustees are thinking about the assets before getting anywhere near a transition, looking for roadblocks. It often comes down to managing illiquidity, while complex LDI arrangements can be
another roadblock for some schemes.

From an assets perspective, we help schemes make sure they have a flexible toolkit to match insurer pricing as they get closer to entering the market, especially if affordability is tight. That reduces costs and risks, but also gets an insurer on board. They do not want to spend time looking at your scheme only to find that buyout becomes unaffordable because you are holding assets you cannot sell or which poorly match insurer pricing.

Hartree: One of the first questions we will be asked when taking a scheme to market is about the assets and what steps have been taken to de-risk. When insurers are busy they do not want to invest time in a transaction that could fall away at the last minute. You must demonstrate that you are prepared, not just on the data and the benefits, but on the assets, too.

Perrella: There is a different dimension to that. Insurers’ appetites vary depending on scheme size, duration and profile, so you have to understand what segment of the market a scheme belongs to. You need experienced advisers across the whole piece.

Pickering: A trustee-specific issue is post transaction protection. If the trustees do not realise until the eleventh hour that once the scheme has no money they will be depending on insurance or internal indemnities to guarantee that they will sleep at night for the rest of their lives because ambulance chasing lawyers will not come after them claiming the benefit payments are wrong. You do not want to double bank external insurance and internal indemnities, but it is important to send trustees into retirement with peace of mind.

Myerson: A conversation I have with my schemes is should we go for residual risk cover or just do the investigative work and take comfort from having done the due diligence and solved the issues that came up. So it’s unlikely that anything else will be found to make the cover worth paying for. Clients are saying they have done the work and do not then want to pay the extra 1% to 2% because they have done enough.

Cusack: We always think we do the work, but experience shows that something comes out of leftfield or someone does not have the right information.

Pickering: I have a client who invented the paperless office before the computer came along. There is a lot of “you will be okay; you have this entitlement”. No matter how much due diligence we do, we will not avoid a disenchanted executive saying they had a promise that we have not kept.”

Hartree: It is part of seeing the end from the beginning and going on a journey with the sponsor. Do they understand that after the deal has been done that it is not the end of the matter? Alongside that, who is advising the sponsor? We expect that their corporate advisers need to do their job. What will make this run smoothly is tag teaming. Your advisers are talking to their advisers, your lawyers are talking to the sponsor’s lawyers. It is like a three-legged
race which we are all trying to get to the end of.

Cusack: It does not always work in practice. Our lawyers may not like the sponsor’s lawyers, for example.

Hartree: The trustees can then have a role in making people play nicely.

Cusack: But what if the trustees believe they are in a position to buyout and the sponsor is not engaging? Do the trustees sit on their hands and manage the scheme indefinitely incurring costs or do they go to buyout if it will not cost the sponsor?

Hartree: I wouldn’t recommend it because you will come unstuck at some point. It comes down to does the sponsor understand where the balance of power lies.

Pickering: It goes back to making sure the employer is properly tooled up. It might be that their existing adviser relationship is not appropriate, particularly if it is a small company. That is one of the good things about the regulator guidance for consolidators. They have to make sure employers are not receiving advice from someone in Guildford high street who spends most of their time giving divorce guidance. They will be out of their depth on this and you have to warn the employer that they are not working with the right team.

Does the size of the scheme make a difference when trying to attract an insurer?

Quarmby: Insurers often prefer larger schemes. There can be various reasons why but one reason is that part of their work is fixed, and therefore does not vary too much depending on the size of the scheme. For smaller schemes – those below £100m – the challenge is getting enough insurers to quote and to negotiate an attractive price and favourable commercial terms. That comes down to getting the attention of insurers, which is the real challenge. Some of the smaller schemes are not necessarily that simple. For example, they may have complicated benefits. These schemes have to work even harder to get insurer engagement.

Barron: What is the answer? What can they do?

Quarmby: It is about streamlining the transaction as much as possible so it is appealing to the insurers. As a result of the challenges smaller schemes face, we have developed a service called Pathway. Using pre-negotiated contracts and a carefully designed process, insurer engagement is maximised and smaller schemes get access to much better pricing and commercial terms.

Perrella: It goes back to it being not just what you do before the transaction. The insurer will be involved during the data cleanse process and if the data is messy and the timeline is extended to complete the process there will be a lot of work for the insurer. That before and after is not just relevant for the
trustees but for insurers, too. But some insurers do like smaller schemes, they like the diversification. They also like to provide a service to the whole market. I have never struggled with placing a well prepared small scheme. There will continue to be a market, it is just that the benchmark for what well prepared means has become more challenging.

Wayne, do you approach large and small schemes differently?

Phelan: We have a strange relationship with the insurance market. When insuring your car, you put into the system that it is a car. But with these transactions we have to make a storyboard of how prepared and wonderful we are to be insured. We have to paint everything we have done to not only to express our
seriousness but that we are not a big risk. It is unusual in that sense.

Schemes which have appointed a professional trustee are probably engaged enough to think about these issues. Schemes which have not are going to struggle that little bit more.

I have a client who has five defined benefit pension schemes on the path to full buyout. There is a timeline we share with insurers when we do a transaction which explains that another transaction or scheme will be coming down the line so come and talk to us about a price. That has been helpful.

Is pricing good at the moment?

Hartree: It has been an interesting dynamic. At the backend of last year, a lot of business was written, but the market was quiet at the start of this year. Many insurers have half-year targets and want a good news story to share. They have not written that much. So there is good pricing as a result of insurer demand.

Perrella: The market is getting progressively busier. A number of larger schemes hit the market this month. Depending on
the geopolitical situation, it could be a repeat of last year which is good news for brokers.

Barron: The market conditions aspect is interesting. Schemes have had a boost from rising interest rates if they have not fully hedged their liabilities and also from inflation rising if there are specific maximum limits on pension payments when inflation is higher. Credit is a little cheaper, which is also driving pricing. So do you have the right allocation to credit and can you lock-in that good insurer pricing even if buy-in/buyout is some way off?

Pickering: Lucy, what is affecting the insurers’ ability to line up assets now that they may deploy later in the year against the
background of geopolitical mayhem?

Barron: They are looking for illiquid credit. As insurers line up those assets, having your scheme at the front of the queue, ready to transact, means you are getting better pricing because you are getting the benefit in pricing of those higher-yielding assets which is key.

Pension schemes and insurers are looking at gilts, corporate bonds and illiquid credits, while assets with an ESG flavour are becoming increasingly important.

Is ESG compatible with what insurers look for in portfolios?

Barron: Pension schemes are doing more in this area by setting policies on their expectations for ESG. There are certain things schemes are increasingly doing as they approach insurers or following a buy-in. For example, we are seeing more due diligence on insurers’ ESG capabilities and, in some cases, decisions are now being taken based on ESG considerations. Insurers are looking to do more in this area, too.

Phelan: An insurer will have more bandwidth to do something 1on ESG. A lot of defined benefit pension schemes will be with an insurer by 2050, so talking about what their investment strategy will look like by then is not quite truthful, because they will be gone by then.

Why do some schemes opt for a buy-in instead of a buyout?

Pickering: You would normally go for a buy-in before a buyout. One of the challenges on the journey is to determine if you should wait for one big buy-in or do smaller buy-ins along the road. That is where you need the advice of someone who is experienced and can tell you if you are going to decrease your
firepower by doing lots of little buy-ins. Whereas others will tell you that is the way to transition. For technical reasons, most go to buy-in before buyout, which gives you a window to sort out your data and your sleep-at-night policy for the trustees.

Phelan: Typically, it is the age of the membership that is going to be a barrier to buyout. It is cheaper if most members are of pensionable age or beyond. Waiting is an alternative to buy-in or buyout. Having your capital sitting waiting for the scheme to mature makes it cheaper. This also allows you to close off longevity risk, which schemes are not exploring too heavily.

Perrella: One of my deferred only transactions was pushed by the sponsor. They were happy to run the risk of a pensioner payroll that in real terms would decline. They would have to pay contributions from the payroll annually but wanted to do a partial buyout of the deferred members, which they saw as the bigger risk.

We had a good price from an insurer for that one. It was unusual but it makes sense if you have the appetite and funds to pay that deferred premium.

Barron: A few things are coming together for schemes. As they de-risk their investments longevity becomes an increased component of overall risk. At the same time the LDI portfolio is becoming less leveraged. We are seeing buy-in pricing well above the return you could achieve from continuing to hold gilts on some pensioner transactions, which is attractive. In some cases, the sponsor of a larger scheme is happy to take a profit and loss hit, but they want it to be phased to avoid a single large hit. This can be achieved with partial buy-ins along the journey. Planning ahead and thinking through the timeline has a role to play.

Cartwright: When you are doing buy-ins, along the way it becomes an investment decision around are these the right assets. We spend a lot of time with our clients looking at what it means for the residual strategy. What are you going to leave behind and can it cope in different market conditions? We stress test the residual strategy for different leverage levels in the LDI portfolio and higher return requirements, if needed. Do you retain the flexibility in your residual strategy to manage in different market conditions to achieve your goals? If that works, you can do a number of transactions along the way.

Myerson: That comes down to having the right advisers. Not every adviser will be as assiduous in making sure a journey of several buy-ins works for everyone because there is, of course, a premium for them doing the buy-in work themselves. I have seen buy-ins where the residual assets are not sufficient to provide growth at a steady rate of return, so the sponsor has been badly advised.

Cusack: I have a sponsor whose adviser is telling the trustees that that they must do a buy-in. The sponsor is offering a lot of money to do it. But the amount they are offering, the residual assets and the time horizon do not stack up. They said they are not looking to buyout at the moment; they are looking to manage their longevity risk. The trustees are concerned that they are cutting their nose off to spite their face.

Barron: We can help with those stress tests to make sure the illiquidity risks of doing a buy-in are understood as well as the benefits. If the interest rate falls that have happened over the past 10 years reverse, how will your liquidity look when yields rise and equities fall?

Pickering: This underlines the importance of having a project plan and being nimble. Often the project plan can envisage an intermediate asset class and the cost of roundtripping in and out of that asset class may be sensible over eight years, but at five years the cost dwarfs the investment benefits. One needs a project plan but one also needs an adviser to say we do not need to apologise for changing the project plan.

Hartree: You need a can-do adviser. When talking about long-term planning, are you holding anything too illiquid? There is usually a way around things, there is usually a price. If that is understood on both sides, the sponsor could be happy to take a haircut. There will be a market for it, but you do not want your adviser to say there is nothing we can do as it does not mature until 2023. You need them to say, we can do x, y and z.

Perrella: There is a difference. Some assets are illiquid and some are very illiquid. The timeline for this disinvestment could be anywhere between six months and five years, although it is generally only a small proportion of a scheme’s assets that are sitting there.

Part of the preparation is having proactive advisers looking at when is the right time to come out. It might be later on if the assets are delivering good returns and we then accept the risk of a significant haircut. Or we start the disinvestment process earlier.

That is sometimes because there is no pressure, addressing the issue just gets delayed until you reach a certain funding level and then you are stuck with it because the timeline becomes problematic.

Phelan: There is also a degree of challenging people along the way. You would not build up a massive allocation to illiquid assets, but even if you took a haircut, and you probably will, you could get a good return. We did it with one scheme where we recovered most of the money.

But you have to make sure those who say it is difficult to get out of these things are not holding onto them because they are paid to. There might be some push to do it and there might be some push to not do it. There are so many competing tensions in this.

Barron: You have to think about your endpoint when you are going in. A large scheme that bought out recently went into an illiquid asset, which had a complex tax structure because it gave them a slightly higher yield. They later found out that this was a significant barrier to any insurer taking the asset and impacted the sale price they could achieve. Thinking that through in advance is important.

Perrella: You can manage illiquids if you have a strong sponsor who can loan you the money, you can disinvest over a period and repay the loan. That has happened in a number of transactions.

Pickering: Having a 12-month period before your money is drawn down is helpful. I had a trustee board where there was such a waiting period. The asset manager had not called down any of the money during that period so we cancelled without penalty. Buy-in/buyout became nearer during those 12 months and the trustees were bright enough to know that it does not make sense anymore because the period is much shorter. So you may not have to pay an exit fee.

This market is not just about insurers. There are other options. What do schemes have to do to attract a consolidator?

Cartwright: The consolidator market is an interesting, and hopefully welcome, addition to the endgame options for pension schemes. We are yet to see the first deal, but hopefully that will not be far off.

Many of the considerations are similar in that you need to prepare your asset strategy and benefit spec. There are additional conversations around whether you will pass the gateway test, or if you could ultimately get to insurance. It will be an easier conversation for schemes whose sponsor is weak.

Alan, you are the chair of trustees at Clara. What will it take to get you to go with a deal?

Pickering: Clara is trying to make sure that resources are not needlessly wasted. Not only does the regulator set a high bar for potential deals to clear, but Clara has a triage due diligence process up front so we do not waste money and neither do potential clients if the deal cannot be consummated. Clara is trying to be frugal with its assets because we would rather use our money to pay benefits than consultancy fees. There will be a high bar. The other point is the due diligence an insurer would go through in terms of liability precision and the quality of the incumbent administrator. Although Clara has an administrator, during the transition it will be dependent on the efficiency of the incumbent administrator who knows that their time is limited. It is a case of running a tight ship.

It is not my job to sell Clara, but I will tell the seeding trustees that if they decide to come with us their members will be treated like foster children. There are the softer and human aspects to these transfer arrangements. If you are transferring your members to an insurer the seeding trustees want to know that the foster parents will do a good job.

Cusack: Mark, you posed the question, what should schemes do to be attractive to consolidators? Surely, you should have asked, what should consolidators do to be attractive to schemes?

You are right about that, Melanie.

Pickering: It is not in anyone’s interest for the pensions industry to waste money on deals that are never going to be consummated. Clara and the other consolidators should decide early in the process if a deal has a fair chance of being consummated. You are wasting the sponsor and trustees’ money if a consolidator spends 12 months talking to you and the deal fails. Some intensive triage at the beginning could avoid all that heartache and expense. It takes two to tango.

Cusack: Who drives the conversation? Is it the sponsor who wants the trustees to pursue going into Clara, for example?

Cartwright: On the occasions we have looked at this over the past two years, it has been a bit of both. Sometimes it has been a distressed situation where the sponsor has gone bankrupt and a consolidator is an alternative option. I have also seen sponsors lead interest in the project because they see it as a cheaper way to get liabilities off their balance sheet. Sponsors also like to hear new ideas. Given that Clara is the only consolidator to receive regulatory approval and is yet to do a deal, people are watching and could be more interested once the first deal is done. Planning and engagement are needed to
understand what you are trying to achieve. We had a client last year in the capital- backed journey plan space. When we went through the detail to get it right, we realised that they were not far from full insurance, so we went down that route instead.

Perrella: Capital-backed journey plans are not difficult for trustees to assess. Essentially, what you are looking at is securing a yield for an acceptable level of risk. If you could secure the same yield for less risk elsewhere then go down that route. If you go to Clara you need to look at outcome by member. And the advisory process is more complex.

Myerson: I am surprised to hear that. There is a difference in covenant strength. If you take a capital-backed journey plan you need to have a stronger covenant so you can sweat the assets.

Perrella: I understand that, but I was talking from an investment perspective, subject to due diligence on the backers.

Cartwright: The capital-backed journey plans do not want to transact with weak sponsors because they do not want to become a consolidator. There is a little regulatory arbitrage which the regulator will look at but the capital-backed journey plans have spent time proving they are not a fiduciary manager or consolidator.

Conceptually, the consolidators are easier to understand. When you look under the bonnet of a lot of capital-backed journey plans there is more to understand than you are guaranteeing yourself extra yield. What are you giving up in return for that? But they are a welcomed addition to the pensions space and I would like to see the consolidators and capital-backed journey plans gain traction so we have more options to secure members benefits.

Cusack: I will be interested in the first transactions. From a trustee’s point of view, the covenant aspect becomes crucial. Our guidance is all about the covenant. I get the distressed aspect. There are many overseas sponsors walking away from the UK. For a run-of-the-mill scheme, the compulsive argument from a covenant perspective is not there,

So where does the interest come from?

Cartwright: I have seen interest from sponsors when their relationship with the trustees has broken down and they want to exit. Sponsors have a greater focus on efficient management of capital on their balance sheet. Is there a way to remove that liability or are the accounting profits coming through? Sponsors are looking at that, they see it as a new idea. A number have moved on, which is part of the triage we do before it gets to a consolidator because no one wants to waste their time. There is a demand to secure members benefits in the most capital efficient way. New ideas will gain interest and traction.

Cusack: I agree that having alternatives is helpful. If insurance is not the only route, then you do not have to pay a premium to
buyout. It is good to have competitive tension provided the options are suitable. Some options will appeal in some situations more than others.

How are schemes opting for self-sufficiency preparing their portfolios?

Phelan: It depends where you are on being hedged. Most schemes are well hedged, so their journey is largely done. But there are some who are a way off completing that journey, so self-sufficiency is still a landing post. It is back to speed and nimbleness. You might think you are heading for self-sufficiency, but you could be at buyout or buy-in or another option much faster than you think. There is a lot to play for in terms of what your investment strategy does for

Cartwright: Self-sufficiency is interesting from an investment perspective. Once you get down to low required returns – gilts plus 1% or below – there are many ways you can achieve that. It comes down to philosophy: do you like credit or equity risk? Do you believe in diversification or simplicity and lower fees?When we need high returns, equities or private equity can get us there. When we need low returns, there are more options, which make decisions harder but also more fun in working out what is important for the investor.

Pickering: I have been a trustee for 41 years. What makes me feel young is people talking about captives. When I first started, captives were used in a range of financial planning. Now they are being discussed as a possibility to give employers the best of all worlds, providing that they keep their books open. Some argue that a captive is the nearest an employer is going to get to a free lunch.

Cartwright: We are talking to clients about if this a sensible way to manage the risk and is an efficient use of capital. The insurers are making money. Whilst they are securing our members benefits, is that a way for the company to access those profit streams over the long term? It is an interesting discussion.

There are lots of hurdles to get over and it will not be the answer for everyone but is another option to get our members paid.

Hartree: What is driving that self-sufficiency? Is it coming from the sponsor? Some companies see looking after employees to the grave as part of their mandate. So they might have some interesting illiquid portfolios. This is supportable, but will it flip if they get a new sponsor or a change on the trustee board? Then you have problems if you hold something you cannot transact.

Cusack: Self-sufficiency means different things. To some it is a fully funded level with a buffer so the trustees can pay the expenses for the employer the scheme would be truly self-sufficient. They will need an income generator to provide that buffer as compliance costs go up and up. Then you have an age
profile, which is mainly deferred, and a liquidity point that makes it an interesting dynamic.

You are not just seeking to close a gap; you are seeking to preserve a position and meet the liquidity requirements for paying pensions. It is interesting when you take buyout off the table as some employers do not want to pay an insurance premium.

Where will the endgame market be in 10 years’ time?

Cartwright: We will see greater capacity coming into the insurance world and could see £40bn, £50bn or £60bn worth of deals each year. Trustees will become more comfortable with the different options and more of them will be looking at the endgame. Most of their population will be pensioners and we
need to have solved most of our problems because there is not a lot of time left when all your members have retired.

Barron: There has been a lot of innovation, which we need to continue seeing. There is about £1trn of pension scheme liabilities looking to buyout or considering an alternative option. That means we might see a £50bn a year market which will have lumpy demand due to lots of schemes arriving during a
good year for equities or when yields go up. If we go back 10 years, LDI was not used by everyone, now it is widely used. Schemes heading towards buyout will see matching credit sensitivity in insurer pricing using tools like synthetic credit in the same way as LDI has been used to better match interest rate and inflation risk in the liabilities.

Pickering: The biggest dividend of getting DB to a good place in 10 years’ time is that we can harness the brain power of Colin and Lucy to look after DC members. They need a lot of help given that the shareholder is not financially on the hook. It saddens me that so much brain power has been allocated to DB with DC almost standing for ‘Don’t Care’. In DC, the brain power is used for the benefit of the member rather than the shareholder. That is a big step forward.

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