For DB pensions running on, what might be the right investment strategy?
As more pension schemes choose to run on, trustees will want to select the right investment options that will deliver their objectives
The historic perception of defined benefit (DB) pensions schemes has been glass half empty. Deficits weighed on balance sheets as the cost of running schemes increased, which typically resulted in scheme closures and less generous benefits being offered thereafter. However, in the context of improved funding levels and a more accommodative regulatory environment, and for the first time in decades, the glass may now be half full.
Having been plagued with years of deficits, trustees and sponsors are now considering their approach to tackling surplus. Mercer’s 2024 Financial Strategy Survey, which covers a sample of DB and hybrid schemes that had actuarial valuations in 2023 and are advised by Mercer, found that the median scheme is now >100% funded on a technical provisions (TPs) basis. The Pension Protection Fund (PPF) also estimate that the aggregate surplus across the universe of DB schemes exceeds £200bn1.
Distribution of Technical Provisions funding levels
Comparison of distribution of funding levels on a Technical Provisions basis for 2020 and 2023 valuation dates from Mercer’s Financial Strategy Survey 2024.
Risk transfer exercises have been the focus for many DB pension schemes over the last ten years. Many have capitalised on improved funding positions and entered these sorts of arrangements. However, at the same time, there is increasing interest in running schemes on and not taking an immediate step to transfer risk. Whether preparing for an insurance transaction, or at the other end of the spectrum considering perpetual run-on, all schemes will have a period of run-on. Considering the make-up of a run-on portfolio remains appropriate.
As outlined previously in our DB pensions: all pain, no gain? article, it could be of material benefit to the members, sponsors and the UK economy to have a healthy mix of schemes that buyout with an insurer and those that run-on.
There is a perceived wisdom about what both buyout and ‘low dependency’ run-on portfolios look like, with schemes investing heavily in government bonds and high-quality fixed income assets. However, not all schemes run-on to target low risk. Some may target surplus generation, and in this case there is less perceived wisdom regarding the approach to the investment strategy.
We outline below broadly what a scheme targeting surplus growth might look like, and the potential pay off, plus the risks that trustees and sponsors should be aware of when investing in line with this objective.
What do we mean by ‘investing for surplus’?
Schemes considering run-on have typically adopted high liability hedge ratios and investing in income generating assets with low probability of default. The purpose of these ‘cashflow-driven investment’ (CDI) strategies is to increase certainty of return and therefore reduce the likelihood of a deficit emerging (whilst also paying member benefits through the income generated on invested assets).
However, the emergence of surplus (whether by design or luck) and the growing realisation that a surplus is a natural evolution to maturing well-funded DB schemes has led trustees and sponsors to consider how these run-on strategies might be repositioned, adopting what some are referring to as a ‘CDI+’ approach. Arguments for setting investment strategies to generate surplus are set out in our DB pensions: all pain, no gain? article, however at a high-level can include:
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Funding discretionary benefits
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Covering expenses (including administration and advisory costs)
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Subsidising or enhancing accrual (e.g. for defined contribution (DC) plans)
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Release of surplus to the employer (or surplus sharing arrangements)
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Greater member security and lower employer dependency
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Maintaining flexibility in member options (early retirement, pension increases and exchanges, flexible retirement options)
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Retaining control and flexibility in managing risk (particularly any unknown risks)
To achieve these objectives, it may be expected that schemes choose to take more investment risk (relative to a buyout or traditional ‘low dependency’ portfolio). While this may be true in relative terms, in absolute terms a CDI+ strategy remains low risk and can be seen to protect surplus in downside scenarios.
This is because assets up to the present value of 100% liabilities (on a given low dependency basis) would continue to be invested in line with a traditional CDI strategy (i.e. large allocations to government and investment grade bonds, with high hedge ratios), with assets in excess of this invested in growth assets which could range from traditional equities to more conservative growth fixed income assets. The chart below illustrates this framework.
How might the investments deliver a surplus?
We show two scenarios below to demonstrate how a surplus might grow under a CDI+ approach. The first scenario considers growth under a low-risk, business as usual run-on approach, and the second where the surplus is grown with the intention of sharing proceeds between the members and the sponsor.
Both scenarios are based on investment returns alone. In reality, as the actuarial prudence unwinds (because reserving for paying benefits is on a more prudent basis than best estimates) the funding level of a scheme could reasonably be expected to increase by an additional 5% to 20% over a period time which the projections below do not make any allowance for.
It is important to note that the scenarios reflect two outcomes from a broad range, and that in practice approaches to investing for surplus will be driven by scheme-specific circumstances and objectives, so will vary. The scenarios therefore show two outcomes out of a significantly larger number of possibilities.
Risk/Return Statistics |
Strategy 1: CDI |
Strategy 2: CDI+ |
Liability Basis |
Gilts +0.5% |
Gilts +0.5% |
Starting Funding Level |
110% |
110% |
Asset Allocation |
Gilts/LDI: 50% IG Credit: 40% Alternative Credit: 10% |
Gilts/LDI: 27% IG Credit: 36% Alternative Credit: 27% Surplus Growth: 10% |
Interest Rate & Inflation Hedge Ratio |
100% |
100% |
Median Return 10 year p.a. |
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Absolute Return |
4.1% |
5.1% |
Relative to Liabilities |
0.3% |
1.1% |
Volatility 10 year p.a. |
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Relative to Liabilities |
1.4% |
3.2% |
Possible future framework for investing for surplus growth
Illustration showing that surplus assets on a low dependency liability basis could be invested into “new” growth assets.
Funding level projections under different scenarios
Charts showing expected funding level progression assuming different investment strategies.
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Target: Maintain low-risk run-onThis scenario shows the surplus’s projected growth for a scheme that adopts a ‘traditional’ CDI strategy. The starting point is that the scheme is 110% funded on a Gilts + 0.5% p.a. basis, which translates to a surplus of £50m. Based on this approach, assuming an overall expected return on assets of 0.3% above the discounted rate for a 10 year period, the scheme’s surplus may be expected to grow to c. £90m.
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Target: Growth for release of surplusThe alternative scenario assumes the same starting funding position and liability basis, but with a CDI+ approach that has an associated expected return on assets of 1.1% above the discounted rate. Under this scenario, there is an additional £60m of surplus expected to be generated over a 10 year period (i.e. £150m), which can be used for enhancing benefits and for extraction. Importantly, under this approach, in a 1-in-20 downside scenario (represented by the orange dotted line) the scheme remains in surplus (assuming no extraction over time).
So what?
For schemes that are in or approaching surplus, there are a number of key considerations when determining whether to take the traditional buy-in / buy-out route in the near-term, or instead run-on in perpetuity. Importantly, the security of member benefits should continue to be the driver of any decisions on long-term funding strategy. However, the scope for better stakeholder outcomes from running on for a period of time can be an attractive one.
Strategies targeting surplus creation will vary greatly and will be determined by a scheme’s own circumstances and objectives. When considering the long-term strategy, trustees and sponsors should therefore be asking themselves the following questions, which will be key in determining the make-up of the investment strategy:
- What are the objectives of all stakeholders?
- Based on these objectives, what approach achieves the optimal outcome?
- Based on this approach, what are the implications for investment strategy?
As the perception of DB pension schemes changes from half-empty to half-full, there is an opportunity for members and sponsors to enjoy meaningful gains from the growth and utilisation of surplus.