Of surpluses and spreads

The following is an extract from our 2025 global outlook.

The UK is going global… in a sense. Rachel Reeves, Chancellor of the Exchequer, unveiled in her recent Mansion House speech plans to create Canadian and Australian-style megafunds to power growth in the economy.

In addition to the strong focus on the DC market and Local Government Pension Schemes there was also a nod to insurers, regarding investment in productive assets under the new Solvency UK regulatory regime.

Defined benefit (DB) pension funds were not, however, mentioned at this stage. Therefore, it seems likely that formal feedback around surplus extraction will come in 2025. Nonetheless, with DB assets of c.£1.2 trillion and over a third of schemes (by value) being in surplus on a buyout basis, as at 31 March 2024[1], we would make three key points:

1. On surplus extraction, we recognise the necessity of mutually agreeable guardrails for sponsors and trustees, but expect there to be practical, workable solutions. We touch on these below.
2. It is news to no one that traditional investment grade spreads are low versus history. But as we describe later, there is much more beneath the surface to unpick and consider.
3. Delegation and how much? We think the trustee governance structure must carefully consider what strategic decisions to retain and what to outsource – from the new funding code, to a framework for capturing any sell off in credit spreads, to the transition of a private markets portfolio, to a buyout provider.

Although we await the finer details on surplus extraction, we already have a good idea around plausible strategy based on our long-term asset liability modelling. For an example scheme, we find that extracting surplus when the gilts funding level is greater than 110% could mean there is a 90% chance the scheme will still be fully funded in 10 years. If that funding level threshold is set at 105%, the probability may fall to 80%. At very high funding levels and thresholds for extraction, there is an increasingly strong case for allocating more to growth assets, in our view.

Spread vol

For pension schemes derisking or looking for extra returns to generate surplus what to do about tight credit spreads? Pension funds are fortunate to be long-term investors who can weather mark-to-market volatility. Our research, backtested to 1973, suggests that a relatively simple buy and hold credit investment is challenging to beat on a risk-adjusted basis because spreads can remain low for longer-than-expected periods, and tend to come with less risk. As such, even at lower credit spreads, we believe long-term credit investments still have their place.

That said, we do find there is room to add incremental value though a more proportionate strategy which could, for example, use shorter dated credit (be that traditional investment grade, securitised or private assets) to maintain carry.

Liquidity and resilience

The new funding code is live and effective for pension fund valuations from 22 September 2024. For their low dependency investment allocations, DB Pension funds will have to demonstrate investment strategies which are sufficiently liquid to meet cashflow requirements and highly resilient to short-term adverse changes in market conditions. Our observation is that governance structure will be key. A delegated approach could be the way to go to meet these regulations and anything else round the corner.

Finally, we think pension funds need not be wary of illiquid assets if circumstances or strategy changes and a buyout or buy-in is being executed. Private market transitions mandates can build on similar concepts used in public market transitions whilst allowing for key differences. LGIM is able to manage these exercises under the rigour of an investment management mandate, adding value and reducing costs in the process.

To sum up, there is much to be optimistic about for DB pension funds that can take their pick from buyout, run-on or both. As long-term investors, DB funds are able to take a strategic approach to surplus generation and asset allocation whilst taking advantage of flexible solutions to deal with private and illiquid assets. We can support all levels of delegation models to fit with trustee governance structure and objectives. 

The above is an extract from our 2025 global outlook.

[1] Source: The Purple Book 2024