What can pension schemes learn from insurers?

Where pension funds approach asset and liability management from the dual perspective of investing in return-seeking and risk-reducing assets, schemes may be wise to consider the broader investment philosophy adopted by their insurance counterparts.

Boris Mikhailov, investment strategist, global investment solutions at Aviva Investors, said a large number of pension schemes was already cash flow negative, and that within the next decade, most schemes are expected to be in that situation.

“Adopting similar approaches to how insurers manage their assets is a natural evolution for pension schemes. This will require moving away from the traditional ‘barbell’ or ‘two-bucket’ approach... towards a more holistic cash flow driven investing approach of building portfolios,” he said.

Using this strategy, schemes would have less dependence on traditional growth assets to generate excess returns, and would place more emphasis on liquid and illiquid income generating strategies.

Mikhailov added: “It is possible to build high-quality investment grade portfolios that generate in excess of 1 per cent return over liabilities, while producing predictable income to help meet liabilities.”

Investing in illiquid assets, such as infrastructure debt, “could provide income for the next 20 years with yields of 2 per cent over fixed interest gilts”, he maintained. This would provide high-quality and low-risk cash flows that would be used towards paying liabilities without paying prohibitive gilt prices, according to Mikhailov.

Employed by capital

The most glaring difference between pension schemes and insurers revolves around their respective attitudes to risk.

Less mature schemes are beholden to risk-bearing strategies designed to achieve asset growth. Insurers, on the other hand, are subject to strict capital requirements.

EU directive Solvency II requires insurers to have 99.5 per cent confidence they could withstand the worst foreseeable losses over the course of a year.

The absence of a sponsoring employer means that for insurers, “capital is their employer”, said Lincoln Pensions managing director Richard Farr.

“The assets they invest in generally are risk-free, and the returns are therefore lower… therefore the deficit that a pension fund would have if it adopted insurance company policy would be huge,” Farr said.

While schemes and insurers diverge on risk tolerance, pension funds have mimicked the insurance industry’s approach to liability-driven investment, according to Farr.

“What you’ll find is that a lot of the advisers in pension funds have adopted what we call ‘insurance-type behaviour’ on LDI, on longevity,” he said.

The key difference lies with “the core rump” of deferred pensions, “which can’t be insured, can’t be bought out [and] can’t be hedged so well”.

An insurer’s approach requires maturity

The growing maturity of the pensions landscape, and the rising number of schemes closing to accrual, means that liabilities are becoming more well defined.

Andrew Harrison, director at Law Debenture Pension Trustees, sees this stronger flow of liabilities as “an insurance-type problem to solve” for mature schemes.

Harrison said that “the jury’s out” on less mature schemes. The uncertainty surrounding projected liabilities for more junior schemes makes it harder to import an insurer’s investment strategy.

Transfer activity adds a further layer of complexity to liability forecasting for both mature and immature schemes, he said.

Harrison cited the Pension Protection Fund as an example of a scheme that has incorporated an insurance philosophy into its investment approach.

“Some of the work that insurance companies do, particularly on the risk management side, is probably unnecessary for pension funds,” he said. “Nonetheless, the way insurance companies think, I personally think it’s very important that pension funds take that on board.”