Paul Sweeting, Head of Research at Legal & General Investment Management, sets out in the attached research paper a framework for designing endgame investment portfolios for schemes aiming for self-sufficiency.
The three key findings:
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“First, we find that schemes focused on self-sufficiency need to rethink how to measure success. We believe that success for a self-sufficient pension scheme is the assets outlasting the liability cashflows. To quantify the chances of this happening, we introduce a new measure – the chance of ultimate excess or ‘CUE’. This is the likelihood that a scheme’s assets will outlast its liabilities. The CUE measure can be used to compare various self-sufficient investment portfolios to determine the most CUE-maximising one for a particular scheme. To measure the CUE, we need to focus on the cashflows generated by the assets held and the extent to which they can meet the liabilities, rather than looking just at the market values of those assets.
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“Second, using the CUE framework we find that corporate bonds are very efficient for endgame portfolios focused on self-sufficiency. All high quality bonds promise stable cashflows, but corporate bonds have an advantage over government bonds for long-term investors. A short-term investor is at risk of loss if credit spreads widen. This can happen even if there is no fundamental change in the creditworthiness of the bond. However, a long-term investor who is less concerned with short-term volatility ought to be less concerned with spread changes, and thus able to ‘pocket’ a long-term investor premium.
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Third, we find that for a self-sufficiency strategy the ongoing evaluation of the solvency of a scheme needs to be grounded in the CUE metric and how that changes over time: continuous monitoring is important. However, changes in credit spreads on corporate bond holdings which are not attributable to changes in the creditworthiness of the bonds won’t change the CUE. This is because the anticipated cashflows from those corporate bonds have not changed and, all else equal, the solvency of the scheme has not changed either. This CUE framework for measuring solvency can be reconciled with the current mark-to-market world by deriving a liability discount rate consistent with the level of funding and the desired probability of success.
In conclusion
“The objectives of defined benefit pension schemes have changed in recent years. In particular, they are increasingly focused on being able to pay their accrued benefits rather than allowing new members to join and earn pensions. But not all pension schemes are on a path to buy-out – many view self-sufficiency as a realistic endgame.
“As such, it is worth reconsidering the way in which pension schemes measure funding. If the aim of a self-sufficient pension scheme is to have enough money to pay benefits when they fall due, then the measure of success should reflect this. The CUE
does exactly that.
“The CUE can also be used to help design an appropriate asset allocation – and, for a mature pension scheme, such an allocation is likely to be dominated by corporate bonds if the CUE is the primary metric being used. The nature of self-sufficiency allows pension schemes to capture the long-term investor premium.”
Please find attached the full research paper below
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