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Commentary
Liability-Driven
Investing Demystifying the DB End Game
June 2020 Jeremy Rideau, CFA
EMEA Head of LDI
Alistair Byrne, CFA
EMEA Head of Pensions and Retirement Strategy
Plug the words ‘defined benefit end game’ into Google and you’ll be faced with a multitude of
results featuring links to articles covering a range of topics including ‘pension solutions’, ‘DB
consolidation’, ‘Pensions Superfunds’, ‘buy-out’ and ‘buy-in’.
This complex array reflects the increasing desire of trustees and corporate sponsors to
explore ways of closing down the risks of DB pension schemes. Drivers include increasing
regulatory pressure, for example with The Pensions Regulator’s proposed new approach
to scheme funding. Financial markets are also challenging, with low interest rates and high
levels of volatility sparked by the COVID-19 pandemic. In the very short term, funding levels
have deteriorated and the ‘end game’ may have been pushed off, but the market turmoil will
underline the need for scheme sponsors to find a sustainable solution.
This paper examines the different routes available and offers some thoughts on what might
work for schemes facing different circumstances:
• In Heading for the Exit we look at the various flavours of ‘exit’ options open to schemes,
offering our thoughts on the advantages and disadvantages of each.
• In Working the Assets Harder we consider how the key risks can be managed efficiently
with a view to achieving the different exit options.
UK Defined DB schemes have been diminishing — whether by consolidation or going into the PPF — with
Benefit Market the number of scheme numbers falling by around 25% in the past decade. But their demise
is over-egged as there are still around 5,400 pension schemes in the UK. Of these, 44% are
closed to new members and benefit accrual, and only 11% are open to new members (with 1%
in the process of being wound up).
As Figure 1 shows, there has been a consistent trend of scheme closures since the early
2000s, with the number of active members declining from 3.6 million in 2006 to 1.1 million in
2019. Total assets invested on behalf of UK DB schemes total around £1.7 trillion, while the
estimated liability of those schemes is around £1.9 trillion.1Percent
Figure 1 100
Trend Towards UK
Defined Benefit 80
Scheme Closures
60
In Wind-Up
Closed to New
Benefit Accrual 40
Closed to
New Members 20
Open
0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: PPF Purple Book 2019, data as at 31 March 2019.
Heading for the Exit So, what does the DB end game look like? For some schemes, it will be a case of a long-term
run-off with support from the corporate sponsor, and there are a range of options available to
help in that journey. For other scheme sponsors, the desire will be for a clean break, passing
on the assets and liabilities of the scheme and allowing management to focus on running
the company.
According to Aon’s Global Pensions Risk Survey 2019, buy-out and self-sufficiency are the
most popular long-term solutions so we have outlined more details here.
Figure 2
Which Endgame?
Self-Sufficiency Buy-In / Buy-Out Other / Consolidator
43% 35% 22%
Source: Aon Global Pension Risk Survey, data as at 31 October 2019.
Self-Sufficiency To reach self-sufficiency in general means that a scheme can run until its last member has
died without a need for further contributions from the sponsoring employer. This can mean
that once the scheme has reached a suitable funding level that it runs a low-risk investment
strategy with a focus on regular cash flow requirements.
On the journey to self-sufficiency, schemes can have more flexibility in their asset allocation
as they don’t have to worry about long lock-up periods, provided the future cash-flows or
upside can be quantified. Some may also consider longevity swaps to manage longevity risk,
otherwise the risk remains with the scheme and may undermine the self-sufficiency.
Demystifying the DB End Game 2Buy-Out Buy-out has traditionally been the key method of removing the ongoing governance, risk and
administration of DB pension schemes from the sponsoring employer. Individual scheme
members become policy-holders of the insurance company and receive pension benefits
from that organisation.
Due to scale, investment efficiency and regulatory oversight, insurance companies are well
placed to manage the process on an on-going basis. The buy-out market has been running at
around £10bn a year and 2019 was a record year with over £40bn transacted. However, when
faced with a £2 trillion pool of liability, the buy-out market is unlikely to be able to meet the
demand that exists.
The market is being fueled by deals for multi-billion schemes, meaning transactions are lumpy
and smaller schemes may not attract so much interest from insurers. From an investment
perspective, schemes with this as an endgame need to make sure their investment strategy is
consistent with their end game approach, including avoiding locking up assets for time frames
longer than their planned buyout.
Buy-In In a buy-in, the scheme buys a bulk annuity contract in respect of individual members which
guarantees those pensions for the rest of their lives (and any death benefits, such as
dependants’ pensions). The contract becomes an asset of the scheme and the scheme
receives the pension payments to distribute to the member. As such, the buy-in can be
considered an asset that hedges the liability risk — including longevity risk — of those covered.
A full buy-in will provide cover for all of the scheme’s liabilities and be the sole asset of the
scheme. A partial buy-in will only cover some of the liabilities. The trustees will only be able to
change the allocation of assets excluding the buy-in policy, which may create a challenge in
working the assets hard enough to meet the remaining liabilities.
55 Billions £
Figure 3
50
Volume of Risk
45
Transfer Deals Since
40
2007 up to H2 2019
35
Buy-in/Buy-out 30
25
20
15
10
5
0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: Hymans Robertson, 2019.
DB Master Trusts Although fast becoming the vehicle of choice for defined contribution schemes, master
trusts have not been as significant in the DB market. As regulators encourage debate around
consolidation — particularly for small schemes — it will be interesting to see if the DB master
trusts option develops further. The key benefit of DB master trusts lies in economies of scale:
as smaller schemes aggregate assets, the collective buying power can reduce the fees of
investment management and administration.
Demystifying the DB End Game 3In addition, the governance oversight provided by the master trusts should provide members
with greater comfort about the efficient management and operations of the pensions
arrangements. Whilst the investment options open for individuals schemes to utilise will be
constrained by what the master trusts offers, this has to be balanced with the additional
governance support.
There is no risk transfer — the scheme remains liable and the membership remain exposed to
the covenant of the employer.
DB Consolidators Non-insured DB consolidators are a relatively new concept and the market is not yet active.
To date, two organisations have been founded to offer consolidation options to the DB market:
the Pension SuperFund and Clara-Pensions. There is not yet a clear regulatory framework for
these vehicles, which may make trustees wary of transacting.
The objective of the Pension SuperFund is to improve the probability of benefits being paid
in full via:
• The injection of additional funds from the employer or its parent group
• The capital buffer provided by the Superfund’s investors
• The efficiencies of scale offered by a consolidation vehicle
• The absence of potential future sponsoring employer insolvency
If a scheme chose to use the SuperFund, all assets and liabilities would be transferred, with the
covenant of the sponsor replaced by a capital buffer (15% of the assets of the scheme — 10%
from external investors; 5% from ceding employers). Unlike Clara-Pensions (see below), the
SuperFund operates as a run-off vehicle, providing and administering pension payments for the
duration of the pension scheme’s liabilities. In addition to full pension payments, there is also
the potential for upside to the member — each year 1/3 of any improvement in the funding is
paid to the SuperFund Trustee who can provide this as a bonus or build a reserve for future use.
Clara-Pensions to a large extent operates on a similar basis to the Pension SuperFund —
there is a transfer of assets and liabilities and the sponsoring employer will provide a cash
injection which, alongside investors’ capital, will form a buffer to replace the covenant. Unlike
the Pension SuperFund, however, Clara-Pensions operates each pension scheme as an
individual section, managing them separately with a view to getting the funding to a level
where a bulk annuity purchase can take place with an insurance company.
Fiduciary Management Whether the scheme is on a journey to one of the consolidation options, or aiming for
self‑sufficiency, the trustees may wish to improve the effectiveness of investment decision
making. Fiduciary management involves delegating the design and implementation of the
investment strategy to a specialist — usually an asset manager or consultancy — with
the aim of harnessing greater investment expertise and more nimble decision making and
implementation. The recent market turmoil as a result of the COVID-19 pandemic is a good
case study for the potential need for timely reaction to changing circumstances.
Sole Trustee For pension schemes where governance is the key concern, changing the trustee arrangements
may be a preferable solution to risk transfer. This option replaces the trustee board with a single
trustee — usually a corporate entity — to oversee the ongoing management of the scheme.
Although the focus is on improved governance, greater efficiency can lead to improved cost
control and provides schemes access to a depth of experience in pensions that may not be
achievable with traditional trustee models.
Demystifying the DB End Game 4So, Which Model for The table below summarises the main end game options and approaches that can be used on
Your Scheme? the journey and what they mean for sponsors and members.
The choice for each scheme will depend on multiple factors, such as the maturity of the
scheme, the strength of the sponsoring company’s covenant and funding level. Well-funded
schemes will have the choice of the full range of options. Those with weaker funding may need
to focus on the investment efficiency and governance improvements in order to get to the
point where the end game options are feasible.
In the second section of this paper, Working the Assets Harder, we set out some thoughts
on what are the key risks, what trustees can do to manage these within existing arrangements
and what longer-term solutions may be appropriate for consideration.
Figure 4
End Game Options
Option What Does It Mean for the Sponsor? What Does It Mean for the Member? Is It the ‘Endgame’?
Insurance Buy-Out The liability is transferred, together The risk of non-payment moves Yes, for the sponsoring employer and
with the assets to purchase the from the corporate sponsor to the scheme — which will be wound up.
buy-out. the insurance company providing
the contract. Pensions payments made by the
insurance company.
Buy-In Certainty of benefit payments for From the member’s perspective there No, although the cashflows for the
those members bought in. is little difference — the ultimate risk members under the buy-in are
of payment remains with the scheme. secured, the scheme continues.
Continued liability for those members
not bought in. Investment flexibility or remaining
assets constrained.
Consolidation DB No risk transfer. Additional governance oversight. No, the scheme continues albeit in a
Mastertrust different form.
Economies of scale. Economies of scale should lead to
improved probability of payment.
Cheaper administration.
DB Effective risk transfer. Capital buffer should improve Yes, for the sponsor.
Consolidators probability of pensions payments.
Some concern that regulatory
Pension SuperFund Payments framework is yet to be settled.
made in run-off by the SuperFund.
Clara Transfer to insurance
company once at buy-out level.
Increased Fiduciary No risk transfer. Potential improvement in governance No, simply a change in the
Outsourcing Management could lead to improved probability oversight arrangements.
Economies of scale. of payments.
Access to investment opportunities
otherwise out of scope.
Sole Trustee Removes need for company and Potential improvement in governance No, simply a change in the
member nominated trustees. could lead to improved probability oversight arrangements.
of payments.
Quicker decision making.
Professional oversight.
The Very Pension PPF is to protect schemes of Pension payments capped. Potential that PPF tries to pursue the
Last Resort Protection Fund insolvent employers. scheme sponsor or related parties for
additional assets.
Demystifying the DB End Game 5Working the Given the desire of schemes to reach their long-term objective, whether it is self‑sufficiency,
Assets Harder buy-out or one of the newer consolidation alternatives, there is a need to assess their
investments with this long-term lens. To recap, the key risk for a scheme is a mismatch
between their assets and liabilities. Looking at the liability side, it is driven by changes in
interest rates, inflation and longevity risks.
Since so many schemes have the double whammy of being in deficit and (now or soon to
be) cashflow negative, they need to maintain the delicate balance between liquidity and
generating returns in a low return environment.
Sweating Your Large schemes have historically taken an approach of using leverage in their traditional asset
Traditional Assets classes, freeing up assets to invest in more illiquid or higher-yielding solutions. In those large
schemes they make the most efficient use of their assets by using segregated accounts with a
single pool of cash to cover collateral calls. Recent times have seen development of solutions
for smaller schemes which allow them to be more flexible and efficient.
Our Target Leverage Fund range provides a pooled solution which allows schemes to use
leverage in their equity and LDI assets and free up cash to invest in alternative strategies.
The pooled fund approach with both equities and bonds sharing collateral means that
the schemes should have a smaller number of collateral calls and therefore can plan their
cashflow needs better.
Figure 5 Equity Funds LDI Funds
Target Leverage 4x Exposure Fund Target Levarage 5x Exposure Fund Target Levarage
Funds
UK Nominal
Short / Long Profile
Global Real
Hedged / Unhedged Short / Long Profile
3x Overall Client Target
Leverage at Inception
Efficient Collateral Pool
Source: State Street Global Advisors, data as at 31 March 2020.
Demystifying the DB End Game 6Cashflow Driven Cashflow driven investment, or CDI, is investing with an awareness and focus on the liabilities
Investment and payments to pensioners. Our view is that the best way to do this is matching short to
medium-term cashflows where there is more certainty. Given schemes’ long-term targets and
circumstances may change, focusing on the foreseeable future minimises risk and produces
cashflows to smooth distribution schedules. Our view is that the characteristics of a robust
CDI approach are:
1 Buy and maintain credit portfolio, with systematic and transparent screening of
credit quality.
2 Global universe to create the widest opportunity set, currency hedged as required.
3 Incorporating ESG screens to further increase sustainability of cash flows.
We expect CDI approaches to see increasing take up as more and more schemes
become cashflow negative.
Conclusion Schemes need to maintain their focus on their long-term funding objectives and plan
accordingly. Risk management is critical to ensure that the assets are considered in light of
the liabilities. Schemes will need to continually revisit their thinking as their long-term options
increase. While fiduciary management was a new concept a few years ago with £10bn in
assets, it is now increasingly mature with £150bn and growing. Consolidation may be right
for some schemes whether through master trusts or super funds but these are still in their
nascent phase so time will tell how successful the model is. Improving the funding level of
schemes remains paramount in any scenario so making sure the assets work efficiently and
smoothing the path to the end game are key.
Endnotes 1 PPF 7800 Index, April 2020.
Demystifying the DB End Game 7About State Street For four decades, State Street Global Advisors has served the world’s governments,
Global Advisors institutions and financial advisors. With a rigorous, risk-aware approach built on research,
analysis and market-tested experience, we build from a breadth of active and index strategies
to create cost-effective solutions. As stewards, we help portfolio companies see that what
is fair for people and sustainable for the planet can deliver long-term performance. And, as
pioneers in index, ETF, and ESG investing, we are always inventing new ways to invest. As a
result, we have become the world’s third-largest asset manager with US $2.69 trillion* under
our care.
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