BT targets cash flow-matched strategy by 2034 with IRM

Experts predict that IRM will only increase in importance as covenant risk comes to the fore of trustees’ minds.

But until recently, there were few tools available to streamline the process, with traditional risk management approaches taking a relatively narrow view of company accounts, as well as being prohibitively expensive for smaller schemes looking to ensure best practice.

IRM approaches are typically more holistic than the tools traditionally deployed in assessing risk for DB schemes, accounting — for example — for covenant impact and sponsor viability.

One of my frustrations at the time was this is not something the pensions industry has done a very good job of doing, in terms of modelling covenants and pension schemes. I think we could have done some really bespoke detailed modelling with other firms, but there wasn’t a ready-to-use piece of software that did this in a fairly intuitive way

Paul Rogers, BT

Gazelle, founded in 1996 by Simon Willes as a Financial Conduct Authority-regulated specialist corporate finance company, has been developing software designed to ease the IRM process. 

BT commissioned the company to begin working with its pension scheme in 2018, using its Mousetrap tool to help manage BT’s risk and reach its 2034 target.

Since then, Gazelle has developed a slimlined version of the product designed for use with smaller schemes, providing covenant reports at a fraction of the price of a traditional assessment. This makes it a significantly more cost-effective solution for the underserved small and medium-sized market. 

Catering for the big guys

Gazelle operates an IRM tool for larger schemes. Its Mousetrap tool was the first commercially available IRM model, used by the Pensions and Lifetime Savings Association for its defined benefit task force, and referenced by the Pensions Regulator in its 2016 green paper on DB pensions.

“It is a big, sophisticated model, which tries to represent the employer in some detail and integrate that with a more detailed asset-liability modelling setup,” Willes explains.

It has been used by the BT Pension Scheme, the UK’s largest corporate DB scheme, which has around £58bn in assets. BT and Gazelle began working together shortly after the 2017 valuation, where the decision was taken to move gradually from equities to a fully cash flow-matched strategy by 2034.

“I think the question we started to ask ourselves was: what’s the right level of risk, not just for BT but for the pension scheme for all our members, and really to ask what is the right investment strategy for the pension scheme,” says Paul Rogers, head of pensions risk at BT. 

“And that was the real start of the work [with Gazelle]. Once we’ve been through that valuation, just to go through and look at all those scenarios and it actually helped us to go into the next valuation to the 2020 valuation with a very clear view.”

The cost of Gazelle’s larger IRM modelling service was not necessarily a deciding factor when selected by BT, but rather that “at the time, there was no one else offering this”, Rogers continues.

“One of my frustrations at the time was this is not something the pensions industry has done a very good job of doing, in terms of modelling covenants and pension schemes. I think we could have done some really bespoke detailed modelling with other firms, but there wasn’t a ready-to-use piece of software that did this in a fairly intuitive way,” he says.

Helping the little guy

Gazelle launched DBiCAM, its tool for small and medium-sized schemes, in September 2021. The company describes it as “a fully integrated pension risk model designed to benchmark covenant risk” into TPR’s existing “strong-weak scale”.

Priced at around 10 per cent of the cost of standard covenant assessment, the company bills DBiCAM as “a great way to organise available risk information about your employer and scheme joining everything up to support better decisions about pension risk”.

While normal covenant assessments done by accountancy firms spend a lot of time looking over the most recent accounts and the most recent one-year forecasts, DBiCAM looks “at the whole period to the scheme reaching an endgame, whether it’s insurance or consolidation, and the risks that the employer pays into the scheme over that period”, Willes tells Pensions Expert.

“It doesn’t replace the whole covenant process because we are purporting to give covenant advice, which is what you can do about the situation that you’re in,” he says. 

“We are producing a covenant assessment, which diagnoses what covenant support the employer is providing for a particular scheme or risk profile over the short, medium and longer term, and then looking at why it’s weak or why it’s strong in terms of whether affordability is the issue, or whether the rest of the benefits on default are the issue.”

The smaller scheme market has been “particularly problematic”, Willes argues, because “there is a cost constraint on compliance with the guidance” set out by TPR.

Smaller schemes, of which there are between 3,000 and 4,000, can often be “a bit stuck” as some lack the means to assess covenant strength beyond merely asking the employer to rate their own viability, which can lead to some “gaming” the system.

“On the smaller end of the market, there are a number of actuarial firms that look after the smaller schemes and that’s really where our marketing focuses and probably where our initial gains will be,” Willes says. 

“Some of the consolidators may find it useful to have a very economic way of screening and filtering a large number of covenants, and it’s those types of application where I think we’ll make early progress.”

Covenant comes to the fore

Willes and Rogers agree that the need for tools like Mousetrap and DBiCAM will become ever more pressing as covenant risk comes to be seen as one of the biggest risks to closed and maturing DB schemes.

“I think very shortly, perhaps within the next two years, most of the medium-sized and larger schemes will try to agree with their employers on long-term funding objectives, which is what the regulator’s encouraging them to do,” Willes explains. 

“Once the longer-term funding objective is the target and set in stone, then normal actuarial valuations will change considerably.”

This will make for “a very different game”, where the job of actuaries is to “monitor the flight path and check for any divergences”, he says.

“Will the employer last the course, and can the employer afford the course? I know we’re all discussing climate change ad nauseam at the moment, but I still think those two things are going to come out over the next few years as being the big risks to look at.”

It therefore becomes important that “we find a way of introducing covenant risk into the scheme-side asset-liability modelling setup”, Willes continues.

“Actuarial science stops at the boundaries of the scheme. They really don’t like looking at sets of accounts and companies — I think there’s a natural boundary there — and on the covenant side it’s quite accountancy and restructuring dominated, and with a very heavy short-term bias and accounting focus.

“The two don’t very easily marry up together,” he adds. The accountants “don’t like the sort of probabilistic modelling which is the asset-liability modelling side, and they don’t really have anything medium or longer term to put alongside the asset-liability modelling”. 

“So that’s really what we’ve done. We’ve developed a company simulation model that provides a picture of risk and uncertainty on the employer side that can be married up with the asset-liability modelling side, and then you can see what the impacts are between the employer and the scheme.” 

Rogers concurs, telling Pensions Expert that “it does feel like the way forward”.

“The typical view has been to do an asset-liability modelling study that looks at the pension scheme in isolation and tries to work out what investment strategy works best for the pension scheme. And the impact on the sponsor has not often been considered,” he says. 

“And I think over time there’s more and more focus being put on proper IRM. Once the products become more available to those smaller and medium-sized companies and schemes, it will only grow — it has to.

“We’ve certainly found the analysis gives you a lot more than you can get if you don’t look at the covenant dynamic.”