Despite recent market volatility, a combination of strong long-term returns across growth assets, company contributions and, latterly, real interest rate increases have resulted in improvements across the funding levels of many defined benefit pension schemes on an endgame basis. With the endgame now in sight, trustees have begun to turn their attention to what a suitable target might be and how to get there.
For lots of schemes, buyout is seen as the ultimate endgame objective. But how do you decide whether it’s right for your scheme and what the next steps are once you have? In this blog series, we’ll be guiding you through the six steps to buyout to help you navigate your journey. If you need any support along the way, please get in touch.
Step 3: Getting your portfolio buyout-ready: LDI
Did you know that the nature of your scheme’s LDI portfolio could be an obstacle to buyout? One could be excused for thinking that achieving a full hedge is the only necessity when preparing for buyout; but, in reality, there are several factors to be considered.
Should your scheme be fully hedged?
It’s advisable to fully protect your scheme’s liabilities from movements in interest rates and inflation, as this is something insurers will typically require. We can help you determine the optimum amount of hedge to put on, and suitable tolerance ranges around this, to arrive at an appropriate solution.
Another vital consideration regarding the level of hedging is inflation. Inflation models vary from insurer to insurer, and different models will come up with different amounts of sensitivity in liabilities with ‘caps’ and ‘floors’ on the inflation linkage – these caps and floors are inherent in a scheme’s member benefits. As a result, some insurers may view your scheme as over-hedged to inflation, while others might not think your inflation hedge is sufficient. When narrowing down to a particular insurer, we recommend you check what they consider the inflation exposure on your scheme to be in order to hedge the amount of inflation that’s consistent with your preferred insurer.
Does it matter how your liability hedging portfolio is constructed?
It certainly can – here are some aspects to consider:
Swaps: Insurers have different views on whether they find particular types of vanilla swaps acceptable (which is largely dependent on the collateral terms). Complicated portfolios with large amounts of offsetting swaps can also pose an issue for a number of reasons, including workload and initial margin regulations, which impose additional costs on insurers for holding large swap books. From our experience, restructuring complex swap portfolios tends to be a long process (often multi-year) if done on a cost-effective basis.
Illiquidity: You might already be aware that avoiding illiquid positions in your portfolio ahead of buyout is a good idea (more on that in our next blog!). The same goes for certain types of LDI positions, such as LPI swaps, that are highly illiquid. Again, insurer appetite varies, so it’s good to check this upfront. Due to the idiosyncratic nature of longevity swaps, it’s important to flag these positions to the insurer early in the process.
How should you go about restructuring your LDI portfolio?
The first step is to check your LDI portfolio for any potentially difficult-to-transfer assets or assets that certain insurers might find undesirable. If such positions exist, you should devise a plan on how to tackle them early to allow your LDI manager sufficient time to deal with these positions in a cost-effective manner. While this might already seem like a lot of work, the real challenge in preparing for buyout often lies in the growth assets. This will be the focus of our next blog.
Unless indicated, these are the views of the author and may differ from those of the firm.