The UK government recently published its highly anticipated Pension Schemes Bill, opening the door to more flexible treatment of defined benefit (DB) pension scheme surpluses. While buy-out remains the gold standard for member security, many trustees and finance teams are now exploring if, and how, running-on their scheme could work for the benefit of its members and the sponsor.
If insurance companies can secure member benefits while also generating attractive investment returns on their capital, why can't pension schemes – especially as, unlike insurance companies, pension schemes do not have to adhere to the strict matching requirements of Solvency II?
However, some pension schemes are finding it challenging to implement an insurance-like investment strategy in practice. We explore the reasons why – but more importantly, how trustees can overcome these challenges.
Investing like an insurance company
Insurance companies follow an approach like the one below, which is typically known as Cashflow Driven Investing (CDI).
Step 1: Buy and hold onto a portfolio of high-quality corporate bonds that will deliver payments in line with the insurer's pension obligations. When credit spreads are tight (as is currently the case) insurers will also often find other ways to match cashflows that still capture value, and then look to switch these into corporate bonds when spreads widen (more detail on this later).
Step 2: Invest in additional cashflow generating assets, like private credit to boost returns further.
Step 3: Use Liability Driven Investing (LDI) derivatives, like swaps, to top-up the interest rate and inflation hedge. The LDI strategy will consider the hedging already provided by the assets bought in Steps 1 and 2.
This insurance-like approach can also be beneficial for pension schemes because it gives trustees greater comfort that they will be able to meet their ongoing payment obligations, without having to sell assets at the wrong time. Investing in high-quality, contractual assets like investment grade (IG) corporate bonds can also reduce the chance of the pension scheme failing to achieve its long-term return objectives. Adding in LDI also protects the day-to-day funding position of the scheme from fluctuations in interest rates and inflation.
While the building blocks of CDI will be familiar to many trustees, they face several challenges when seeking to mirror this strategy in their pension scheme.
Challenge 1: Delivering high enough returns at the same time as matching
When implementing a CDI approach, pension schemes need to put aside enough assets to meet the collateralisation requirements of the derivatives in their LDI strategy, as well as to match their pension cashflow obligations.
Most pension schemes are only able to post cash or gilts as LDI collateral, which means they need to tie up a considerable proportion of their assets in these low yielding assets. Additionally, the credit spreads available on cashflow matching assets like corporate bonds are at historic low levels. These two factors mean that some pension schemes will struggle to generate high enough returns from their CDI strategy to make running-on worthwhile.
To offset the low yields available on their CDI portfolio, some schemes have retained a small proportion of their assets in growth strategies (such as equities) that they hope will earn much higher returns – a so-called bar-bell approach. However, as relatively few asset classes are able to deliver these returns, this can lead to a very concentrated growth portfolio, with significant downside risk.
To overcome these challenges, insurers will usually implement LDI more flexibly than pension schemes. For example, they can typically post corporate bonds as LDI collateral, as well as cash and gilts, on attractive terms. This means that they can invest more of their assets in credit and less in gilts and cash to earn a higher yield on their CDI portfolio. This is particularly important for inflation hedging, for which there are fewer physical matching assets available that also deliver an attractive yield.
Insurers may also be able to use their balance sheet as a source of last-resort liquidity. Again, this can reduce the amount of cash they need to commit up front to support their LDI strategy.
An example pension scheme asset allocation and an example insurance company asset allocation are shown in the charts below. The insurance company can allocate more of its assets to corporate bonds and private credit than the pension scheme, which needs to hold more in gilts and cash to support its LDI strategy. The pension scheme has also retained a 10% allocation to a concentrated growth asset strategy to enable it to achieve its long-term return objective. The insurance company has more assets available to achieve additional returns, so can construct a more balanced portfolio overall.
