Invensys swaps linkers for nominal in hunt for cash flow

Low interest rates and sustained low gilt yields have seen UK defined benefit deficits surpass £1tn on a full buyout basis, with Hymans Robertson research last month showing DB pension accrual now costs sponsors around 50 per cent of pay.

Meanwhile, Invensys’s funding level remained largely stable, dropping slightly to a deficit of £73m at March 31 2016 from a surplus at the 2015 actuarial valuation.

A scheme might want to move from index-linked gilts to fixed income gilts if it had managed to reduce or remove inflation-linked liabilities

Jonathan Crowther, Axa IM

In the scheme’s annual newsletter, trustee chair Kathleen O’Donovan said: “The funding level, along with the security provided by Invensys Limited and the Schneider Electric guarantee, gives the trustee confidence that the scheme is well positioned to pay the pensions promised to its members.”

Fixed rates deliver cash flow

Invensys upped its allocation to fixed interest gilts in the year to March 31 2016 to 40.2 per cent of the overall portfolio from 28.5 per cent previously.

The move reflected a similar decrease in its allocation to index-linked gilts, which now make up 27.3 per cent of the portfolio.

The scheme, which is cash flow negative, said the primary motivation for the switch was to increase its incoming cash, helping it to meet pension payments.

The 2016 financial statement reported: “The trustee regularly reviews the efficiency of its asset allocation in delivering both the required returns and cash flows to pay pensions.

“As part of this, the allocation to index-linked gilts, which pay a low cash coupon and are used to generate a return above swaps within the [liability-matching fund], was reduced and the allocation to fixed interest gilts increased.”

The effect of inflation on scheme liabilities is also important to consider when choosing between index-linked and fixed interest gilts, according to Jonathan Crowther, head of UK liability-driven investment at Axa Investment Managers.

“A scheme might want to move from index-linked gilts to fixed income gilts if it had managed to reduce or remove inflation-linked liabilities by doing something like a pension increase exchange exercise,” he said.

Invensys has undertaken several Pie exercises, and manages further inflation risk through the use of swaps. Fixed rate gilts offer a higher coupon payment than index-linked gilts, but do not adjust coupon and principal values in line with inflation.

Not all doom and gloom for DB

As a mature scheme with more than 60 per cent of its assets in a liability-matching fund, and coverage ratios higher than 85 per cent, it would be unsurprising if the Invensys scheme has largely weathered the storm of adverse market conditions that developed over the summer.

Recent weeks have seen a string of high-profile scheme closures by companies such as ITV or Marks & Spencer as the cost of DB provision has risen.

The Invensys scheme, although closed in 2015, has secured a funding guarantee of up to £1.75bn from Schneider Electric, which acquired the sponsor in 2013.

But according to Jon Hatchett, head of corporate consulting at Hymans Robertson, unusually high funding levels have not been a prerequisite for post-Brexit success.

“Schemes that have used leverage have tended to do well, and some have seen funding level improvements through this year,” he said. “One of the reasons schemes use leverage in LDI is because they don’t have enough money.”

With interest rates at record lows, unhedged schemes should not be tempted to forgo LDI based on the assumption that it is expensive, argued Crowther.

“Trustees have indirectly or directly been making calls on interest rates for a long time,” he said. “That call hasn’t necessarily been that successful, so I think at this point nobody’s in a position to make that call.”