DB considerations for 2025 

In summary, the three topics we expect to impact corporate DB pension schemes in 2025 are:

When numerous investors rush into a common strategy, asset class or approach, history tells us this can end badly, usually through unintended consequences.

Many corporates and trustee groups are beginning to question whether transferring DB pension risks to an insurance company and breaking ties with the sponsoring company represent the best option both for members and sponsors. Nevertheless, flows to insurance companies show little sign of abating.

There are a few things to note when considering running on a closed and maturing DB pension scheme. First, it’s natural for such schemes to amass a surplus. This is because of the very prudent approach to funding which naturally leads to over-reserving on average. It’s also worth noting that a scheme in surplus with a strong employer behind it could be as secure as the risk transfer option — if not more so and calls into question those citing risk transfer as the “gold standard” or the short term desired destination. Whilst attitudes are changing this does not seem to be widely appreciated in the market so as advisors we perhaps need to think broadly in order to best serve clients.

At Mercer, we’ve designed a new framework that accommodates running-on DB schemes. The framework’s objective is to secure benefits and grow surplus for the benefit of members and sponsors. We believe many DB schemes can do so with minimal downside risk and significant upside benefit.  

The framework uses a different lens to consider the value placed on the liabilities. Schemes that run on will want to define a risk buffer greater than the value of the benefits they expect to pay out. They will also need to differentiate how the assets backing cash flows are invested compared with any surplus assets. 

We believe such an approach can be in members’ interests, helping to support a diversified DB landscape with a better balance between those schemes that end up with an insurer and those that continue to run on and offer a greater benefit to their key stakeholders. The related issues here are how to spend the surplus and providing covenant support to make the approach widely applicable. In essence, the framework is easy to follow, intuitive and not overly complex. Below we show an illustration for a typical DB scheme that has decided to run-on and target surplus growth, allowing a move away from a pure Cashflow Driven Investing (CDI) approach, where assets are invested to match pension outgoings, to taking an approach where a modestly higher level of risk is taken by investing surplus in growth assets (whilst still maintaining the cashflow match associated with a CDI approach). 

This approach isn’t for everyone, but we’re hopeful that the current Pensions Review will identify ways to make surplus-sharing easier. It would also be helpful if accounting standards could be reviewed to allow companies to more easily recognise the gains on offer.

There are currently several dynamics at play in the gilt market. Investors should be aware of these dynamics and consider the implications carefully:

• Higher borrowing by the government and therefore higher gilt issuance
• Rising long-dated yields
• A lack of demand for longer-dated issuance
• Potential selling of longer-dated issuance by some insurance companies
• Longer-term pressures on government debt levels

Here in the UK, there are few buyers of long-dated gilts now that corporate DB pension funds have all but de-risked and most have hedged all their interest-rate and inflation-liability risk.

Government borrowing, and therefore gilt issuance, has grown (as shown below), not least due to COVID-19 and the chancellor’s recent budget committing to higher levels of borrowing over the next five years. That debt is being financed in the gilt market at short to medium tenors, where there’s more potential demand from hedge funds and foreign investors. At the same time, gilts are being sold back into the market by the Treasury (currently at a loss) as it undertakes quantitative tightening; that is, selling back the gilts bought during COVID under quantitative easing (QE). The pace, however, is modest at around £80 billion pa. By comparison, the total debt financed by the Government is around £280 billion to £300 billion pa, and the total value of gilts bought through QE is estimated to be £875 billion (to the end of 2021 according to Parliamentary committee papers).

As interest rates have started to come down, so have gilt yields at the short end. However, long-dated yields have risen over the course of 2024. It’s a similar story in the US, possibly for similar reasons surrounding the level of government debt and a widening budget deficit (which occurs when government expenses exceed revenue¹) — plus a new president who aims to lower corporate taxes.

Meanwhile, in the UK, we’ve seen another record year for DB pension funds passing off their liabilities and assets to insurance companies — the “buy in” market. Interestingly, for the past 18 months, many insurers that have been successful in winning new schemes have been insisting that payment be made in gilts and cash rather than the natural go-to asset class for insurers of UK investment-grade credit.

One reason could be that the additional return on investment-grade corporate bonds over government gilts is at historically low levels, meaning these investments don’t deliver returns that are attractive to their business model. Another reason might be that these insurers are keeping powder dry to invest in more risky and higher-returning assets when Solvency II reforms come into play beginning 31 December 2024. Either way, the sale of those long-dated gilts is likely to happen at some point (which we estimate to be around £30 billion–£40 billion). This could put further pressure on long-dated yields to rise and prices to fall. To put that into perspective, during the 2022 gilt-market crisis, UK schemes sold c.£23 billion of gilts in the weeks during the market turmoil, according to Andrew Bailey in a speech to the Treasury Committee in January 2023.

So what? Well, this could have some significant implications:

A. Higher yields on government bonds can put pressure on the value placed on other assets. 

B. Long-term borrowing costs could increase, making refinancing more expensive for businesses and, in the worst-case scenario, lead to greater defaults.

C. A higher gilt yield at long tenors means a lower value placed on long-dated liabilities like those of DB pension funds — a good argument for schemes not to hedge all their liability risk. If the rise were to happen rapidly, it could ultimately test the LDI industry again since finding the collateral needed to shore up the liability hedges when they’re losing value may be difficult.

D. The underlying investment risk backing bulk purchase annuities will be higher going forwards due to solvency II reforms.

The longer-term outlook for the level of government borrowing versus the income earned from taxes and revenue also looks rather bleak. Figure 2 below, a chart produced by the Office for Budget Responsibility (OBR), summarises the issue. Here, it’s not only the government’s higher level of borrowing and investment at play but also the impact of an ageing population, with fewer of us working and paying taxes even as we place greater demands on public services.

There are several options for addressing this growing deficit, but not all of them are popular:

Without these factors, gilt yields would be expected to continue the upward trajectory reflecting higher levels of borrowing.

We’re all aware of the strong run equities and credit markets have had and that equity market returns have largely been driven by a small number of stocks known as the Magnificent 7.

In essence, higher returns from equities temper future return expectations. Additionally, the concentration in equity markets means future returns now largely depend on what happens to a small number of companies — rather than a diverse range of businesses that might represent the state of the economy and growth. This, in turn, introduces a higher level of variability in possible return expectations and makes it harder to rely on equities to fulfil their traditional role of generating decent future real returns.

The counter argument to all this is that the current artificial intelligence (AI) phenomenon will make a real difference in productivity gains. This would justify these valuations and mean more rewards to come for equity investors.

As risk assets become more expensive in equity and credit markets, the downside risk also becomes larger.

We recommend considering stress testing return assumptions and considering how such investments can impact portfolios as this will potentially change the asset mix.

Markets can continue to look expensive for some time before moving towards more normal levels of fundamental value. Some investors may be happy to ride out any future volatility and keep portfolios simple. Those more cognisant of risk may wish to temper riskier growth asset exposures through diversification.

We think you might consider ensuring the portfolio is diversified into areas that have underperformed in recent years, such as developed ex-US equities, value or emerging market (EM) exposures. You could employ hedge funds to capitalise on the alpha opportunities. 

Looking to identify strategies that can truly diversify when that diversification is most needed can be difficult, so it pays to be open minded and cast the net wide to help build more robust strategies.

Higher rates offer choice — but be wary of historically tight spreads.

For instance, exposure via a multi-asset credit portfolio offers diversification across areas such as EM debt and loans and provides flexibility for the manager to be more opportunistic. 

For investors with a liquidity budget, private debt strategies continue to offer relatively attractive yields. However, employ flexible mandates to reduce exposure to crowded areas. Asset-backed and structured strategies, along with rated debt, can offer regulated investors efficient capital treatment. Open-end private market funds may appeal to a wider audience, but beware.

An unwind in concentration is not guaranteed, but active management will likely be rewarded when/if it occurs.

Evaluate whether a completion portfolio would make sense to remove this risk.

A portfolio may be underperforming a benchmark but still performing as expected in the prevailing market conditions.

There are of course a wide ranging number of issues influencing markets and our UK pension industry.  We have identified three topics we think will be key in 2025 specifically for DB schemes and would be happy to engage with you further on these.  For a wider perspective of the trends driving global markets over the medium to longer term please see our Themes and Opportunities publication.