Andy Tunningley, Head of UK Strategic Clients at BlackRock, comments on the latest PPF 7800 Index figures: “Two steps forward, one step backwards… The PPF 7800 index aggregate funding level stepped back again in February to 95.6%, after jumping ahead to 96.9% in January as markets moved unfavourably. Weaker equity markets eroded pension scheme asset values and resulted in lower funding levels, while UK bond yields finished roughly flat. During February, bond markets lost the momentum that has driven yields higher since the turn of the year; geopolitical tensions and softer activity data took the wind out of the bond market’s sails. Whilst we expect yields to rise further over coming months and years, we think progress will be slow, with bumps and setbacks along the way, meaning pension schemes cannot rely on rising yields to meet their funding level objectives. Although the PPF funding level aggregate has improved greatly over the last 12-18 months, from around 80% to 95%, there is still further to go. Coining an analogy used by Chancellor Hammond to describe the UK’s budget deficit ahead of the Spring Statement later today; there is light at the end of the tunnel, but we are still in the tunnel.
“For schemes approaching their funding targets – the end of the tunnel – de-risking is the natural progression. One common choice is to phase in insurer buy-ins over time, another is to phase in a cashflow matching strategy. The two approaches ultimately achieve the same end goal, however, they differ in some important ways. Firstly, a buy-in involves an insurer, which comes at a financial cost and often requires the scheme to hold specific ‘insurer-friendly’ assets in preparation for the buy-in. In contrast, cashflow matching simply involves buying cashflow generative, high-quality assets. There is no insurer involvement - the pension scheme maintains control of their investment strategy, so there is the flexibility to scale up or down the strategy as needed. Furthermore, if a buy-in is phased in early, when a significant funding gap remains, it may be detrimental for some scheme members, raising the question of fairness. Buy-in assets and liabilities all remain on the scheme’s balance sheet, so overall funding level does not change, however, those members protected by the buy-in assets are now effectively guaranteed full-funded status by the insurer.
On the other hand, the residual members (most likely younger scheme members) now implicitly have a lower funding level. The risk of not reaching fully funded status becomes tilted towards the younger generation. Whilst cashflow matching strategies do not raise questions of equality, due to expensive valuations (low yields) on corporate and government bonds, phasing in a matching strategy too early can jeopardise the ability of the whole scheme to achieve fully funded status. In addition, it does not protect against longevity risk in the way a buy-in does, so liability values could grow unexpectedly over time.
“While incremental de-risking is a prudent approach, achieving returns in excess of liabilities through the remaining growth portfolio is essential to close to gap. Current market conditions make this particularly challenging. Having borrowed from future returns the expected returns from equities at this point look modest, and you can’t rely on significant returns from bond markets with yields set to rise and credit spreads standing tight today. Faced with this predicament, private assets may seem a common sense home for your money, yet at the lower end of the risk spectrum there is huge competition with demand outstripping supply. The sensible risk decision may turn out to be take a little more risk; invest beyond the insurer’s sweet spot, play the game on your turf not that of your competitor. Asset class risk may appear high, but with idiosyncratic features and careful deal evaluation, the diversification and return impact on the portfolio of investing in private market assets can improve the probability of reaching the end of the tunnel.
“Whether approaching the end of the tunnel, or still in the dark, staying cognisant of the potential opportunities and setbacks posed by markets is key. Good decision making avoids tunnel vision, and welcomes the examination of all opportunities.”
Boris Mikhailov, Investment Strategist, Global Investment Solutions at Aviva Investors comments on the latest figures: “The main story in February was a sharp sell-off in equities with the FTSE All-Share falling 3.3% and putting a dent into pension scheme portfolios. This, coupled with a slight fall in long-dated gilt yields, has resulted in a deterioration of funding positions. With pension schemes typically investing up to a third of their assets into equities and running 60%-70% underhedged positions in interest rates changes, the PPF updates will continue to show volatile positions until we see widespread changes to asset allocation.
“With the volatility in the markets likely to increase, it will continue to result in more volatile funding positions. For most schemes it is possible to reposition the portfolio to achieve more consistent returns, and to protect against severe drawdowns.
“For example, diversifying out of public credit into private debt assets that have bond-like characteristics but offer better returns with less risk, is what some savvy pension schemes are currently doing. Infrastructure debt, real estate debt, private corporate credit and other structured finance transactions with transparent cash flow characteristics can provide higher yields than public credit, through illiquidity premia and diversified return premia. When high quality public credit yields around 1% above gilts, comparable private debt investments could provide spreads well in excess of 2%.
“With pension schemes not falling under the same stringent regulations as insurers, they are in the unique position to exploit the best opportunities in private debt assets that are not currently accessible to insurers. This not only increases the speed of deploying assets, but could also lead to better risk adjusted returns.”
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