Natalie Winterfrost: Who else would buy index-linked gilts without significant further increases in the yield?
There are systemic risks associated with inflation hedging and insurance buyouts despite a growing pension scheme focus on resilience, the Society of Pension Professionals (SPP) says.
The society's Vision 2030 report for defined benefit (DB) pension schemes - published today (18 September) - outlines what it saw as the dynamics that will likely define DB investment strategy over the next decade, the challenges that will face trustees, and how they might rethink the endgame target ahead of them.
In particular, it focused on how different the position is for DB schemes today compared to ten years ago - noting improved funding positions and lower-risk portfolios. It also said there would be a continued focus on resilience and a continuing debate on the future of endgame.
The report comes when many DB schemes are on track to achieve their endgame objective of self-sufficiency or insurance buyout within ten years and also at a time when pension schemes have become the focus of intense scrutiny in the wake of the gilt market volatility of late 2022 and the Mansion House Reforms announced by chancellor Jeremy Hunt in July. A call for evidence from the government on options for DB schemes has sharpened the focus on their future further.
SPP president Steve Hitchiner said: "The lifecycle of DB pension schemes has reached a critical tipping point. Schemes are, in general, continuing to mature and, following a decades-long battle against deficits, funding levels have improved with many schemes now finding themselves in surplus on a low-risk basis.
"DB strategy has been a key focus across the policy agenda, and so our Vision 2030 paper takes a well-timed look at the future for DB pension scheme investment. We hope the issues explored help move the debate forward in this crucial area."
Systemic risks
SPP investment committee chair and LawDeb Pension Trustees director Natalie Winterfrost said there were still issues around resilience for schemes to consider - noting systemic risks associated with inflation hedging and index-linked gilts were still an issue.
She said this was a particular problem as the inflation hedge of a scheme is imperfect because an RPI asset is used to hedge an inflation-linked liability, where the inflation linkage of the latter is limited by caps and floors - something that meant the amount of index-linked gilt exposure needed would change as inflation levels and inflation volatility changed. But she said, if pension schemes needed to adjust their index-linked gilt allocations at the same time, this would cause problems in an asset with few other natural buyers.
Winterfrost asked: "If pension funds were to start selling them, who would buy them without significant further increases in the yield?"
The SPP also said insurers bore the potential for significant systemic risks - raising concern over the concentration of the insurance buyout market in around nine insurers and adding that current proposals to adjust the Solvency II regulation in the UK were likely to further reduce the capital insurers are required to hold against liabilities.
Winterfrost said: "At the moment, if liabilities grew for some reason, because, for instance, of longevity, you have got a diversity of different backers to that. If anything goes wrong in insurance, then you've got an awful lot of very similar companies backing those pension liabilities and it does seem that it's increasing systemic risk."
She also noted insurance portfolios were changing - moving from the position where insurance companies ran low risk investment strategies with a substantial capital buffer and pension funds were poorly funded and ran more investment risk; to a new position where insurers were taking more risk with less capital, and pension funds were running largely cashflow matched portfolios and were much better funded.
The SPP paper noted: "Assuming an insurance covenant will always be stronger than a strong corporate might be imprudent."
Key aspects of Vision 2030
The SPP set out three key aspects for DB pensions looking ahead to the end of this decade. These are:
1. DB pension schemes today are in a very different position
The SPP's report said schemes are in much stronger funding positions and invested in lower-risk portfolios compared to ten years ago. Legislative, regulatory and tax framework adjustments following the Department for Work and Pensions' (DWP) call for evidence could impact how trustees and sponsors view options before them - both for schemes' long-term investment strategies and endgame options.
2. The future of DB scheme investment: a focus on resilience
The SPP paper said schemes hold much larger collateral buffers following the gilts liquidity crisis, and there is a greater focus on building investment resilience, including avoiding being a forced seller of assets. There is an emphasis on physical investment in gilts, and assets which offer contractual cashflows and a return over gilts, such as forms of high-quality corporate debt, that are likely to form the core of most schemes' investment strategies going forward.
- Systemic risks associated with inflation hedging: the inflation hedge of a scheme is imperfect because an RPI asset is used to hedge an inflation-linked liability, where the inflation linkage of the latter is limited by caps and floors. This means the amount of index-linked gilt exposure needed will change as inflation levels and inflation volatility change; but if pension schemes need to adjust their index-linked gilt allocations at the same time, this will cause problems in an asset with few other natural buyers.
- The gilt liquidity crisis sharpened the focus on resilience: The Pensions Regulator's (TPR) subsequent guidance outlines what trustees should consider regarding liability-driven investment, including the need for resilience testing, effective governance and resilience standards.
- The draft funding and investment strategy regime: sharpening the focus on risk: since the new TPR revised code of practice on compliance with DWP's draft regulations on DB pension scheme funding was first envisaged, changes in DB scheme circumstances have raised questions as to its applicability and relevance. The Work and Pensions Select Committee has since asked TPR to postpone the launch of the code and the timetable before the next general election is short - raising doubts about when, or if, it will be implemented in its current form.
- Improving resilience in pension investment strategy: we expect pension investment strategy to focus on managing investments holistically, maintaining or improving their governance and focusing on cashflows. All investment decisions will need to be made in the context of the trustees' overall funding objective and endgame target to increase the certainty of achieving that goal. Trustees and their advisers will also need to agree decision-making processes.
3. Deciding on the endgame: ensuring the best outcome for scheme members
The SPP said the suitability of a specific endgame target will depend on a scheme's circumstances, but an insurance buyout is not always the answer. Pension schemes can secure their members' retirement income with low reliance on their sponsor, meaning they could potentially invest for the long term.
- Insurers bear potential for significant systemic risks: current proposals to adjust the Solvency II regulation in the UK are likely to further reduce the capital insurers are required to hold against liabilities. The Bank of England estimates this would lead to a 20% increase in the annual probability of life insurer failure, if a firm met just the minimum regulatory standard. Assuming an insurance covenant will always be stronger than a strong corporate might be imprudent.
- Insurer failure would lead to Financial Services Compensation Scheme (FSCS) support for pensioners - but systemic risks still raise concerns. FSCS protection is contingent on future policy and political appetite. Coverage could fall back from 100% if circumstances change; if insurers fail, the FSCS may not be able to charge sufficient levies on the sector to cover the funding required. Depending on the wider political and socioeconomic context, considering intergenerational inequality, it could be very difficult for a future government to bail out pensioners through financial support to the FSCS.
- Incentive changes could align with the chancellor's Mansion House three golden rules:
- Secure the best possible outcome for pension savers: Enabling DB schemes to run on could lead to better outcomes for pension savers within and outside DB schemes.
- Prioritise a strong and diversified gilt market: DB portfolios today focus on gilts. Allowing DB schemes to run on would enable them to maintain their existing gilt holdings, while a transfer of that capital to insurers could lead to material sales of gilts.
- Strengthen the UK's position as a leading financial centre to create wealth and fund public services: Once retirement income is secured, pension schemes' excess surplus could be deployed over time, and its scope for investment in riskier markets could grow.
