DATA CRUNCH


Shouldplanstakealeaf frominsurers’books?


By Stephanie Hawthorne


Given that pension schemes do not face the same regulatory constraints as insurers, some experts say it makes sense to take advantage of the greater freedoms available to them when it comes to credit risk


S


hould defined benefit pension schemes – with their greater investment freedoms – beat insurers at their own game and


take a page from their playbooks? Indeed, pension funds have one


major advantage over insurance companies: they are not bound by the solvency capital requirements that can penalise insurers for taking on greater credit risk and the chance of greater returns. Pension investors rarely face


such problems when constructing their portfolios. But some are slow to use their greater flexibility in their choice of credit quality, structured products and derivatives, and managing portfolio turnover, according to JPMorgan Asset Management. In it latest Pension Pulse report,


JPMAMsays that if pension funds are not taking advantage of the spectrumof buy-and-maintain options available that have long been used by insurers on a more constrained basis, they might be missing a trick. Jerry Song, an associate in


JPMAM’s Europe, Middle East and Africa pensions solutions and advisory team, suggests that schemes could use “a higher proportion of BBB-rated credit and securitised assets in their allocation while actively managing the higher credit migration risk”. In this way “pension funds could capture incremental return opportunities as part of their journey towards their long-term goal”, he says. This is potentially a big plus


since approximately half the global 42


investment-grade market is rated BBB, although the risk of default is greater than with top-grade bonds. The potential rewards for taking


credit risks can be significant, according to JPMAM: over one to five years the expected surplus return on A+ bonds is 0.2 per cent, while for BBB one to five-year bonds it is four times as high at 0.9 per cent. However, its analysis indicates


that, in an average year, around 5 per cent of BBB-rated bonds migrate to sub-investment grade, and in an average recession scenario that proportion increases to around 15 per cent. “Making smaller allocations to


higher-yielding (typically sub- investment grade) credit can enhance portfolio returns without unduly impacting risk metrics,” says Pete Drewienkiewicz, Redington’s chief investment officer for global assets.


Potential rewards for taking on greater credit risk higher


for pension schemes Comparable expected return ofA+versus BBB GBP corporate bonds, adjusting for default and cost of Solvency II regulatory capital (applicable to insurers)


Yield to worst %


0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5


Default adjusted Default and capital cost adjusted He has also found that portfolios


of higher-yielding assets recover more quickly from market shocks than investment-grade portfolios. There are also other ways to


achieve liability-aware, buy- and-maintain objectives, says Mr Drewienkiewicz, citing real assets – including renewable infrastructure, ground rents, and long-lease real estate. Others are more cautious.


Francis Fernandes, senior adviser at covenant specialists Lincoln Pensions, says: “While DB pension schemes can benefit from operating free from solvency and accounting restrictions, the asymmetry of outcomes facing members means that many trustees are unlikely to take more investment risk than they believe is necessary.” He adds: “A DB scheme’s


greatest strength is the employer covenant – which people often forget stands behind any risks run in a scheme’s asset portfolio.” Where the employer covenant


is robust, trustees might be able to justify being more brave in their investment decisions – or get additional funding – in order to reach their endgame more quickly, he says. “But the covenant can also be a DB scheme’s greatest weakness.” Buyouts are often the ultimate


answer for companies that do not want the millstone of long- term liabilities around their necks, but illiquidity and Solvency II-unfriendly investments may limit any ability to access a competitive buyout from an insurer. Sammy Cooper-Smith, business


1.5 yr 5-10 yr 10+ yr 1.5 yr5-10 yr 10+ yr A+


BBB


Source: Bloomberg, Moody’s Corporate Default and Recovery Rates 1920-2017, JPMorgan Asset Management; market data on yield-to-worst are as of March 31 2019. Capital cost adjustment reflects the annualised cost of capital buffer required for the average UK insurance company with a target solvency capital ratio of 155 per cent to hold against basic market risk solvency capital requirement (ex-interest rate module). Annual weighted average cost of capital is assumed to be 8.45 per cent based on Bloomberg.


development at Rothesay Life, warns that if “pension schemes adopt this approach and specifically target investment instruments that are unavailable to insurers, maintaining liquidity on those assets is vital if their long-term exit plan includes buying an annuity”


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