Run-on and surplus
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Tracking DB scheme surplus over time on a low dependency basis
Amid the rise in aggregate funding levels in recent years, many scheme are now not only fully funded, but in surplus. The chart below highlights the extent to which PPF data currently implies that DB schemes in aggregate are in surplus on a low-dependency basis of ‘gilts+50bps’.
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Source: PwC Low Reliance Index as at October 2023
Seeking to maintain and even grow this surplus has many potential attractions for schemes given the recent regulatory change surrounding surplus extraction, whether that is to generate enhanced benefits for members, to be paid to the sponsor, or to be utilised within funding of a defined contribution (DC) or other DB pension scheme.
Investing for run-on and the potential to generate surplus
As trustees review their investment strategies with the objective of running on to pay pensions and grow a surplus, they will need to consider whether to return value to the sponsor, provide an uplift in benefits for members or to top-up a related DB or DC scheme (or a combination thereof). It is therefore vital for them to take into account the assets, the liabilities and the sponsor covenant. Whilst an important feature of portfolio construction is that it is should be holistic, it can be useful to think in a segmented or ‘pot-based’ approach to construct:
· A matching portfolio with the primary objective of meeting accrued benefits, a key feature of which will be to consider a cashflow-matching approach, integrated with LDI strategy, to pay cashflows, hedge liability risks and generate a surplus over time.
· A surplus portfolio being the remaining assets in excess of the value of the liabilities, invested partly as a ‘rainy day portfolio’ to be used as a first point of call
for any deficit in the matching portfolio, but also to generate short-term or long-term growth commensurate with a surplus extraction plan with the intention of extracting
a surplus that could be returned to the sponsoring company and potentially used to offer additional discretionary benefits to DB members, or to fund the company’s DC pension scheme.
Considered
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Solutions
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Portfolio
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Official
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Key trends
to watch
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Where schemes have a high allocation to cashflow-matching credit within the matching portfolio, it can make sense to deploy a ‘dynamic discount rate’ when calculating the value of the liabilities, where the discount rate is based on the yield of the cashflow-matching assets, so reducing volatility in the funding level.
For more detail on strategies for maintaining scheme health and unlocking surplus, please read our whitepaper: Running on into retirement? Alternatively, please view our video summary or roundtable discussion.
Is it cost effective to implement a cashflow matching approach in the current market conditions?
For schemes that are seeking to implement a cashflow matching approach within their run-on strategy, it can be important to consider the implementation plan in light of credit spread movements – when credit spreads are higher, the cost of implementation is cheaper and vice versa, as shown in the below chart:
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Source: LGIM, Bloomberg L.P as at 31 October 2024, GBP Corporates Index (UR00), percentiles from 31 December 1996 to 31 October 2024. Past performance is not a guide to the future.
Credit spreads have continued to fall over the past six months as investors have become more sanguine about both the domestic and global economic outlooks. Inflation has fallen notably from high levels and central banks have now begun to ease policy rates in response. This has left credit spreads near the bottom of their long-term ranges and makes cashflow matching implementation expensive compared to longer term averages.
To discover more about the outlook we see for credit spreads, please see recent LDI chart update: Where next for credit spreads? For those schemes wondering how best to invest for their endgame amid today’s environment of low spreads, please see our blogs: Investing for the endgame at low spreads and Time to increase your allocation to credit?
The buy-in and buyout market at a glance
For the latest commentary from our industry experts, watch or listen to our dedicated de-risking series, The PRT Pod.
Recent analysis
In the September edition of our PRT Monitor, we offered a side-by-side analysis of the two largest PRT markets globally – the US and UK. Based on current levels, more than £250 billion of combined UK and US volumes are likely to be secured by insurers in the next three years alone.
Preparing portfolios
Endgame strategy
Research issued by Legal & General in partnership with the Centre of Economics and Business Research in March reveals insights into the
de-risking journeys of some of the UK’s largest pension schemes, with over half of respondents planning to use insurance as part of their endgame objectives.
Changing time horizons
46% of respondents said their time horizon is shorter than a year ago by an average of over two and a half years. All the schemes that cited buyout as their long-term objective are aiming to complete a transaction within the next 3 years.
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PRT market
in focus
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in focus
PRT market in focus
In this section we explore the key themes and dynamics that we’re seeing in the PRT market.
Why might a scheme choose buyout?
A buyout removes the risks of investment, longevity, interest rate changes, inflation and future running expenses for the scheme.
Trustees settle their obligations and fulfil their fiduciary duties to their members.
Companies draw
a line under their historical obligations, knowing they have secured them for the long term. This enables them to focus on their core businesses and the future.
Scheme administration moves to a customer services platform building for a long-term future.
Members receive enhanced security; their pensions move from the pensions regime to the safety of the more prudently regulated insurance environment.
UK PRT market volumes
In the first half of 2024, insurers completed £15.2bn of buy-ins and buyouts. We expect the total market volume at the end of the year to exceed £40bn, which would be one of the largest years on record.
As the chart shows, we expect appetite for buy-ins and buyouts to remain elevated into 2025 and across the next decade. Healthy DB funding levels are expected to persist resulting in a paradigm shift to an average c.£45bn per annum UK PRT market. The structure and timing of large transactions (particularly those of £5bn+) can materially impact the total market volume in any given year, as indicated by the forecast ranges (below).
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John Towner
Managing Director Pension Risk Transfer - UK PRT
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Source: LCP, baseline indications are L&G estimates
Growth in UK PRT is further reflected by the increasing number of transactions over time
Over the past two years, there has been a significant increase in the number of £1 bn+ buy-ins and buyouts.
Source: LCP
In a record-breaking 2023, insurers completed 12 transactions of over £1bn. In 2024, we expect insurers to have completed a further 12 transactions of this size.
The number of transactions completed each year is steadily increasing, primarily driven by schemes smaller than £100m, which make up the vast majority of transactions. 226 transactions were completed market-wide in 2023. In H1 2024, insurers secured 134 transactions, with the market on track to surpass 250 transactions across 2024.
Prepare don’t predict
The geopolitical landscape continues to be uncertain and trustees who are
both nimble and well-prepared can attract insurer attention in a busy market and take advantage of fast-moving changes in market conditions. Key to this is understanding market dynamics and being able to react to opportunities. Trustees that understand their scheme funding level and how insurers price are better equipped to take advantage of short-lived opportunities that can arise as a result
of unpredictable market movements. Legal & General can help schemes to align their investment strategy with insurer pricing and put in place trigger-based buyout hedging. To help schemes prepare their market approach, we offer a simple
step-by-step checklist.
Partnering with an insurer
We’re seeing more large schemes adopt a partnership model in their approach to the market, where they work collaboratively with a single insurer in an open and transparent way to achieve their buyout goal. Partnering with an insurer allows us to work through any complexities and offer a solutions-focussed approach across all elements of the transaction. More broadly, the insurer and scheme benefit from the ability to work dynamically to improve a scheme’s funding level, provide the scheme with priority access to the insurer’s best resources and to take advantage of pricing opportunities when they arise. This can lead to more pricing certainty for the trustees and greater execution certainty for the insurer. Legal & General’s recent £1.1bn buy-in with the SCA UK Pension Plan is an example of this approach in action.
Solving the illiquid assets conundrum
Given the current higher interest rate environment, many schemes are now finding that they have reached full buyout funding earlier than expected but still have significant illiquid asset holdings. This can be problematic for PRT transactions if the assets aren’t straightforward to sell or transfer to an insurer. In a recent survey of some of the UK’s largest DB schemes run by Legal & General in partnership with Cebr, one statistic that jumps off the page is that 75% of the schemes surveyed said they were decreasing their allocations to illiquid assets.
We have seen significant innovation in both investment strategies and insurance solutions to support schemes in this position – from insurers accepting illiquid assets in-specie as part of the premium payment to allowing schemes to defer part of the premium to coincide with the redemption or run-off timeframe. Click here to learn more about illiquid asset solutions.
Opportunities for small schemes
The market for smaller schemes continues to flourish with the number of transactions below £100m more than doubling from 2020 to 2023. A recent survey from DLA Piper found that all consultants operating in the small scheme space have seen successful transaction rates alongside affordable pricing. At L&G we offer a dedicated solution for smaller schemes called Flow which offers:
· Immediately transactable pricing
· Tailored price locks and flexible premium payment options
· Dedicated and personal post-transaction support
Click here to find out more about Flow.
Increased affordability means increased focus from pension schemes on non-price factors
Delivering members’ pensions on time, every time is the central purpose of the transaction. Trustees want to ensure that the post-sale process is reliable and well-managed, and that their members will receive an excellent level of service and care for the long term.
Our award-winning in-house administration function holds a world class net promoter score of +70 and we have a five-year resource plan in place to support growing volumes. We have recently opened a new office in Glasgow, having welcomed an additional 17 colleagues from the British Steel Pension Scheme administration team to L&G in October. Find out more our customer service ethos.
A selection of L&G transactions across the last 18 months
May 2023
November 2023
May 2024
May 2024
July 2024
August 2024
October 2024
November 2024
Market
conditions
Rising funding levels
DB schemes have been on a long-term journey towards full funding, with sponsoring companies contributing hundreds of billions of pounds to repair pension scheme deficits across the past two decades. As at 31 March 2024, the PPF estimates that total DB assets were c.£1.2 trillion and over a third of schemes (by value) were in surplus on a buyout basis.
The chart below shows the evolution of the total value of DB assets compared to the total cost of UK DB schemes entering the Pension Protection Fund (Total PPF Liabilities) and the total cost of all UK DB schemes insuring liabilities. Having spent many years seeking to improve funding levels, the surge in bond yields since 2022 has accelerated this progress as liability values have fallen more than asset values.
This has meant that many schemes find themselves better funded than ever before, as indicated by the yellow dots on the chart showing increasing funding levels on a buyout basis. Consequently, the average DB scheme now holds assets that could already be sufficient to meet their long-term liabilities of paying all members’ pensions in full as they fall due.
Click here to read the current market conditions report.
Source: The Purple Book 2024, PPF7800 Index as at 30 November 2024, including restated data from 31 March 2023 to reflect revised calculation methodology.
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Distribution of buyout funding levels
According to the Purple Book 2024, just over a third of DB pension scheme assets are above 100% funding on a buyout basis, as shown in the chart below, corresponding to c.£413bn of assets. This brings to life the potential immediate demand for PRT from UK DB schemes.
The distribution of buyout funding levels is not even, with larger schemes tending to have higher funding levels on average than smaller schemes
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Over the past six months, this overall dynamic has remained largely unchanged
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Dave Corbett
Director of Marketing PRT UK
Source: The Purple Book 2024, L&G analysis, as at 31 March 2024.