Katherine Lynas looks at the investment challenges facing schemes following the liability-driven investment (LDI) crisis and assesses some of the solutions that may help.
It is now clear that the effect of the LDI crisis on defined benefit (DB) pension schemes was not uniform. The amount of hedging a scheme had in place had a material impact on the position it found itself in after the market volatility had subsided.
Schemes that were under-hedged were able to capitalise on the surge in yields and emerged as the winners. Conversely, some schemes remained mostly unaffected, while others experienced a decline in their funding position following the mini budget, as yields rapidly increased, and LDI managers were unable to secure capital swiftly enough to address the issue, leading to reduced hedging levels.
No matter what experience schemes had over the LDI crisis, a large majority will have had to increase capital in their LDI funds, and this will have had significant implications for their investment strategies.
At a high level the challenges can be broken into two themes:
- Maintaining the hedge ratio
As well as having to post capital to maintain the hedge ratio over the LDI crisis, schemes are now faced with lower leverage ratios in their LDI funds. To maintain their hedge ratio they need to allocate more assets to their matching portfolios, which simply means they have had to sell growth assets, reducing the amount of assets in their growth portfolio.
A further drain on growth assets is the need to provide a bigger liquidity buffer for collateral calls. The liquidity buffer needs to be invested in easily realisable assets, which tends to mean high grade fixed interest strategies which can be sold quickly and also that the assets are held within the same investment house as the LDI provider.
- Maintaining the scheme's return target
All this re-allocation to matching assets will have had a material impact on the ability of the remaining growth assets to meet the current return target.
It may be that the scheme's funding level has improved and therefore it is possible to de-risk and target a lower return objective, but where that is not the case schemes are left with an unenviable choice of increasing risk to target a higher return, reducing the return target or turning to the employer for help. Obviously, none are ideal, if even possible.
The struggle many schemes are facing to find the right balance between growth and matching portfolios in this new post LDI crisis world has, as frequently is the case in our industry, created a new term - the denominator factor.
The denominator factor is made even more challenging for some schemes as the reduction in the market value of assets over the LDI crisis and the sell off of a large proportion of the liquid growth assets to support the LDI funds has left some schemes with an overly large proportion of assets in illiquid private market assets. This creates a third challenge for schemes:
- Maintaining liquidity
Liquidity is needed in a scheme to provide pensions when a scheme is cash flow negative (higher withdrawals to pay pensions than contributions in), provide LDI buffers and collateral calls, and as a scheme gets closer to buyout, to provide the appropriate assets to the insurer.
For many schemes, the need for liquidity will now have emerged to have an equally important role alongside maintaining the hedge ratio and return targets.
Several market participants are trying to address schemes' need to liquidate private market assets, and the secondaries market is seeing a strong flow of high-quality opportunities off the back of pension schemes selling off their private market investments. The point to note here is that the case for investment in private assets is still compelling for many, but not if you are a DB pension scheme close to the point of buyout where your bulk annuity provider is not willing to accept your private market assets or one where the scheme dynamic has changed so significantly that you do not have another source of cash to maintain your hedge or pay your pensioners.
Is there more to come?
The last three years have been extremely tumultuous for DB schemes, but there will be more challenges ahead and they could be as daunting. Some we are aware of, like climate transition threats and opportunities, or gilt issuance versus demand creating further pockets of market stress. But one we are already into much of the detail of, as an industry, is the new DB funding regulations and accompanying code of practice.
This will add to the considerations schemes must weigh up when devising their investment strategy and journey plan. In particular, at the point of significant maturity schemes will be required to de-risk. Some schemes may already be at that point but not be funded sufficiently to adopt such a low-risk investment strategy. Their only option may be to turn to their employer for support.
Scheme duration is also likely to change as UK life expectancy at retirement has fallen. This will bring many schemes' durations down, maybe closer to the 12-year liability duration currently being touted as the point at which schemes will need to adopt a low-dependency investment strategy.
Schemes turning to their employer for support has been mentioned several times already, and covenant assessment is a building block of the new funding code. Most schemes have reduced in market value post the LDI crisis, which has improved sponsors' affordability resilience, but as UK and other developed nations remain on the cusp of recessions, how reliant can schemes be on their employer?
Practically, what does this all mean?
The pension world has always been complex and ever changing but the LDI crisis has resulted in a step change in our industry. For some schemes it has been a really positive outcome and they are queuing up at the insurers' doors, but for many there are just more balls to juggle and some of those balls are spiky.
Most schemes and their advisers have been very busy addressing the immediate denominator factor issues post October's market volatility but are now firmly looking at the challenges coming down the pipe. Governance structures are becoming a focus as trustees seek more support and expertise in addressing the renewed complexity. But for some, hiring a professional trustee or appointing a fiduciary manager will not address the underlying issue that they just don't have enough of the right type of assets to get them out of the hole they find themselves in post Trussonomics and onto an end game with any certainty.
Are there solutions to help?
There are a range of solutions, at various stages of development, which consulting firms and asset managers are bringing to the market to try to support schemes facing these challenges. They range from co-investment vehicles that allow the sponsor to benefit alongside the scheme, to superfunds that sever the covenant and consolidate the scheme into their structure.
Capital-backed solutions provide a capital buffer to augment the schemes' assets and provide a reservoir for liquidity needs, the ability to target a risk-on investment strategy and, with some solutions, maintaining the existing robust governance structure.
Some solutions go even further by addressing the wider risks that schemes face alongside these newly created challenges by enhancing the employer covenant and reducing the likelihood of contributions being required from the employer in the period until buyout is achieved.
With all these alternatives there are pros and cons and no one solution fits all, but if you are connected to a scheme that is facing liquidity, return or hedging challenges and can't identify an immediately obvious solution, they are worth investigating. The step change resulting from the LDI crisis and the headwinds some schemes face and will continue to face, demands a new type of solution.
Katherine Lynas is senior consultant at Punter Southall's Pension Safeguard Solution