Feature – De-risking
invested in a low dependency investment strategy to provide for accrued pension rights and is not expected to need further employer contributions”. For better or worse, schemes seem to have taken that as follow- ing a liability-driven investment (LDI) strategy, whereby assets are invested in fixed income and hedged against inflation, interest rate and longevity risks to meet the present value of liabilities. Some 73% of DB funds employ an LDI strategy, according to Mercer. This concerns particularly medium-sized schemes with assets between €50m and €2.5bn (£44m-£219bn), while larger DB plans often do not use them as they remain open. But the focus on low dependency is set to accelerate the trend towards investing in LDI assets, warns Con Keating. “The new funding regulations, the portfolios that everybody is going to be forced into, are LDI portfolios, and that would be a disas- trous mistake,” he said.
“The funding regulations say that you have to be invested in a low dependency portfolio. This means, people will have to sell their growth assets to buy inflation linked and conventional gilts. Depending on their holdings, let’s say 450 billion at an excess return of 4%, multiply that by 450 billion and the differ- ential is significant,” he adds. Mercers Charles Cowling agrees. “The draft proposals would force the sale of £500bn of return-seeking assets, the majority being required before 2040,” he says. This is based on an assumption that DB schemes in the PPF universe collectively hold £500bn in return-seeking assets. Cowling also warns that this could see some £200bn of liabili- ties added to the balance sheets of employers responsible for DB schemes during the next 10 to 15 years. This estimate is based on the difference between the cost of pension scheme liabilities already accounted for compared to the cost of secur- ing benefits with an insurer. It also includes the prediction that the new rules could bring forward the date that trustees and sponsors are forced to transfer pension scheme liabilities to an insurer. But for Dan Mikulsis, partner and lead investment adviser at LCP, it is far from clear that DB schemes are required to sell all their return-seeking assets. “One issue with the commentary around it is that there aren’t enough details in the public domain yet and there is now an information vacuum which the industry has filled with educated guesses with a bias towards negative thoughts, because they make the headlines,” he says. Mikulsis adds that in the absence of detailed information, the most detailed reference to asset allocation is the regulator’s 2020 guide to the DB funding consultation, which implies a 20% exposure to growth assets, even at significant maturity. “Everyone is jumping to this conclusion that they are going to be forced to sell growth assets, but that is not necessarily the
44 | portfolio institutional | October 2022 | Issue 117
De-risking has happened for the past 10 years, not because anyone has regulated it but because people decided that it was the right course of action.
Dan Mikulsis, Lane Clark & Peacock
case. If the regulator decides that they are going to be happy with 20% that might even do the opposite, it could even be that schemes were able to take a bit more risk than they thought at significant maturity. But most schemes are on a path to de-risk quite a lot,” he says. To put this into context, mature schemes, defined by the PPF as those with 75% to 100% of liabilities are related to current pensioners, are less than 10% invested in equities. The same goes for schemes with a lower level of covenant strength. Only 13% of those schemes are invested in equities, compared to 17% for schemes with a strong covenant, according to Mercer. Mikulsis says that critics might be getting the chain of causality wrong. “De-risking has happened for the past 10 years, not because anyone has regulated it but because people decided that it was the right course of action,” he adds. So the debate around DB de-risking being stuck in a chicken and egg loop, with proponents and advocates arguing whether regulatory pressures or market conditions were the driving fac- tor in pushing investors into LDI portfolios. But perhaps the crux here is a different question, should investors continue to allocate in to LDI portfolios given that market circumstances have changed dramatically?
Linker troubles
Bond markets have been on a rollercoaster over the past year but overall, a sharp rise in gilt yields has benefited DB schemes.
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