The end game for UK pension schemes is fast approaching, a sharp focus brought on by The Pensions Regulator (TPR) mandating that schemes set a long term funding objective. Of course, schemes need to consider how to get to a secure level of funding - that is a known problem. But less attention is on the assets they will need to hold when they reach that point.
We would argue this is a more pressing issue than trustees are currently considering, and the longer they delay, the more costly it will be to address. Analysis completed by the TPR suggests that benefit outflows for many pension schemes may be close to their peak already. If a scheme is not well funded and holding suitable assets when it reaches its tipping point of peak cashflows, the scheme's funding level would deteriorate just through the process of paying pensions.
What is the size of the problem?
UK pension schemes have been on a de-risking journey for some time. Switching out of growth assets, in particular equities, and buying government and corporate bonds. The speed of this transition has accelerated in the last five years, supported by a significant fall in gilt yields with pension schemes increasing their liability driven investment (LDI) programmes.
As a scheme approaches full funding on a low risk basis, they will need to lock down risk by further matching sensitivity to changes in interest rate and inflation, but also thinking more consciously about matching cashflows as they fall due. This will naturally lead to deleveraging of LDI portfolios. This has been accelerated by the continued rise of insured risk transfer activity and now also the emergence of consolidators.
We believe approximately £1 trillion of liabilities remain exposed to changes in interest rates and inflation. In addition, in the region of £250-£300 billion of exposure will be converted to physical exposure from derivatives as schemes deleverage their LDI portfolios.
That is a great deal of activity for capital markets to cope with even at a global measure, let alone in the UK. This is intensified by the narrow set of assets that ideally would be purchased.
Musical chairs
A large proportion of this will likely continue to be met by purchasing UK government bonds and sterling credit. Combine this with how soon they need to be purchased as UK schemes mature and de-risk, and the driving up of prices is amplified. It will therefore be even more expensive to buy UK government bonds (particularly longer dated index-linked gilts), and even harder to find good quality, suitably yielding, credit assets.
Over the next 5 years, some estimates suggest the UK Government will need to issue £1.25 trillion of gilts to meet expenditure of the current crisis. Problem solved? Not quite; whilst there is a chance that some of this new issuance could be useful for pension schemes and insurers, they will have to compete with other investors, including the Bank of England as it continues to broaden its quantitative easing programme.
The size of the sterling investment grade credit market is c. £375 billion in size, with c. £60 billion issued in new corporate debt last year. Debt issuance has exploded in recent years with the cost of issuance being particularly cheap due to the low interest rate environment. In addition, quantitative easing programmes in the UK, US and Europe have been widened to include the purchase of corporate bonds. To put the sterling credit market in to context, the euro investment grade credit markets is €2.4 trillion in size and with over €660 billion of new issuance last year, and both pale in comparison to the US.
It therefore appears that corporate bonds may be a source which can help fill this gap at a more affordable level for pension schemes. However our initial analysis shows that the race to purchase high quality credit (the kind a scheme would want) may have already been began. What will be left for those pension schemes who are looking to purchase credit later is likely to be lower quality credit (and/or lower yielding). We have already began to see this trend in the aggregate, with pension scheme's share of investments in BBB credit having increased in recent years. Although you have greater issuance, and brand new issuers in the market, the quality of marginal issuance relative to debt outstanding is worsening. This race is only exacerbated by insurers having a significant demand for the same type of UK credit assets.
UK firms issuing more debt is unlikely to be the answer. Non-UK issuers are already are c. 50% of sterling issuance. We are likely to see more in the future. However Brexit does put a cloud over this, in particular sterling issuance being expensive relative to USD and Euro domestic issuance. Therefore even though there is a wall of money of ready buyers of sterling denominated credit, lots of issuers are waiting until after the dust settles to decide whether this is the market they want to issue long dated credit in.
Where does this leave us?
The implication of this is that de-risking is not just about setting a suitable journey plan or glide-path. We need an even wider lens through which to consider a truly integrated risk management framework, one that includes opportunistically de-risking ahead of plan if circumstances permit, to avoid a costlier decision later. De-risking later may cost scheme sponsors far more than biting the bullet sooner as credit spreads fall during this race and they are forced to buy more gilts than expected.
Going forward de-risking may not just be funding level led, but capital market led as well.
Want to know more details? You can read our whitepaper The Tipping Point: The race for end game assets here
