Time to be buyout aware: The accelerating path towards endgame

While the upward move in rates throughout 2022 led to volatility across investment markets, it also resulted in a significant reduction in the future value of an average DB pension scheme's liabilities. With this fall in liabilities typically more than offsetting the drop in asset prices, both larger and smaller DB schemes saw continued improvement in their average funding levels, particularly on a buyout basis where liabilities are driven not only by market volatility in credit spreads, but also by interest rates and inflation.

By way of example, the at Legal & General Investment Management (LGIM) funding level tracker tracks a ‘typical' scheme set up in 2018 when we estimated its funding position based on data from the Pension Protection Fund. The estimate for buyout funding levels combines gilt funding levels with an estimate of buyout pricing from Legal & General's (L&G's) affordability index - an index that gives a first order indication of L&G's typical level of pricing at a point in time.

Estimated pension scheme buyout funding levels have risen
Source: LGIM. Notes: All data as at 28 February 2023. Assumes rates and inflation hedge ratios of 70% of liabilities on a gilts basis and no future accrual or deficit contributions.

A different set of issues in 2023

Given the backdrop of improving funding levels, we believe 2023's investment strategy reviews are likely to present a different set of issues and challenges from previous years for many pension funds. Buyout is, on paper, attainable for a sizeable portion of DB schemes, while many more are likely to be fully funded on a low-dependency basis.

As they approach their endgame, trustees and sponsors are faced with a vast array of challenges in managing their pension schemes. These challenges include market movements, cashflow requirements, the current regulatory environment and proposed changes to it via the new funding code, increased governance and funding level volatility, to name just a few. The combination of these challenges can create a much larger burden for smaller schemes that have more limited time and resources.

In this vein, we believe there are a number of factors for smaller schemes to consider to create a more seamless route to buyout. For instance, managing risks relative to buyout liabilities and pricing is crucial. Other than longevity, there are three main drivers of buyout pricing to manage: interest rates and inflation, of course, but also credit spreads. Buyout prices tend to increase when credit spreads narrow because insurers invest in credit, and credit-like assets, to support buyout contracts. This is an important, and potentially neglected, source of endgame risk.

As funding levels continue to improve, we expect to see more and more schemes approach the buyout market. Whilst some schemes will be able to jump straight to the option of buyout with the support of their sponsor, many will need to start by being ‘buyout aware', by preparing for buyout.

This can mean setting governance in place, cleaning member data, liability management exercises and potentially buy-ins along the way. However, the market volatility that got schemes to the current funding level might not help them get to buyout, so it is crucial to focus on managing buyout price volatility, to hedge interest rates, inflation and credit spreads on a buyout liability basis.

We believe, a flexible approach to managing the journey to a scheme's low-risk run-off phase is therefore vitally important. All schemes' situations are different and will require a bespoke approach to prepare for buy-in or buyout. Getting this preparation right is likely to be key in our view, if schemes are seeking to approach the market in a strong position to achieve a successful outcome.

Mathew Webb is head of insurance solutions and strategy at Legal & General Investment Management