It’s time to review the value for money of the traditional ‘end games’ for defined benefit pension schemes.
It’s time to review the value for money of the traditional defined benefit ‘end games’, says David O’Hara. Trustees and sponsors should question whether there are other methods of securing future cashflows due from pension schemes.
Traditional ‘self-sufficiency’ targets, which focus on generating marginal returns over government bonds, have significantly increased in cost with falling yields. Trustees and sponsors typically have an ultimate objective to either insure the pension scheme or to reach a position where the scheme is ‘self-sufficient’ (i.e. a position where the scheme can run in a relatively stable manner with very limited reliance on the sponsor).
For many, it is assumed this ‘self-sufficient’ portfolio will deliver only a marginal return above (or sometimes even below) long dated government bonds. While this may have been appropriate in the past, today’s pensions landscape is a very different place and current market conditions mean there are other ‘self-sufficient’ targets to consider for long term holders of pensions risk. These targets can deliver similar levels of risk reduction but at a cheaper price thereby opening up the opportunity to achieve significant de-risking at a much earlier point.
A critical advantage that pension schemes have over many other market participants is the ability to invest for the long term. In the current environment pension funds are paid handsomely for providing long term investment capital. The government bonds that form the basis of most self-sufficiency targets carry a liquidity premium that most pension funds have no need to pay. Developing a ‘self-sufficient’ target that takes on some illiquidity and credit risk has a dramatic impact on the cost enabling material de-risking, while still investing in a way that places little reliance on the scheme sponsor.
It is entirely possible in current markets to design a portfolio of bonds that delivers a return of 1.3% above government bonds (with an overall investment grade credit rating) that is designed to closely match the expected benefit pension payments as these fall due.
Allowing a generous haircut for the risks associated with re-investment and default, this strategy still allows a prudent discount rate of around 1% over gilts. For a typical scheme with a ‘gilts +0.25%’ 'self-sufficiency' approach, an overall investment grade portfolio approach could be around 15% less expensive while offering similar risk reduction characteristics.
Once this investment strategy is designed, the actuarial valuation approach can be modified to reflect that the cashflows arising from the assets are designed to match the liability payments falling due. The value of assets and liabilities then moves in tandem delivering a very stable funding position.
This combination of a low risk strategy, stable funding position and inherent prudence means this could well be seen as ‘self-sufficiency’, particularly for larger stronger organisations who are aiming for a long term pension run off rather than insurance.
Traditional 'self-sufficiency' targets may be driving inefficient decision making and credit based strategies may represent a credible self-sufficiency target around 15% cheaper than the traditional approach.
If 'self-sufficiency' is your destination, you might be closer to arrival than you think.
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