Investment for mature schemes

The London & SE Region of the Occupational Pensioners' Alliance

February 2007Simon Jagger MA FIA

Jagger & Associates Ltd

Structure of a typical mature scheme

• Usually closed to new members and to ongoing accrual – i.e. deferreds and pensioners only

• “Active” deferred members may have salary linked benefits• Need to consider age-by-age reserves profile, and associated

matching asset allocations - duration of liabilities will influence strategy

• Examine future cashflow pattern• [Sample charts follow later] • Consider how any strategy will evolve over time, and at what

speed, plus materiality• Compare size of Scheme to financial size of sponsoring

employers - Trustee concerns over employer covenant

General Considerations• Benefits go up broadly in line with RPI• So do payments on index-linked Government Stocks• So I-L gilts are a natural “match for these liabilities BUT – the

match is not perfect ….

• Inflation can (in theory) be negative (unlike pension increases)• Pension increases typically have a ceiling• Index-linked gilts are not “long” enough, and too sparse at longer

dates• Too many pension schemes want them, therefore very expensive!• Not a match for salary increases

Gilts and Corporate Bonds

Sources: Financial Times, Barclays Capital

0123456789

10111213

Dec-85 Jun-88 Dec-90 Jun-93 Dec-95 Jun-98 Dec-00 Jun-03 Dec-05

%

Long bond yield ILG RY

-500

50100150200250300350400

Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04

Non-Gilt AAA AA A BBB

Example Cashflow Projection

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2005 2015 2025 2035 2045 2055 2065

Time

Cash

flo

w (

£k)

Active Deferred Pensioner Total

• A typical closed scheme pattern• Scheme Actuary will normally update data as part of valuation

NB – a generic scheme

Another cashflow example, this time with ILG “matching”

• Spikes are the years when the 11 ILGs mature• Not much of a cashflow fit, so you have to realise a lot of capital as you go along

NB – a generic scheme

0

20

40

60

80

100

120

140

160

180

2007 2017 2027 2037 2047 2057 2067

Liability (£m) ILG

Cashflow Projections

Assumptions

• Pension increases (RPI?)

• Salary increases where relevant (RPI+2%?)

• Mortality – much more a subject of debate now

Note that investment returns do not figure at this stage

Example Liability Profile

NB – a generic scheme

0%1%2%3%4%5%6%7%8%9%

10%

23 33 43 53 63 73

Age next at April 2004

% o

f lia

bili

ty

Active Deferred Pensioner

The Problem

Cashflows have to be met from:

• Investment proceeds, and/or

• Employer contributions

More of one means less from the other

• Can work out “required yield” from current fund (which is where the investment return starts to enter the situation)

• Often very sensitive

Example Fund Projection

-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060

Year

Fu

nd

siz

e (£

k)

5% 6.27%

• A mature scheme, almost at the contracting stage, and with a sizeable FRS17 deficit

• Implied required investment return

NB – a generic scheme

The XYZ Pension Scheme

• If assets are sufficient on basis of gilt yields, why risk failure by investing elsewhere? But there is still exposure to mortality risk.

• Very few schemes are in the luxury of having this as an option.

The XYZ Pension Scheme

• Most schemes rely on ongoing contributions from the employer

• What investment return was assumed in calculating the contributions?

• Does this force the trustees to look for higher returns?

• If not, do the trustees want to “help” the employer? (e.g. charities or non-profit employers)

The XYZ Pension Scheme

What are the options?

• Corporate Bonds

• High Yield (sometimes still called junk bonds)

• Property

• UK Equities

• Overseas Equities

• Private Equity

• Hedge Funds

Example Risk-Return Profile

Cash ILGUK bonds

OS bonds

HY

UK equityProperty

OS equity

Current

0

1

2

3

4

5

6

0 2 4 6 8 10 12 14

Risk (% p.a.)

Rea

l Ret

urn

(%

p.a

.)

NB – a generic scheme

Equity Risk Premium

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

Feb-97 Feb-99 Feb-01 Feb-03 Feb-05

UK prem US prem trigger

• Based on market and earnings levels, plus bond yields• Want the result to be well above the “trigger” to justify holding equities

Commercial Property

• Long run of strong returns – too good to be true?• Still a good income generator for many schemes

-20

-10

-

10

20

30

40

73 78 83 88 93 98 03

% R

etu

rn

Sources: IPD, UBS

“Period to deficit payoff” analysis – allowing for investment risk

• Little chance of eliminating deficit in the early years• Initial peak is around the term used by the actuary, assuming no investment risk• Material risk that the deficit is still outstanding after 25 years

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

0 5 10 15 20 25

Conclusion

• You need to understand many things for a mature scheme before you can begin to assess what the investment strategy should be!

These include: • The shape of a scheme, and how it is expected to evolve,

both in liability profile and cashflow terms• The employer covenant, and scope for support via direct

contributions or other methods

• Make sure you focus on material aspects first!