As mentioned earlier in the report, UK DB pension schemes are in the healthiest, best funding position they have been for decades. Considering these improvements, much debate has centred around whether schemes should choose to buy out or run on.
From speaking to pension schemes, our view is that most schemes will incorporate insurance into their long-term de-risking strategy and for many, moving to buyout will be a question of optimal timing.
Objectives will depend on individual circumstances. A proportion of schemes will opt to run on in perpetuity while some may want to take more time to achieve different objectives, for example, to generate a surplus, or to restructure illiquid assets and prepare for buyout.
It doesn’t need to be an all or nothing decision and the option remains open to run-on for a period, before buying out at a time of the trustees’ choosing.
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With monetary easing cycles under way in developed economies and bonds once again providing potential insurance against equity risk, we believe that interest rate hedging could be key for DB schemes looking to maintain elevated funding levels.
Dave Corbett
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Director of Marketing PRT UK
Endgame Options
Buyout
Schemes wishing to ‘lock in’ their strong funding positions by progressing towards buyout to ensure full security of their pension scheme and its members. The goal here to guarantee members pensions, irrespective of market volatility. Click here to learn more.
please supply links for 3 endgame options
What could be in store for funding levels?
With monetary easing cycles under way in developed economies and bonds once again providing potential insurance against equity risk, we believe that interest rate hedging could be key for DB schemes looking to maintain elevated funding levels.
As we look towards year-end, with lots of lower-inflation data in the bank, we think it's hard for investors to get concerned about high inflation. We therefore believe there's plenty of scope for bonds yields to fall relative to equity yields.
Whatever your scheme’s preferred endgame, please don’t hesitate to contact us if you have any questions or would like to hear more about how Legal & General can help you build the bridge to your chosen destination.
Run-on
Many trustees want to ‘run on’ their scheme in perpetuity i.e. remain invested and focussed on paying pensions until the final member benefit is paid. These schemes may be seeking greater value for members from a potential surplus. Click here to learn more.
Both
A significant group of well-funded schemes are keen to stay invested now (and potentially target a surplus), while keeping buyout in mind over on a longer-term horizon. These schemes are seeking to have the ‘best of both’ endgame destinations. Click here to learn more.
Source IPE Research 2023.
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’.
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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Select a trend to learn more
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.
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.
