BlackRock – Portfolio Insight


The Pensions Regulator looks carefully at the covenant, that link between the pen- sion scheme and sponsoring employer, is broken with the superfund becoming the sponsoring employer. One thing to add is a variant of that, which is basically the same bridge to buyout methodology but not breaking the link with the sponsor. The capital-backed funding plans seek to do that. The pen- sion scheme will still be attached to the sponsoring employer, but it will be some third party capital that will be used to sup- port any losses in between now and buy- out. There is a great deal of interest in that. We are talking to a number of pro- viders and it could well plug a gap. You could well expect to pay a bit more as someone else is providing the risk capital, but you are considerably reducing your downside.


How is inflation and rising interest rates affecting endgames?


Those who are hedged are less concerned. All things being equal, rising rates reduce your liabilities if you are not hedged and the value of your assets go up. On inflation, a lot of pension fund bene- fits are linked to it. If inflation goes up that can be a bad thing; that is why many hedge against it. However, if inflation is high then many pension schemes have a cap, so the impact can be more limited. Schemes need to think carefully about how they are impacted. And if there is something that is hard to predict and is potentially damaging, then that would point towards hedging, or substantially hedging.


Then what investment strategy options should DB schemes consider?


It is defined by the funding level and what is happening with the covenant, but more in fixed income, LDI and cashflow match- ing. Schemes have to consider the end- game objective in the light of the new funding code that would push schemes towards a cashflow matching approach. If


ESG and climate risk is an investment risk.


you are sufficiently funded to cashflow match you will be largely using bonds (as- suming you don’t need an excess return from equities). Here, it is probably worth talking about bulk annuities. There has been a maxi- mum of £40bn worth of annuities pur- chased in a year, which is where we are now, and less than 3% of total pension lia- bilities. A lot of pension schemes are suf- ficiently funded to buy annuities: so is there the market capacity in insurance to take them? Are there enough people to turn the wheel to make the trades hap- pen? As these are big trades, are there suf- ficient assets for insurers to invest in? So even though schemes may want to buy out, can they? Perhaps then, it is a sellers’ market – with insurers.


the sellers being the


And there is a value loss in pension schemes de-risking up to the point of an- nuity purchase, but then the insurer re- risking afterwards – what can be done to bridge that?


How influential is ESG over the investment strategy of DB schemes?


It is central to everything we do. ESG and climate risk is investment risk. Steward- ship is vitally important and it doesn’t ap- ply just to equities. It can be more chal- lenging with asset classes such as LDI to have a direct impact through portfolio management. However, we take an active role through engaging with the Treasury and DMO on their green bond framework


and spending of proceeds. In addition, we engage with our counterparties through our stewardship team on a range of ESG factors.


What is the path ahead for DB schemes? There are probably a number of catego- ries. The easiest is run off, “stay the course” if you like. Either they are big enough to do that themselves or they join forces with others via OCIO, or fiduciary management through one of the capital- backed funding arrangements. Then there are those who have targeted a credible path to annuity buyout. They will invest in a mixture of cashflow-matching assets, corporate bonds, illiquid credits and LDI to hedge against the long-term li- ability risks. For the ones going to buyout there will be a mixture of corporate bonds and LDI. Watch out for some innovation that will enable them to invest in alternative cred- its for a longer period, that may even transfer to an insurer. But they will need lots of liquid assets: LDI, cash and some credit when they go to buy annuities. Then you have a tail who are in a less for- tunate position. Their funding levels are not so good and they need to invest in re- turn- seeking assets, equities and alter- natives to bridge their funding gap. If there is a covenant gap, they may need to lock down what they have got and get whatever they can. So it will be interest- ing to see the outlook for DB pensions in the years ahead.


Issue 124 June 2023 | portfolio institutional | 31


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