The race to buyout is on as schemes look to target a buyout or buy in within the next two years, research from Professional Pensions shows. But there are no shortcuts in preparing for such a move. Forward planning is essential to ensure schemes remain in a strong position to engage with the insurance market and react to market conditions if they run on.
Investment risks and surplus challenges
Chapter 2.
Investing in the assets of the future
Chapter 3.
Preparing for the race to buyout.
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The race to be buyout ready
Chapter 1.
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The race to be buyout ready.
Schemes are closer to the funding levels required to de-risk, and more than 60% of respondents are actively targeting a buyout - but that may mean the challenges for them have only just started… Volatile markets, geopolitical instability, rising rates, inflation, and general economic malaise – trustees and employers have seen their fair share of uncertainty over the past two years and the impact on pension schemes has been significant. Indeed, the market turmoil following the now infamous mini-budget of September 2022, exposed vulnerabilities in leveraged schemes, with many left exposed to movements in interest rates and inflation. Yet two years on, the outlook is changed again: following a rise in long-term gilt yields, many DB schemes’ funding levels are now much improved, and the challenge today has become access to the buyout market and the ability to react quickly and make the best investment decisions. Research from Professional Pensions suggests that in 2024 DB scheme trustees are operating with healthy funding levels. Over a third, 37%, are fully funded or operating with a surplus while 23% have a funding level of between 95% and 100%.
62% of respondents are actively targeting a buyout while 22% are expecting to run on the long-term
Unsurprisingly, the path to endgame has become much more straightforward and most DB schemes are now actively targeting buyout. 62% are actively targeting a buyout while 22% are expecting to run on the long-term.
Mitul Magudia, chief origination officer at PIC, believes the market will be busy as more schemes now find themselves able to afford a buyout or being within touching distance of it in the coming months and years. “Five years ago, a small percentage of schemes were fully funded on a buyout basis. Now around 30% of schemes are fully funded,” he says, noting that annual volumes of between £40bn-50bn are not unusual today. There could now be an ‘occasional’ spike in volumes of around £70bn-100bn a year, especially as it has become clear that even the very largest schemes can be insured in this market – as seen by RSA’s £6bn buy-in, and Boots and Co-op’s £4.8bn and £4bn buy-ins all in 2023. However, he adds that there will not be a ‘one-size fits all solution’ for schemes coming to market and it is more important trustees choose an option that aligns with the best interest of members.
How well-funded is your scheme currently?
17%
More than 105% funded on a buyout basis
100% to 105%
24%
95% to 100%
23%
90% to 95%
80% to 90%
15%
Less than 80% funded on a buyout basis
8%
Key
Whole of market solutions.
“Five years ago, a small percentage of schemes were fully funded on a buyout basis. Now around 30% of schemes are fully funded”
Mitul Magudia, chief origination officer at PIC
62% Targeting buyout
22% Expecting to run on long-term
14% Not yet agreed a long-term goal
2% Targeting superfund/ consolidator
What is your scheme’s long-term goal at present?
£6bn
£4.8bn
£4bn
£937m
£750m
£150m & £140m
What lies ahead: Investment risks and surplus challenges.
After a stormy period of uncertainty, a range of new options have emerged for schemes to make better use of the surplus and put their improved funding positions to work. To gauge sentiment among DB scheme trustees, respondents were asked to rank what they perceived to be the biggest risks their schemes currently faced. Investment risk came out on top, ahead of regulatory risk and cyber security risk. See full list to the right Kevin Wesbroom, professional trustee at Capital Cranfield, notes this has been the biggest challenge for schemes, with the impact of high inflation meaning some with uncapped-index-linked pension increases will be more exposed, and others may face calls to apply for an uplift. Meanwhile, the prospective lowering of rates in 2024, if the Bank of England continues on its suggested trajectory, could also impact investment decision. “Schemes can get to full funding either from investment or contributions from the sponsor,” says Wesbroom. “What has changed now is that the improvement in overall funding means there is less reliance on the sponsor to pay contributions to meet (smaller) deficits. So, investment becomes risk number one again.
What do you think are the biggest risks facing your pension scheme currently?
In your view, is extraction of any surplus in the best interests of your scheme's members?
10%
Yes
No
41%
We are considering the merits
49%
Kevin Wesbroom, professional trustee at Capital Cranfield
“Schemes can get to full funding either from investment or contributions from the sponsor”
Even when schemes are well hedged, PIC’s Mitul Magudia explains that market volatility is always a concern, as demonstrated by the LDI crisis of 2022. He explains: “While the rise in interest rates have helped some schemes reach their buyout objective sooner or shorten their de-risking journey plan, there may have been some schemes that did not fare well during this time.” However, away from investment risk Magudia also believes there is a risk of schemes ‘missing the boat’ by failing to take advantage of their current position. “It would be awful to find in a years’ time interest rates have plummeted, schemes that were in surplus are in deficit and need to ask sponsors for contributions…so it is important that schemes lock-in; whether that is via a buyout, hedging liabilities or use interest rate and inflation swats on assets.”
Surplus options
Meanwhile, with so many DB schemes in surplus the survey revealed trustees are still split on the best course of action when it comes to surplus extraction. Nearly half of respondents (49%) were still considering the merits and couldn’t answer as to whether or not this would be in the best interests of members. However, 41% certainly did not feel it would benefit them. There was greater certainty when asked about the conditions in which a scheme could return its surplus, with 59% identifying this as windup.
There are no restrictions
29%
Only if the members receive a percentage of the surplus
12%
On wind up
59%
Under which of the following conditions can your scheme return its surplus?
This may be because surplus is measured in different ways; for example a surplus relative to buying out with an insurance company or relative to the measure the scheme has set for itself for running on. Surplus can also be measured relative to an accounting basis, which can mean they are in a weaker position. “My view is that surplus extraction will be a minority sport in the pensions industry. It just won’t be relevant to many schemes, who will use the improvement in funding to get to buyout sooner than they had expected,” says Wesbroom. “But that minority could represent a large pool of assets, probably with sophisticated sponsors in financial services, who can deal with the challenges of running a scheme on to extract surplus.” Whilst the government’s consultation on Options for DB schemes and on how surplus capital can be accessed has halted for the time being (in part as a result of the General Election); around 10% of respondents said the consultation could change their scheme goals – just over 10% of respondents said they were more likely to target a longer term run on for their schemes. “The language used is important here: surplus extraction speaks to money flowing to sponsors,” points out Calum Cooper, partner and head of pension policy innovation at Hymans Robertson. “Many will feel philosophically opposed to that. But sustainable surplus sharing is of interest to many schemes of sufficient scale. In any event, clarity from DWP on how this can be done safely for the benefit of all stakeholders will be very helpful.”
A driver of the original consultation on surplus was part of the government’s motivation to free up pension capital and facilitate its investment into productive assets in the UK, thereby stimulating the economy. Against this backdrop, Magudia, believes guidance for DB scheme trustees on how they can improve portfolio liquidity is key, as he warns about the viability of investment in productive assets. “There is a lack of availability of infrastructure type assets to invest in across the UK,” says Magudia. “There are both structural reasons for this, and market specific reasons. On the structural side, local authorities quite simply don’t have enough capacity in their planning teams to manage the potential flow of development applications. This has severely curtailed the number and quality of projects available to invest in. PIC is at the forefront of efforts to resolve these structural issues, for example through our work with the Purposeful Finance Commission.”
Infrastructure focus
Investment risk Regulatory risk Cyber security risk Political uncertainty Operational risk / delivery of member administration Interest rate risk Inflation risk Longevity risk Sponsor covenant risk
1
2
3
4
5
6
7
9
8
Kevin Wesbroom, professional trustee at Capital Cranfield, notes this has been the biggest challenge for schemes, with the impact of high inflation meaning some with uncapped-index-linked pension increases will be more exposed, and others may face calls to apply for an uplift. Meanwhile, the prospective lowering of rates in 2024, if the Bank of England continues on its suggested trajectory, could also impact investment decision. “Schemes can get to full funding either from investment or contributions from the sponsor,” says Wesbroom. “What has changed now is that the improvement in overall funding means there is less reliance on the sponsor to pay contributions to meet (smaller) deficits. So, investment becomes risk number one again.
Investing in the assets of the future.
Why calls to reform the way DB schemes manage their cash to invest in sectors such as infrastructure and technology would be a significant change from the norm for trustees. Shifting bond markets have allowed DB schemes to repair deficits but macroeconomic uncertainty and geopolitical upheaval in 2024 could bring about market volatility. Perhaps this is why most respondents in the survey identified portfolio derisking as their main priority – with 37% having completed this, and 25% in the process. Closely tied to this was a reduction to illiquid asset allocations, with 23% and 27% at these same stages, respectively.
What actions are your scheme considering to progress towards your long-term goal?
Buyout Buy-ins Review of scheme administration and benefits Reducing allocation to illiquid assets Transitioning to a lower risk investment strategy Data audit and cleansing projects
Already implemented
“Schemes can get to full funding either from investment or contributions from the sponsor,” says Wesbroom.
Ian Mills, partner at Barnett Waddingham
“Pension schemes have invested on a global basis for many years, so it’s neither surprising nor troubling that investment in the UK is a low priority”
However, where does UK infrastructure feature in these decisions? The government has been actively encouraging UK pension funds to invest in UK infrastructure and it was a core element of the Mansion house reforms last year. While many pension funds want to increase allocations to UK infrastructure over the coming year; our research showed there was an equal 50/50 split between respondents who felt they had the necessary scale and expertise to invest in UK infrastructure, and those who didn’t. A challenge here, according to Roger Mattingly, trustee director at Independence Governance Group, is the potential for liquidity mismatch. “Trustees invest in the best way they can for their beneficiaries,” says Mattingly, “and if that means investing in UK infrastructure, then great. But infrastructure is invariably illiquid and if you have a time horizon of 2-3 years, and LTAFs often have a lock in period for three years, there is a challenge.” Over the past few years there has been discussions around forcing pension schemes to invest in assets directly linked to the UK’s economic future in a bid to kick-start the economy. This could be a significant change for schemes which to date have not prioritised it. Over half of respondents were not engaging with this, with 42% considering UK economic investment as low priority and 25% not considering this. Ian Mills, partner of investment consulting at Barnett Waddingham, explained: “Pension schemes have for many years invested on a global basis, and the UK is now a relatively small part of the pie, so it’s neither surprising nor troubling that investment in the UK is a low priority,” says Ian. “If pension schemes ranked investment in general as a low priority, then it would be troubling! “This is not to say there are no good investment opportunities in the UK – it’s just there are many more good investment opportunities around the rest of the world.”
Sustainable outlook
DB trustees may be divided on how infrastructure fits into their schemes, and their exposure in general to the UK economy, but they were more positive about engaging with sustainability as a theme. When asked, 76% of respondents were confident they could effectively build sustainability into investment decisions. Mitul Magudia – chief origination officer at PIC - says this reflects the demand they are seeing for guidance around Environmental, Social and Governance (ESG) on a wider basis. “ESG has been high up on schemes’ agendas for many years now,” says Magudia, “In particular, they are required to meet and demonstrate a certain level of ESG standards, so it has come a long way in UK pensions.” There is also an increasing trend within DB schemes to re-orientate their focus around ESG – and in particular focus on the ‘S’. According to Magudia, the term social value is yet to be fully defined, and there is considerable work to do to evidence and assess the extent to which these investments create it.
Low priority
42%
Medium priority
30%
High priority
3%
How much priority does the scheme place on investing into the UK economy?
Barnett Waddingham’s Mills still sees room for improvement, with many schemes reliant in off-the-shelf asset management products that may not align with their objectives. “The good news is that the level of innovation in the asset management industry has stepped up with new product launches,” adds Mills. “We encourage schemes to regularly review their policies and implementation approaches to ensure that they can take advantage of the evolving landscape. That said, care needs to be taken to avoid churning investments too much.” While there may be confidence among respondents, Mattingly is unconvinced how much this may be followed through. The logic being many DB schemes pursuing buyout may be motivated to reduce these allocations and rotate into cash and bonds to entice insurers. “Investing in companies geared towards sustainable energy, biodiversity etc is directly proportional to the time horizon of investments as things stand because the insurers – dictated by their own regulatory reserve requirements – won’t accept equities,” says Mattingly. “Divestments have to be made when you go to the buyout market, ordinarily. Most organisations now, if they are fully funded, will hedge against the buyout pricing which doesn’t lend itself to ESG and sustainability.”
Room for innovation
Currently implementing
Planning to implement
Considering over next 24 months
Not considering
Not considered
25%
When talking to trustees and policyholders, they see considerable value in this work, helping them understand how assets are invested responsibly and have a net positive social impact. To this end, PIC’s recent report, The social and economic value of finance published in conjunction with capital markets think tank New Financial, shows the footprint of the group’s investments and policyholder payments across the UK and the real-world impact of these investments on the economy. “By helping to engage trustees and other stakeholders on the real-world impact of long-term investments in infrastructure and regeneration projects providing the cashflows to back pensions stretching decades into the future, we hope to continue to help drive innovation, understanding, and progress in reorienting the sustainability movement onto the people at the end of the investment process.
Social and economic impact of finance
Buy-ins
Review of scheme administration and benefits
Reducing allocation to illiquid assets
Transitioning to a lower risk investment strategy
Data audit and cleansing projects
