Boris Mikhailov looks at the risks and benefits for schemes targeting self-sufficiency
Corporate pension schemes targeting a buyout have the certainty of a clear finish line - a time when assets and liabilities are transferred to an insurer through the purchase of bulk annuities. But for those targeting self-sufficiency, it is more like the scene in Forrest Gump when the lead character decides to go for a jog and keeps on running.
Self-sufficiency assumes the scheme will keep running until the last payment is made to the last surviving member. Importantly, this journey must be taken without additional sponsor contributions.
According to a recent Mercer survey, self-sufficiency is the aim for 38% of UK defined benefit (DB) schemes. But it also revealed 56% of schemes are cashflow negative, while half of those currently in the black are at risk of falling cashflow negative within five years.
So how can vulnerable schemes plan for a self-sufficient future? The de-risking journey is crucial. And regulation is pushing schemes to be cautious, with the Department for Work and Pensions outlining that investment objectives should be linked to long-term goals, such as self-sufficiency or buyout.
In asset allocation, the challenge is to find investments that meet cashflow needs whilst helping to close deficits or build a stronger buffer. Traditional barbell approaches combining a growth bucket with a liability-driven investing portfolio may prove inadequate. As schemes mature, they need income to pay member benefits and can become cashflow negative in the short term, even if long-term targets are on track.
This is less of an issue in benign markets; however, sequencing risk could become a factor in tougher conditions. Forced into selling assets to generate cashflows, a scheme will essentially be locking in losses; increasing portfolio volatility and putting more pressure on the remaining assets to bridge shortfalls. The investment time horizon also shortens, leaving less scope to invest in the growth assets needed to improve funding levels.
To mitigate this, schemes are increasingly turning to cashflow-driven investment to capture a more predictable income stream that is less reliant on short-term market movements. While such strategies may not offer as much upside when markets thrive, they are more likely to provide predictable cashflows and protection against sequencing risks.
As schemes reduce investment risk they could still face sizeable non-investment risks, such as covenant and longevity, which can throw funding levels off track.
Covenant risk - the risk a sponsor is unable or unwilling to provide financial support - is increasing. In the UK, 12.2% of companies failed in 2017 compared to 9.7% five years earlier, according to the Office for National Statistics. Since then, household names with DB schemes that have collapsed include Carillion, Toys ‘R' Us and House of Fraser. Brexit and a slowing economy may have contributed, but structural shifts - such as digital disruption - are other factors.
One way of addressing unexpected corporate events or inaccuracies in liability assumptions would be to build a stronger funding buffer or add contingent assets; another would be to purchase surety bonds when covenant risk is heightened. Traditionally used in construction, surety bonds ensure a certain level of contributions is made in case the sponsor doesn't fulfil its obligations.
Longevity risk - the risk that schemes wrongly predict member lifespan - can also impact funding. Adding longevity risk to a diversified credit portfolio targeting gilts plus 0.5% per annum (typical for self-sufficiency) could increase the level of funding ratio at risk to about 4.7% from 2.6%, according to Redington. Schemes can target a higher (or lower) funding level depending on the recent longevity assumptions or turn to insurance solutions, such as longevity swaps.
Having a game plan for managing exogenous risks early in the de-risking journey could pave a smoother self-sufficiency path. External shocks that materialise later may prove more difficult to recover from. First, there would be fewer investable assets as schemes mature. Second, the sponsor could have become financially weaker - or, in extreme cases, could have gone out of business.
If self-sufficiency is ultimately just a stepping stone until the resources needed to run the scheme outweigh the cost of a buyout, schemes can still benefit. A portfolio that can match cashflows to liabilities having considered investment, covenant and longevity risks will be well-positioned to target a buyout. As in the movie, even Forrest stopped eventually.
Boris Mikhailov is an investment strategist at Aviva Investors
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