Defined Benefit Dynamism: Navigating Towards Better Outcomes

At the PLSA Annual Conference in October, SSGA, VLK and Clara delved into trustees’ views on endgame planning, consolidator models and LDI management as the DB landscape continues to shift.

Recent shifts in the pension landscape have brought significant challenges for UK defined benefit (DB) schemes, demanding strategic adaptation from trustees. In a recent survey of 100 UK DB trustees, conducted by State Street Global Advisors (SSGA) in partnership with Van Lanschot Kempen Investment Management (VLK) and Clara-Pensions (Clara), trustees shared their perspectives on these emerging challenges and their approaches to endgame planning, including consolidation, liability-driven investment (LDI) management and the other nuances involved in setting an endgame strategy.

At October’s annual PLSA conference, an expert panel delved into these survey findings, offering insights into how trustees are navigating the challenges their schemes face in setting an endgame strategy, particularly as new solutions emerge, including superfunds and capital-backed journey plans.

Endgame Planning: Varying Perspectives

Jeremy Rideau, EMEA Head of LDI at State Street Global Advisors, opened the discussion by highlighting the complexity of DB trustees' roles, due to the multitude of endgame options and recent shifts in the LDI landscape.

“With the different endgames that exist out there, the new consolidation vehicles, some of the innovations in the LDI landscape, it is now as hard as it has ever been to be a DB trustee,” he explained.

Rideau stressed: "The endgame is something trustees and schemes have to think about. Even if it’s still a few years away, you need to make the decision, and making the right decision is where the complexities arise."

Additionally, Rideau highlighted a gap in the perceptions of trusteeship, versus the actual day-to-day challenges faced by trustees. He asked the audience present at the event to identify the biggest challenge in setting an endgame strategy – 45% cited managing trustees versus sponsors' opinions, followed by ensuring members' priorities are met and understanding different options. Audience participants noted market risk as the least concerning challenge.

This contrasted with the survey results, which highlighted market risks as a major threat to the endgame strategy due to the potential difficulty in adapting to changing conditions.

“Endgames are getting more complicated now; they are not just buyout and run-on anymore,” Rideau said. “There are other options which are not always straightforward, and it is crucial that sponsors, trustees and members understand the pros and cons to all these approaches to make informed decisions.”

Meanwhile, while almost half (45%) of trustees surveyed said that trustees and sponsors have equal influence in deciding a scheme’s endgame strategy, a significant number (17%) of trustees believe sponsors have more influence over the endgame. It is therefore key to the success of the scheme that each party is well-informed about the variety of options available.

Are Superfunds the Future?

Endgame options are increasingly including alternative solutions such as superfunds and capital-backed journey plans – collectively favoured by 17% of survey respondents – but which are generally less widely understood than the familiar run-on and buyout options.

When Rideau asked the audience about the future roles of superfunds, 45% said they believed superfunds will help schemes with weak or uncertain sponsor covenants – a similar outcome to that of the trustee survey. While two-thirds (66%) of survey respondents believed the potential for better member outcomes was a key benefit of superfunds, 61% said they expect superfunds to deliver better member outcomes for schemes coming out of PPF assessment.

The perception that superfunds will primarily serve schemes with weak covenants needs to be addressed, both through industry education and by completing transactions with a variety of sponsor covenants. The panel agreed that any scheme that is unable to access an insurer solution can still potentially achieve improved member outcomes through a superfund solution.

“We have heard about superfunds a lot in the last two to three years, and for the first time we see over half (55%) say that they expect a significant rise in the number of DB schemes moving their assets and liabilities to superfunds over the next two years, a real change,” he said.

Rideau added: “Education is paramount when it comes to endgame. We need to make sure that the sponsors and the trustees all understand the options they have at their disposal, and that superfunds are more than just a lifeline for pension scheme trustees with a weak covenant.”

As for capital-backed journey plans, Richard Zugic, Chief Financial Officer at Clara, emphasised the importance of trustees understanding the underlying investment strategy and, crucially, the risk tolerance and fees. Furthermore, The Pensions Regulator has given clear guidance that trustees should engage with the regulator early if considering capital-backed journey plans. He explained that as a superfund consolidator, Clara operates by bringing new capital to bear and leveraging the benefits of scale.

“One of the benefits of our scale is a better ability to make sound investments and apply those for the benefit of all of the schemes that come into the Clara pension trust,” he said.

Nikesh Patel, Chief Investment Officer at VLK, agreed, saying: “Clara is a very flexible model, anchored on a lower-risk, robust investment strategy, which separates it from some of the other capital-backed models out there.”

Challenges in LDI Investment Strategy

On a related note, a significant number (60%) of trustees believed that a better investment strategy would encourage them to switch managers, with lower fees also being a significant factor (60%).

Rideau explained in more detail: "Almost 80% of trustees we surveyed have reviewed LDI managers in the last three years, but only 23% have taken the plunge and made a change to their LDI arrangements in that time. This might be partly as LDI remains complicated for many pension schemes, and the fear of changing can be quite significant.”

“The main barriers to changing your manager are that a lot of pension plans have been with the same LDI provider for many years, and trustees/pension schemes worry about losing that institutional knowledge,” he added.

The panel agreed about the importance of challenging the status quo and finding ways to improve LDI services and investment propositions.

"We need to ask more pertinent questions of managers, focusing on how they operate in stressed events,” Rideau added, and highlighted the need for better transparency and reporting, advocating for daily updates on leverage and collateral sufficiency.

“If you want to know your leverage and collateral sufficiency, you should have that information to hand every single day if needed. You’re then in control, and you know what's happening without having to email your relationship manager,” he stressed.

Meanwhile, the panel anticipated a shift from pooled to segregated LDI funds. Patel explained that while pension schemes with pooled LDI funds suffered during the recent gilts crisis, pension schemes with segregated accounts remained largely unaffected. As a result, he argued, segregated accounts have proven that they offer more control and robustness.

“The crisis was not a crisis of all LDI. It was a crisis caused by forced selling within pooled LDI funds, which caused a death spiral in gilts. Pooled formats of LDI exacerbated the crisis, and pension funds using pooled LDI suffered the crisis, while pension funds using segregated accounts did not in remotely the same way,” he said.

"With a segregated account, you will always be in control as a client; you will set the boundaries and targets for your pension scheme rather than the necessary burdens placed upon multi-client vehicles. So much the better if you can get that for the same or lower cost than pooled funds," Patel added.

Illiquid Assets and Endgame Strategies

Finally, the panel addressed an audience question on the complexities of managing illiquid assets, stressing the need for careful consideration of long-term implications and the potential for value destruction in transactions.

Rideau warned about the risks of illiquid assets, citing potential mismatches in asset allocation and the high costs of exiting such transactions.

Patel criticised the illogical practice of selling illiquid assets to fund buyouts, only for insurers to have to buy very similar assets back later.

“It really is value destruction on an enormous scale that a pension fund might have to sell illiquids at a discount to fund a buyout, and then an insurer buys very similar illiquids when they take over the assets. Both sides suffer a loss of value,” he said.

“Something being less liquid is not an evil thing. If it's a good investment and it fits your time horizon, return and risk needs, you should be able to do it.”

Zugic concluded that one of the attractions of the Clara superfund solution is that “we have been able accept illiquid assets in-specie which would not have been possible in the insurance regime.”

The full DB trustees survey will be available soon, offering further insights and analysis.