Defined benefit (DB) schemes mimicking typical insurer fixed income portfolios are failing to use their greater regulatory freedoms to maximise returns with higher risk, JP Morgan Asset Management says.
Buy and maintain credit strategies can be better tailored to recognise an individual pension scheme's needs and appropriate level of risk-taking, without being held back by regulation such as Solvency II.
This could include incorporating lower-quality credit and securitised debt to diversify portfolios, whereas insurers would find the costs of doing so more prohibitive, according to the firm's analysis.
Such an approach could help schemes repair deficits and get closer to fully funded on a self-sufficiency basis, levelling down the risk in their portfolios as they close in on the end goal.
JP Morgan head of EMEA pension solutions and advisory Sorca Kelly-Scholte explained there was a "lot of logic" to holding insurer-like portfolios, but schemes do not have to do exactly the same thing.
"There's been a lot of talk about how pension funds are heading towards buyout, or turning themselves into closed annuity books, and therefore their investment needs become more like those of insurers," she said.
"We all want to invest in a way that matches and helps address the liabilities, but pension funds aren't subject to the same regulatory capital regime, Solvency II, the profit maximisation imperative, or accounting constraints.
"There may be things they can do that are difficult or undesirable from an insurer's perspective."
For example, a greater risk-reward payoff may be available to schemes investing in triple B-rated credit. On the other hand, insurers face adjustments for default risk and regulatory capital charges which make the expected return "negligible" compared to A+ bonds.
This does not mean schemes should go "piling into" triple B-rated bonds, Kelly-Scholte said, but the potential yield could be more "desirable".
Furthermore, pension funds have greater ability to invest in securitised debt such as collateralised loan obligations or commercial mortgage-backed securities, which, for insurers, would carry capital charges of 100% at longer durations.
Similarly, schemes can use currency forwards and interest rate swaps for both foreign and base currency investments, exposing them to unhedged currency base risk that insurers would typically avoid to minimise profit and loss volatility.
While this is a riskier approach, JP Morgan's report said the "small source of additional volatility is merited by the additional flexibility afforded".
All of this can be aided by the greater level of turnover schemes can cope with, Kelly-Scholte said.
"Pension funds have a much wider menu of choice in how exactly they choose to cook up their buy and maintain strategy," she said. "It doesn't have to be the lock-it-down, highest credit quality, completely matched to the liability version of it."
And, while opting for a riskier strategy, this would not disadvantage schemes thinking of approaching an insurer for a buyout.
"You certainly would expect that there'd be a high degree of overlap between the universe that insurers are looking at and what's being used in these portfolios," Kelly-Scholte continued. "That would lead to, at least, as straightforward a discussion as if they were holding a broad investment-grade market relative-type bond portfolio, which is what most pension funds are holding today."
She concluded: "Adopting this type of strategy is a step towards the insurance companies and won't disadvantage you relative to where pension plans are currently."
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