DB health improves but covenant strength ignored

The average DB scheme in the UK can now expect to pay 92.9 per cent of accrued benefits, according to Legal & General Investment Management’s defined benefit health tracker, a rise of 1.3 percentage points since last quarter.

Equally, 7.1 per cent of benefits will not be paid under current strategies, funding levels and insolvency rates, ignoring the backstop provided by the Pension Protection Fund.

Over the last quarter, improvements in asset performance and nominal bond yields lifted the chance of success, offset partially by changes in both realised and expected inflation.

If you’re taking more risk at the start, if things don’t work out well the impact is worse

Simeon Willis, XPS Pensions

The 92.9 per cent success rate is an improvement from the start of the year, but is likely to have suffered over the last month – the Pension Protection Fund’s 7800 index recorded a tripling of the deficit over October.

While LGIM did not attempt to capture the changes to individual sponsor strength from quarter to quarter, its metric notes that the average sponsor of a UK scheme has a BB credit rating.

This means one in three of these companies is likely to become insolvent over the next 20 years, although LGIM said tightening credit spreads have eased pressure on sponsors over the quarter.

CDI move branded premature

For Graham Moles, LGIM’s head of portfolio solutions, many schemes are therefore moving into cash flow-matching strategies too early, before they have built up a funding level commensurate with the risk of having to buy out due to a sponsor insolvency.

Cash flow-driven investment involves constructing a portfolio using mostly fixed income assets, using interest to pay pensions rather than taking the market risk of selling assets.

“For most schemes in the UK there’s a reasonable chance of default before the pension is paid,” he said. Unless schemes are funded closer to their buyout deficit, “the fact that you may have some assets that match your cash flows is neither here nor there”.

He continued: “I’m a strong advocate of cash flow matching when the time is right," arguing that all asset classes except commodities deliver income. “My worry is that people are moving into those strategies too early, they’re not well funded enough to do it.”

Moles said the search for yield in CDI has led many schemes into illiquid assets, which may not be attractive to an insurer in the event that the scheme buys out.

Nonetheless, LGIM’s favoured allocation would follow a similar theme, seeing a diversification of equity risk into credit assets and alternatives, while hedging inflation and interest risk without increasing cash calls on the employer via leveraged liability-driven investing. This, the tracker predicted, would see schemes meet 94.1 per cent of pensions.

Schemes told to maintain constant risk

“There are some schemes that are just too far away for them to have sufficient return [from strict CDI],” said Simeon Willis, chief investment officer at consultancy XPS Pensions.

However, he drew a distinction between pure CDI and a broader definition. The first would match cash flows closely with low outperformance of liabilities, holding bonds to maturity and re-investing in gilts.

This strategy might only be available to those looking for less than 2 per cent above the risk-free rate of return. But he said a looser type of CDI, a largely income-focused portfolio, is accessible to a wider band of schemes

He agreed that greater LDI hedging by UK schemes would minimise their downside risk, but cautioned against schemes taking more risk because their funding level is not sufficient or because trustees are concerned about their covenant.

“If you’re taking more risk at the start, if things don’t work out well the impact is worse,” he said, advocating a constant level of risk maintained.

Willis also warned against schemes relying on equity income: “Dividends from equities, whilst they offer a cash flow, they can be turned off in an instant.”

More schemes close to buyout

The general improvement in DB health painted by the LGIM index has been reflected in a massive year for buy-in and buyout activity.

Bulk annuity sales have already broken £20bn for 2018, according to consultancy Hymans Robertson, up 50 per cent on the previous high of £13.2bn sold in 2014.

A survey undertaken by the consultancy found that all independent trustees approached believed that even more deals will be struck in 2019.

James Mullins, head of risk transfer solutions at consultancy Hymans Robertson, said pricing for buy-ins and buyouts has been keen over the past two years as insurers look to enter the market and explore more adventurous investment strategies, but that this dynamic was starting to change.

“2018 has definitely been the first year where the supply from the insurers has been outweighed by the demand from pension schemes,” he said, adding that many schemes are queuing up to transact early next year.

Mullins expected bulk annuity pricing to remain attractive, if not as good value as it was over the past year, despite this shifting dynamic.

One key area where pricing is improving is for deferred members, explaining the increase in full buyouts, and more insurers may enter the market.

Nonetheless, Mullins said limited capacity means schemes considering bulk annuity purchase should look to make themselves an attractive proposition, carrying out data cleansing exercises, member option exercises, and showing that both sponsor and trustee are committed to the deal.