The aftermath of the Covid pandemic, Russia’s war in Ukraine, and the recent gilt crisis have seen the pensions world flipped upside down. Pre-2022, we were experiencing bull-market returns, a positive economic outlook, low and steady inflation and easing monetary policies (falling interest rates). Post-2022, the world looks very different: bear-market returns, recession fears, higher, more volatile inflation and tightening monetary policies (rising interest rates).
This new world has changed the game for pension schemes, and there are a whole host of repercussions surrounding regulations, investments, and operations. In this article, we reflect on what 2023 and beyond might have in store for pension schemes.
Where are we now?
To set the scene, defined benefit pension schemes have a set of cashflows (also known as liabilities) that they’re due to pay to members over a certain time horizon. The value placed on these cashflows and/or the cashflows themselves can fluctuate based on three drivers:
- Interest rates: cashflows are discounted based on interest rates, so the higher the interest rate, the lower the discounted value of the liabilities.
- Inflation: cashflows are often inflation-linked. Therefore, when inflation rises, so does the amount a pension scheme is due to pay its members (and vice versa) and thereby the larger the cashflows out of the scheme.
- Longevity: typically, defined benefit schemes are obligated to pay their members a pension each year until their passing. Therefore, when longevity rises, so does the estimated size and duration of the cashflows.
With this in mind, it’s evident why the shift in rates and inflation have had such a profound effect on the pensions industry. Let’s take a look at an illustrative pension scheme to see what this could look like:
In the new (post-2022) world:
The total asset value is lower due to material rises in interest rates (real yields).
Liability cashflows are greater due to rising inflation.
Net cashflows as a percentage of assets are higher as liability cashflows become a greater proportion of total assets. As a rough rule of thumb, when negative cashflows reach c.4-5% (as they are presented in the illustrative pension scheme post-22), we recommend schemes pay close attention to their cashflow management due to the increasing path dependency risk.
NB: Path dependency risk is: “the risk of being a forced seller of assets following a loss to meet cashflow needs”
The key takeaway from the illustration above is that cashflows out of the scheme as a percentage of assets is likely to be meaningfully higher on a forward-looking basis than it was a year ago. For the past decade, the key focus for pension schemes was to use excess collateral to buy more assets to maintain their risk/return profile. Now, the objective has shifted towards selling assets to fund depleting collateral reserves and higher cashflows.
So, where might we be going next?
We’ve broken down the expected impacts from the changes mentioned above into three core areas:
1. Raising liquidity
Following the recent gilt crisis, all eyes are on liquidity, with more stringent requirements surrounding the liquidity profile of pension schemes likely to be applied. This, combined with the trend of falling LDI assets (as a percentage of portfolios), due to rising rates, results in the need for pension schemes to have a clear plan to efficiently dispose of assets.
Higher gilt yields and wider credit spreads also mean many schemes now find themselves much closer to achieving their “end game” funding objective, whether that be buy-out or moving to a lower risk, more contractual portfolio. This makes liquidity and flexibility even more important considerations.
Never before have schemes needed to focus so much attention on evaluating which assets to sell and when. Schemes will need to assess whether they should sell assets that have performed well in order to bank the gains or those that may not have performed well but that now appear good value. Trustees will need to consider their options for selling illiquid assets early, and deciding an appropriate haircut if they choose to do so.
2. Sustainable “investing”
With less capital to play with, schemes may need to get more creative with their allocations, considering options such as synthetic equities, which allow them to retain their equity exposure while freeing up collateral to maintain their hedge.
Trustees will also need to review their tactics when it comes to ESG. Previously, the focus for ESG has been around what ‘good’ assets schemes can invest in to boost the sustainability profile of their portfolios – like renewable infrastructure and green bonds. Now, the focus is likely to shift to what ‘bad’ assets can I offload and how do I integrate that with my other considerations on which assets to sell?
With the second TCFD report due for large schemes next year, trustees will need to begin evidencing the actions they’ve taken to progress towards the emissions targets and objectives they’ve set, so being able to clearly evidence the rationale behind investment decisions – where ESG is concerned – is essential.
3. Operational efficiencies
With the focus well and truly shifted to increasing liquidity and flexibility, there may be less value placed in provider diversification and seeking optimum risk/return efficiency. Specifically, more value may be placed on the benefits arising from operational efficiencies. For example, pension schemes should consider the merit of delegating operational tasks like portfolio rebalancing to an implementation manager (which would help in the event of another collateral run, for example). Consolidating assets to a single manager (typically the existing LDI manager) can be helpful in this instance.
Another operational consideration is implementing a collateral waterfall, whereby return-seeking assets are provisionally lined up for automatic redemption in the event that collateral pools need replenishing.
It’s clear we’ve entered a new world for pension schemes, and this will take some adjusting to, for both trustees and consultants. We’ve assisted many clients in implementing creative governance structures and liquidity waterfalls and in realising illiquid assets effectively via secondary markets. So, if you’d like some assistance navigating this new world, please get in touch.
Unless indicated, these are the views of the author and may differ from those of the firm.