Rising gilt yields in recent years have resulted in many UK defined benefit (DB) pension schemes now able to afford a full insurance buyout. Many of these schemes are likely to buyout as soon as possible, however, an increasing number are considering continuing to run-on, either for a defined period or for the long term.
So - how should schemes running-on invest?
No single run-on investment strategy is optimal for all, but there are some core principles that can be applied universally. Furthermore, by applying these principles it is possible for schemes to run-on with very low risk to member benefits and a high likelihood of building surplus that can be used to benefit members and/or the sponsor.
Our mantra for schemes actively running on beyond buyout affordability is 'Stable, buyout aware, growth', providing a very important and powerful framework for effective run-on. This should generate meaningful surplus in a risk-controlled way:
Stable
Perhaps the most intuitive of our three aims is stability. The average UK pension scheme running on today is mature and is paying out significant annual cashflows to meet pensioner payroll. In this situation, you don't want large swings in funding level because once you get into substantial deficit, it is much harder to repair that deficit through asset growth while also paying out pensions.
In practical terms, stable investment are portfolios with good cashflow generation, high levels of diversification and robust hedging.
Of course this does not mean targeting no volatility. Schemes in run-on are, by definition, well-funded. With a surplus buffer or downside security (such as a surety bond) to protect against employer insolvency, they should feel comfortable with modest levels of volatility. The key is that you have a stable enough strategy that the risk of slipping into significant deficit is low.
It is also important that you track the right deficit, bringing us to our second principle.
Buyout aware
Buyout aware means assessing investment portfolio risk relative to the prevailing estimated buyout cost and matching movements in the cost as best you can.
You may ask "why do I need to try and track buyout pricing if I'm not aiming to buyout?" Well, many schemes currently running on still aspire to buyout in the future and want to retain the affordability of that option. More importantly, maintaining buyout funding provides a very valuable safety blanket, should corporate risk appetite change or the sponsor covenant deteriorates (even failing completely). Schemes with a buyout surplus can exit their run-on strategy and minimise risk of not being able to insure members' benefits in full if they aspire to always be able to afford to buyout.
For those schemes already fully funded on buyout and close to transacting should hedge against increases in the buyout cost from interest rate, inflation and credit spread movements.
Run-on can also implement strategies that deliver a similar level of tracking for buyout pricing, but can do so with only around 75 percent of total assets in this way (and a modest amount of leverage). This leaves up to 25 percent of the assets to deliver on our third and final principle – Growth.
Growth
Schemes actively running on should usually target a meaningful amount of investment return - the most appropriate level will vary on a scheme-by-scheme basis. For example, schemes with a longer term to invest before they intend to buyout are generally able to target the most growth. For the typical scheme with no aspiration to buyout in the short term, this optimal level of return could be in the region of 1.5 percent p.a., above the risk-free rates available on gilts and cash. Targeting around +1.5 percent p.a. makes run-on more viable to meet ongoing expenses and generate surplus for distribution to members and sponsors.
For many schemes this could be a mindset change and higher than their current target, or what they may previously had in mind for a run-on portfolio.
Getting scheme-specific
As noted above, scheme-specific factors are important to consider in optimising strategy, these factors include:
- expected run-on term
- existing assets
- starting and projected funding levels
- employer covenant
- any contingent security (such as surety bonds)
- surplus distribution to the employer and members
Understanding the interaction of these factors, and quantifying all of these risks accurately, is crucial for trustees when constructing a run-on investment strategy. The best models in the market have evolved to also include the non-investment risks, like employer covenant changes, longevity and buyout pricing risk, in the range of outcomes.
The benefits of investing in this way
Pension schemes invested in this way can expect surplus to grow in a stable way with low investment volatility relative to the estimated buyout cost. Where this type of investment strategy is deployed as part of our Active Solution to Run On (ASTRO) framework, which combines it with; robust multi-layered covenant protections, upside for members, and distributions to employers, it can be highly effective. Further information on ASTRO can be found here.
In conclusion, investment strategy is critical to making a success of running on. But a pension scheme with a well-constructed investment strategy has an unrivalled opportunity right now to simultaneously improve security and enhance outcomes for members and sponsors.
