Over the past 12 months the landscape for UK defined benefit (“DB”) pension schemes has forced trustees and their advisers to focus their attention on their investment strategy and grasp de-risking opportunities as they are presented. Throughout the year headwinds have been coming from all directions: geopolitical risks, stubbornly high inflation, and not least the recent spike in UK gilt yields which caused a tail risk event to occur for schemes holding liability driven investing (“LDI”) strategies.
The accumulation of these events has caused longer dated government bond yields to rise in most developed market economies; in the UK the 20-year gilt yield has increased three-fold since the start of the year. UK government bond markets are no longer mundane investments, a stigma which attached itself to the asset class with the steady decline in yields since the great financial crisis in 2008/09.
Whilst rising yields have been detrimental to the price of fixed income assets, it has of course allowed many UK DB schemes to target their so called end-game a lot sooner than many trustees expected. The startling impact that yield movements will have had on bond and LDI portfolios will have been mitigated by a fall in liability values, paradoxically leaving many schemes with a better funding position.
The end-game will of course look very different from one scheme to the next depending on a host of unique circumstances. However, for those schemes whose goal it is to fundamentally transfer their liabilities to an insurance company the past few months have certainly presented trustees with a golden opportunity to act. Schemes with engaged trustee boards will have been best placed to capitalise on these recent events as they attempt to lock in their improved funding position and make their investment strategy more buy-out focussed.
In preparation for buy-out, trustees should look to restructure their scheme’s assets to protect their buy-out funding position, investing in assets that are more closely correlated with buy-out pricing. Buy-out prices are subject to fluctuation over time with changes in multiple factors such as market conditions (e.g. credit spreads and gilt yields), insurance industry regulation and constraints (e.g. Solvency II), and the individual insurer’s desire to transact (e.g. supply and demand dynamics) as well as scheme specific factors.There is a balancing act that trustees need to consider: wanting to mirror the movements in liabilities associated with interest rates and inflation as closely as possible whilst acknowledging the different premia associated with buy-out pricing. It is this second point that is more difficult to quantify and to protect against. Scheme assets should therefore be invested in a similar way to those that a typical insurance company would hold and are sensitive to the same key factors. In this way, as buy-out pricing changes, the scheme’s assets should move in a similar way.
Having a long-term investment strategy in place is paramount for any scheme. However, recent events have highlighted the need to remain nimble. Schemes who have a designated liability matching portfolio in place have been able to quickly transfer assets from risk seeking assets, such as equities, and invest in line with the movements of their liabilities, such as gilts and bonds; a liquid portfolio being critical to ensuring buy-out pricing can be acted on quickly. Trustees should consider the composition of both the return seeking and liability matching portfolios in more detail, setting up an investment strategy with one eye on long term objectives can certainly improve the ability of trustees to act as quickly possible when the opportunity presents, as has been evidenced recently. In that way, they will be much better placed to capitalise on opportunities as they arise.
Stefano Carnevale, CFA, Investment Consultant, Quantum Advisory