Background
Since the UK Chancellor’s Mansion House speech in July 2023 there has been much talk of pension reform and of well-funded defined benefit (DB) schemes “running-on”. This aligns with work done by several industry participants, namely LCP and WTW, who have been pushing the case for run-on for a couple of years. Whilst all parties are broadly pulling in the same direction, it is worth noting that the motivations are quite different. Pension schemes and corporate sponsors may seek to run-on to generate a surplus to:
- Augment member benefits
- Fund a parallel DC arrangement
- Pass profits back to the sponsor
- A combination of the above
The government, on the other hand, sees pension reform as a means to improve productivity and growth in the UK, and in-turn reduce government borrowing whilst supporting spending plans. Their proposals are aligned around investment in UK centric productive capital, arguing that the c. £1.5tn of UK DB assets could better support UK growth. In the Autumn Budget the Chancellor reduced the tax rate on pension surpluses from 35% to 25%, making it more attractive for corporate sponsors to seek to generate a surplus over the longer term.
Given the widespread journey planning targeted at low risk and low dependency, with a likely eye on buy-out/in, there would need to be a material shift in trajectory across the industry to support these run-on aspirations.
The concept of run-on makes a lot of sense, but there are some obvious headwinds. Whilst not insurmountable, these issues are worth highlighting as they feed into our views on timeframes and investment implications. They may also help inform industry participants as to where and how to lobby for change should they wish to do so.
What are the headwinds?
In no particular order:
- The TPR funding code would need to change materially to support re-risking of pension schemes in order to target future surplus.
- Further detailed work is required to finesse back-stop solutions that allow schemes to target growth, whilst ensuring they cannot leave members in a worse position than at outset. Several interesting options have already been tabled including a 100% PPF guarantee (LCP), credit insurance or surety bonds on the corporate sponsor, and frameworks for limiting surplus usage relative to funding ratio.
- The legal obstacles for utilising surpluses are many and material. Somewhat beyond the scope of this brief note, but there may need to be some legislative change and/or some test cases to guide legal precedents. Scheme rules may also result in complications.
- It is not clear to what extent UK pension schemes will wish to pivot back towards investing in the UK. Over the last decade, schemes have generally reduced allocations to the UK in search of greater diversification and opportunity set.
- With a General Election likely in Q4 2024, government policy on all these issues is in flux.
Election year: 2024 is the biggest election year since records began, globally. The UK is a contributor with an election likely (but not confirmed) in or around November. Of all the many countries going to the polls, the UK election looks the least likely to be a nail biter. At the time of writing, polls indicate Labour has roughly a 20-point lead over the Conservatives which would translate into a substantial Labour majority. What, therefore, does a Labour Government mean for pension reform?
Interestingly, Labour policy is reasonably well aligned with Tory policy here. Sir Kier Starmer and Rachael Reeves have already highlighted the need for pension reform, seeing it as a key component of their economic supply side reforms. They are also exploring the possibility of co-investment with the private sector through the “National Wealth Fund” to avoid such spending hitting the government’s balance sheet.
Arguably, the Labour policy proposals go further than those of the Tories, for example, by considering moving towards a system of superfunds as advocated by research from the Tony Blair Institute. However, they are a long way from having any of the details worked out so it is not clear how, when or if some of these more radical proposals would be implemented.
How may this play out?
We think that there is likely to be a sweet spot of well-funded DB schemes that will be best suited to running-on, exhibiting some or all of the following characteristics:
Medium to large size: so that the surplus is meaningful relative to the size of the sponsor and therefore sufficient to warrant the work required to generate and sustain it. Additionally, from the government’s perspective, pursuing investment in the UK from a small number of very large schemes will deliver a better outcome than doing so from a large number of small schemes. Therefore, the resulting framework may be skewed in this direction.
Strong and stable sponsor covenant: Not sure any explanation is needed here!
Investment expertise: within the sponsor and trustee teams.
Relatively immature scheme: The associated long time-horizon allows for a risk-controlled slow and steady approach to delivering returns. Furthermore, as a scheme matures and its cashflow needs increase it becomes harder to support an investment strategy that targets a surplus.
There is likely to be greater appetite to run on where a meaningful surplus already exists.
Schemes are likely to keep one eye on the insurance market because this will be the most likely contingency should the sponsor covenant deteriorate. Additionally, as the scheme matures and delivering outperformance becomes harder, an insurance solution is likely, meaning that run-on does not entirely replace bulk annuity activity but merely defers it.
What does all this mean for investment strategy?
In a nutshell, not a lot, relative to the current status quo. We anticipate that schemes will continue to favour high allocations to LDI and credit, albeit with some slightly punchier satellite allocations depending on the growth target.
Risk management will be critical which argues for a high liability hedge level. Credit then delivers consistent incremental returns and consistent cashflow. It is likely to be important for the corporate sponsor to have good visibility of cashflows to provide comfort that they will not be required to contribute as the scheme runs-on. The two common approaches to credit investing, short dated global credit and longer dated cashflow matched credit remain highly relevant. Both generate cash and offer good cashflow visibility. Shorter dated credit tends to offer higher flexibility and can be used to target a slightly higher return. It is also an ideal supplementary collateral asset to support LDI allocations. Longer dated credit offers even better cashflow visibility and allows you to lock into market levels for longer but delivers a bit less flexibility and less scope for return maximisation. In practice we can see a scenario where both play a role for individual schemes.
Beyond these core allocations, we anticipate interest in other risk management tools such as equity option strategies. There is probably also a place for credit default swaps (synthetic credit). This allows schemes to moderately boost returns, remain well aligned to buy-out pricing whilst retaining flexibility through not committing an undue amount of the portfolio to physical bonds.
This need to retain flexibility argues against meaningful allocations to illiquid assets, something the government may need to better understand given their push towards this type of investment.
In summary, we would highlight the following near-term investment strategy considerations for run-on:
Plan but don’t overcommit. Nothing is set in stone and the political landscape is highly uncertain:
- Scheme maturity – mature schemes typically have high cashflow needs, limiting scope for growth/run-on investing
- Liability hedging requirements – high hedge ratio desirable in run-on, consider impact on availability of growth assets
- Check your funding level – yields have been volatile; you may be in a better or worse position than you think
- Flexibility – if you wish to retain buy-out optionality, don’t overcommit to illiquids
- Fundamentals: diversification, liquidity & value for money – beware of herding into potentially scarce productive assets
- Be aware of unhedged risks – they may necessitate an additional surplus buffer
- Skills audit – do the trustee have the right skills to support run-on, today and in the future
- Cost awareness – higher advisory fees and insurance (e.g. PPF) create a higher hurdle to sharing any surplus
- Time horizon – some run-on solutions being tabled have a finite life-span
