May 2010
For professional investors and advisers only
A Flight Path to
Self Sufficiency
Longer term planning for pension
schemes
Mark Humphreys and Jonathan Smith,
Head of UK Strategic Solutions & Strategic Solutions Analyst
Introduction
In this paper we discuss how setting a “Flight Path” can help pension scheme trustees and sponsors plan
towards achieving a self sufficiency or buy out funding level. As part of the Flight Path process, schemes can
chart the progress of their funding level and use improvements as an opportunity to de-risk.
From a trustee perspective, the benefits of setting a Flight Path are:
–
A Flight Path is a plan by which trustees can reduce their scheme’s reliance on the continuing support of the
sponsor (the “covenant”) over time.
–
Following a Flight Path enables schemes to “lock- in” or at least increase the protection of gains in the funding
level.
–
A Flight Path can overcome the governance constraints associated with a more ad hoc de-risking strategy and
means that schemes can be better placed to take advantage of improved market conditions when they occur.
A Flight Path approach should also appeal to sponsors:
–
It provides a managed plan to reduce funding level volatility over time, giving greater certainty over contribution
levels and accounting disclosures. Ultimately, a Flight Path can help a scheme attain a level of funding that
allows full buy out of the liabilities with an insurance company (or a stable long-term position similar to buy out).
–
De-risking as the funding level improves makes sense as there is little incentive to take investment risk at higher
funding levels. This is because the circumstances under which sponsors can take refunds of contributions from
their pension scheme are very limited.
–
A Flight Path gives sponsors greater certainty that action will be taken as the funding level improves.
What is a Flight Path?
The basic framework of such an approach is as follows:
–
Set a long term funding target. This is usually to be fully funded on a self sufficiency or buy out basis.
–
Chart the progress of the scheme’s funding level against this target and use funding level improvements as an
opportunity to manage down the overall risk profile, usually by:
–
reducing the scheme’s growth asset exposure
–
switching in steps from growth assets into bonds
–
extending liability coverage using Liability Driven Investment (LDI) instruments such as swaps.
Crucially, working together with a consultant and asset manager it is possible to design and implement a Flight
Path strategy that overcomes governance constraints to ensure action is taken if market conditions are more
favourable.
Issued in May 2010 by Schroder Investment Management Limited.
31 Gresham Street, London EC2V 7QA. Registered No. 1893220 England.
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May 2010
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Figure 1 gives an illustration of what such a Flight Path might look like.
There are a number of considerations when designing such a Flight Path which we will cover in this paper.
Some questions for sponsors and trustees are:
–
How long should the Flight Path be?
–
Should the scheme reduce unrewarded liability risks (such as interest rate and inflation risk) sooner by using LDI
instruments such as interest rate and inflation swaps?
–
When should de-risking take place – should this happen using funding level triggers or market based triggers to
capture ‘good value’ entry points?
–
How will the Flight Path integrate with the scheme’s shorter term “Recovery Plan”?
However, first we shall outline in more detail the benefits of a Flight Path approach.
Figure 1: Flight Path illustration
Funding level %- on low risk basis
110
Interim goal – full
funding relative to
Technical
Provisions
(assuming asset
outperformance in
discount rate)
105
100
95
90
85
80
75
70
Time
Funding level %
Target path
Risk
Source: Schroders, for illustrative purposes only
The case for setting a Flight Path
Trustee perspective
There is a strong incentive for trustees to look to reduce their reliance on the strength of their sponsor in the
long term (the “covenant”). The Pensions Regulator estimates that on average around 1 in 100 of all sponsors
will become insolvent in the next year1. This may not seem high in itself, but over a 20 year period this
translates to broadly a 1 in 5 chance of insolvency at some time. Even allowing for the impact on insolvency
rates of the current economic turmoil, many trustees will feel uncomfortable with this figure.
Traditionally reducing reliance on the sponsor covenant has meant improving the scheme’s funding level until
it is fully funded relative to the Technical Provisions and deficit contributions are no longer required from the
sponsor by law.
However, even when a scheme has funded its Technical Provisions, it is likely that it will continue to depend
on the ability and willingness of the sponsor to support it. For example, if investment returns are lower than
expected or if life expectancy increases then the funding level may deteriorate, which could mean further
contributions are required from the sponsor. Almost universally the Technical Provisions assessment of the
liabilities will include some form of allowance for investing in growth assets and thus it is not possible to ‘lock
1
2
The Pensions Regulator: The Purple Book 2009
May 2010
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down’ a scheme around its Technical Provisions basis as these growth assets bring volatility to the funding
level.
Ultimately, the only way to achieve total independence from the sponsor covenant is to pay an insurance
company to take on the scheme’s liabilities. This usually implies holding assets in excess of the Technical
Provisions (at the “buy out” funding level).
Even if buy out is not the ultimate aim of the trustees, it is often desirable to target a low risk investment
strategy, (e.g. holding only bonds or swaps), which would minimise the reliance on the sponsor covenant.
Again, such a strategy will normally imply a lower discount rate and therefore the need to hold assets above
the scheme’s Technical Provisions. This higher level is likely to be close to the buy out funding level as
insurance companies will typically use a bond or swap based discount rate to value a scheme’s liabilities.
A Flight Path that gradually reduces investment risk over time also has the benefit of “locking in” or at least
increasing the protection of gains in the funding level, whilst maintaining growth asset exposure in the early
years, when extra returns are needed to improve the funding position.
Finally, and crucially, a Flight Path can help trustees overcome the governance constraints associated with a
more ad hoc long-term de-risking plan. Once designed, it may be possible to delegate much of the day to day
monitoring and implementation of a Flight Path to your asset manager. Alternatively, a trustee body could use
an investment sub-committee to meet with the asset manager when a trigger to de-risk has been hit to decide
upon implementation.
This means that the scheme is poised to take advantage of improved market conditions quickly.
Sponsor perspective
A Flight Path approach should also appeal to sponsors of pension schemes for a number of reasons.
The first and most obvious reason is that most sponsors would be more than happy to remove the uncertainty
of their DB pension scheme from their company’s balance sheet, especially given the volatility associated with
the current pensions accounting regime. Of course, for most sponsors buying out their pension liabilities in full
now is not affordable; however a Flight Path puts in place a coherent plan towards achieving this objective
over a period of time. A Flight Path also clearly sets out a route to the end position and is a natural extension
from the sponsor’s realisation that the pension scheme will not be around for ever.
As a cheaper alternative to a full buy out, a Flight Path can help schemes achieve a stable long term position
whereby the assets have been de-risked and the scheme is fully funded on a low risk or “self sufficiency”
basis. Coupled with actions to manage longevity risk (e.g. longevity swaps) schemes can use this approach to
replicate many of the benefits of a buy out. This is likely to be a cheaper option than full buy out as the
scheme would not be paying for the higher reserving requirements of insurance companies (or contributing to
their profits).
Secondly, the circumstances under which sponsors can take refunds of contributions from their pension
scheme are very limited, so the incentive for sponsors to take investment risk in their pension scheme reduces
as the funding level improves. This is particularly true for schemes closed to future accrual where investment
gains cannot be used to offset the cost of newly accrued benefits.
A third reason why most sponsors should look to de-risk their pension scheme assets concerns where
companies are best placed to take risk.
Ultimately all company directors are paid to take some degree of risk. Shareholders usually want companies to
take risks on projects they are good at, i.e. their core business. Shareholders should therefore expect directors
to have a plan for reducing risk in their pension scheme over time where possible.
Finally, a Flight Path that reduces the governance burden on the trustees is also likely to mean less input is
required from the sponsor. Once the design of the Flight Path has been agreed between the sponsor and the
trustees the sponsor can have greater comfort that appropriate action will be taken as the funding level
improves. This latter point will become increasingly important to sponsors as funding levels improve.
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Integrating the Flight Path with a Recovery Plan
Reducing investment risk in a pension scheme is likely to have funding implications. If a scheme uses an asset
based discount rate for funding purposes, reducing the allocation to growth assets can result in a reduction in
the discount rate. This places a higher value on the liabilities and could potentially lead to higher company
contributions. That said, with a less risky investment strategy, trustees may be willing to accept a longer
Recovery Plan, which could reduce contributions.
In any case, it is important to consider funding as part of the Flight Path setting process and seek the
involvement of the sponsor and the Scheme Actuary at an early stage.
As the Flight Path relates to a longer term funding objective it is relatively straightforward to integrate a Flight
Path with a shorter term Recovery Plan. Some examples of how this may work in practice are:
–
Set being fully funded relative to the Technical Provisions as an interim target in the Flight Path (e.g. by restating
this funding level in terms of the buy out/self sufficiency basis – see figure 1 for an example).
–
State the long term funding target in terms of the Technical Provisions. For example the long term target might be
stated as 120% of the Technical Provisions if, for example, a 120% Technical Provisions funding level is broadly
equivalent to a 100% funding level on the buy out basis.
How long should the Flight Path be?
From the trustees’ perspective, the shorter the Flight Path the better, as this will minimise the scheme’s
reliance on the sponsor covenant. However, as the self sufficiency liabilities are usually greater than the
Technical Provisions (sometimes significantly greater), setting a shorter term Flight Path will increase the
funding requirements of the scheme.
This increase in funding can either be met by higher sponsor contributions or additional investment returns.
However the sponsor may be unable/unwilling to pay contributions above those required to meet the scheme’s
Technical Provisions. This will mean that the scheme would need to continue to invest in risky assets (such as
equities) for longer to hopefully generate the required additional return. In this case, trustees may decide to
select a longer Flight Path so as to keep investment risk at an acceptable level2.
Additional inputs that could be considered when deciding on the length of a Flight Path are:
–
Probability of sponsor insolvency during the Flight Path.
–
How quickly the scheme is expected to mature (e.g. how quickly the proportion of active members is expected to
fall).
Use of liability hedging instruments such as swaps
Under a “core” Flight Path approach, as the funding level improves the scheme gradually reduces its allocation
to growth assets and invests instead in bonds. This is a transfer of physical assets. A drawback of this
approach is that the scheme remains exposed to unrewarded interest rate and inflation risk in the early years
of the Flight Path.
Schemes may wish to build into their Flight Path design the flexibility to manage liability risks through the use
of derivatives, such as interest rate and inflation swaps. These instruments can help schemes manage
interest rate and inflation risk, whilst retaining the potential to earn extra returns by investing in growth assets
such as equities.
The timing of the increase in the liability coverage can be linked to improvements in the funding level or using
market triggers. We discuss these in more detail below. Many schemes will benefit from the additional risk
reduction of the enhanced Flight Path, however trustees should be aware of the additional governance
required to design and implement such an approach – particularly if market level triggers are used.
2
We will consider how trustees and sponsors might go about deciding the length of their Flight Path further in a
subsequent paper titled “How long have you got?”
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When should a scheme de-risk?
There are two basic methods to timing the switch out of growth assets and into matching assets, although in
practice a combination of these may be used.
1. Switch at predetermined funding level triggers
2. Switching at predetermined market levels as market conditions move in favour of the scheme
Funding level triggers
Using funding level triggers ties de-risking closely to the funding level, ensuring that growth assets remain
when they are needed to make up the deficit but are reduced when the funding level improves.
Using the funding level has the additional benefit of helping to reduce market timing risk - the risk of “selling
low” or “buying high”. This is because improvements in the funding level will usually be a consequence of a
rise in growth asset prices and/or a rise in the discount rate (and so a fall in bond prices and pension scheme
liabilities).
Market price trigger points
Market based trigger points aim to reduce market timing risk even further and might be coupled with more
detailed implementation decisions such as what type of risk to hedge (interest rate, inflation or both) and which
benefit cashflows to hedge (long, short or all cashflows). This approach is more likely to be associated with the
“enhanced Flight Path” approach discussed above.
Using market triggers in a Flight Path involves taking a view on whether the current price of interest rate and/or
inflation protection (e.g. via the swaps market or bond market) represents good value and if not, at which point
it does. Then, when these triggers are reached, the scheme purchases protection at the more favourable price
according to a predetermined formula.
Thus, even if a trustee group does not wish to extend liability protection at current market levels, putting in
place a Flight Path enables trustees to take advantage of opportunities to de-risk if better value arises in the
future.
Using market level triggers also provides a mechanism by which schemes can protect gains in the funding
level that have arisen because of, for example, rising interest rates or falling inflation expectations.
Figure 2: Illustrative market triggers for increasing interest rate coverage
Yield (%)
2.5
Trigger Level 2 Hit:
Extend coverage to 75%
Funding gain of c. £3.5m
Over 5 year index-linked yield
2
1.5
1
0.5
Current coverage: 20%
Trigger Level 3 Hit:
Extend coverage to 100%
Funding gain of c. £2m
Trigger Level 1 Hit:
Extend coverage to 50%
Funding gain of c. £5m
Liabilities falling
Liabilities rising
Oct-09
Jun-09
Feb-09
Oct-08
Jun-08
Oct-07
Feb-08
Jun-07
Feb-07
Oct-06
Jun-06
Feb-06
Oct-05
Jun-05
Oct-04
Feb-05
Jun-04
Feb-04
0
Potential path of
future yields
Source: Bloomberg, Schroders, for illustrative purposes only
The appropriate trigger levels will depend on the balance between the potential gain and the probability of the
targets being hit. The closer the trigger level is to the current position the more likely that it will be hit (and a
gain will be locked in). However a trigger level close to the current position may only result in a modest
improvement in the funding level when it is hit.
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A disadvantage of both funding level and market price triggers is that if market conditions/funding levels
deteriorate or do not improve to the trigger levels, risk could remain in the scheme longer than desired.
Governance is an important consideration – both funding level and market price triggers require a mechanism
to monitor funding levels/market conditions on a regular basis. Implementation under a market based
approach requires the governance to be able to form a view on market conditions. That said, methods to
delegate this monitoring function and the implementation of the changes in investment strategy continue to
evolve, including the use of Flight Path based mandates managed by LDI investment managers.
Using market based triggers in the Flight Path
Before embarking on a market based approach it is important that trustees understand where the majority of
their scheme’s liability risk lies. As shown in figure 3, the majority of pension scheme risk is usually associated
with benefit cashflows at longer durations.
Whereas trustees may have a strong conviction as to what inflation or interest rates will be over the next 2 or 3
years, it is much harder to form a view over the timescales that matter the most for the majority of schemes –
those of longer durations.
Figure 3 shows the cashflows of an example scheme, split by different pension increase types, together with
the interest rate/inflation sensitivity of its liabilities over various periods of time. The majority of interest rate
and inflation sensitivity (around 95%) relates to cashflows more than 10 years away, however
investors/economists’ views on interest rates/inflation typically cover a much shorter period.
Figure 3: Example scheme cashflows and where the risk is concentrated
Sensitivity to interest rates / inflation (% of total PV01)
5%
5%
20%
19%
28%
28%
24%
24%
23%
24%
Payment per
annum £
14,000,000
12,000,000
10,000,000
Increases due to the effect
of future inflation
8,000,000
Index-Linked Pension
Cashflows
6,000,000
Fixed Pension Cashflow
4,000,000
2,000,000
0
2009
2019
2029
2039
2049
2059
2069
2079
2089
Source: Schroders, for illustration purposes only
It is therefore important to recognise that a market trigger approach involves taking a view on interest rates
and inflation that are material to the scheme, and that this is likely to be harder than taking a short term view.
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Monitoring
At the heart of any Flight Path is a monitoring process, which is needed to determine both the correct asset
allocation at a particular point in time and the continuing suitability of a Flight Path design.
Successful monitoring requires the ability to see all the moving parts of your strategy, including the liabilities
(including cashflows into and out of the scheme), the growth assets and the matching assets. This enables
information to be collated quickly and efficiently so that actions can be taken in a timely manner. For this
reason, it is desirable for a scheme’s assets to be placed on a single platform that can provide this level of
reporting.
An example of how we can assist trustees monitor the progress of their Flight Path is shown in figure 4.
Figure 4: Example of how trustees can monitor the progress of their Flight Path
(1) Impact of passage of time – this causes the
present value of the liabilities to increase as the
time to payment shortens.
(2) This highlights where the hedging assets (e.g.
bonds or swaps) are not exactly matched to the
liabilities being hedged.
(3) The effect of changes in interest rates and
inflation on the liabilities which the trustees have
chosen not to hedge at this stage.
(4) The return on the scheme’s growth assets.
(5) The impact of the scheme’s cashflows not
occurring in line with expectations (e.g. if
benefit payments were less than expected).
Start
Passage of
time
Hedged
Unhedged
Excess
return on
growth
assets
Net inflow
4
5
End
-20
-25
-30
-35
-40
-45
-50
1
2
3
£'m
Source: Schroders, for illustration only. The orange bars represent a worsening in the funding position and the grey bars
represent improvements
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Conclusions
The aim of a Flight Path is to help schemes plan towards achieving a self sufficiency or buy out funding level.
This offers the opportunity to gain independence from the fortunes of their sponsor, whilst at the same time
reducing funding risk and “locking in” gains in the funding level as the Flight Path progresses to its final goal.
A Flight Path can also help trustees overcome many of the governance constraints associated with a more ad
hoc de–risking strategy. This potentially allows schemes to capture more favourable market conditions using
market based triggers.
A Flight Path approach should also appeal to sponsors as it provides a managed plan by which schemes can
reduce funding level volatility, as well as providing greater comfort that appropriate action will be taken when
the funding level improves.
A Flight Path will typically involve charting the progress of the scheme’s funding level and using improvements
as an opportunity to reduce the scheme’s growth asset exposure and switch this into bonds. Schemes may
also reduce interest rate and inflation risk sooner using LDI assets such as swaps.
At Schroders we are able to help trustees and sponsors with the design and implementation of their Flight
Path.
Mark Humphreys
Head of UK Strategic Solutions
+44 (0)20 7658 6576
mark.humphreys@schroders.com
Jonathan Smith
Strategic Solutions Analyst
+44 (0)20 7658 6877
jonathan.smith@schroders.com
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May 2010
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Appendix
Jargon Buster
Buy out basis
This is intended to be a close match to the basis that would be used by an insurance company to take on the
scheme’s liabilities. It will usually use a gilts or swaps based discount rate and, as such, will usually give a
higher liability than the Technical Provisions (which may make some allowance for asset outperformance in
the discount rate).
Enhanced Flight Path
Under an “enhanced” Flight Path unrewarding interest rate and inflation risk is removed early on in the Flight
Path (e.g. by using swaps), whist the allocation to growth assets is maintained. This ensures the scheme
retains the potential for additional returns early in the Flight Path in order to make up its funding deficit.
Flight Path
This is a process whereby schemes set a funding and investment plan to reach self sufficiency over a preagreed number of years. Investment risk is reduced over time as the funding level improves.
Funding level triggers
These are predetermined funding levels at which the scheme will de-risk (e.g. by switching growth assets into
matching assets such as bonds and/or purchasing additional liability coverage via swaps).
Integrated funding
Changing a scheme’s investment strategy has implications for both the scheme’s funding basis and its
Recovery Plan. It is therefore important to consider funding as part of the Flight Path setting process and seek
the involvement of the sponsor and the actuary at an early stage. Such an approach is sometimes referred to
as “integrated funding”.
Liability Driven Investment (LDI)
Broadly speaking, LDI can be defined as a strategy whereby a scheme constructs its investment portfolio with
some consideration for the nature of its liabilities. The most common tools of LDI are bonds and swaps, both of
which hedge the unrewarded interest rate and inflation risk in schemes’ liabilities to some degree. Swaps are a
more flexible tool as they can be used to build a closer match to the scheme’s liabilities and can use much less
capital than bonds in doing so. This frees up scheme’s to invest in growth assets to potentially generate
excess return.
Market based triggers
There are predetermined market conditions (e.g. interest rate levels) at which the scheme will de-risk.
PV01
Actuaries and asset managers often use the term “PV01” to describe the overall size (in £ terms) of the
sensitivity of bonds or liabilities to changes in interest rates. PV01 = (duration x value)/10,000. Interest rate risk
is minimised when the PV01 of the scheme’s assets is equal to the PV01 of its liabilities.
Self sufficiency
This describes the position whereby a scheme is sufficiently funded to be independent of the fortunes of its
sponsor. This usually implies being funded on a buy out basis as this would mean that the scheme’s assets
can be transferred to an insurance company. It can also mean being fully funded on a gilts or swaps basis
(which is likely to be close to the buy out basis). For a scheme to be self sufficient investment risk would need
to be minimised (e.g. by only investing in gilts or swaps) as otherwise the sponsor may need to be called upon
again to meet deficits that emerge as a result of investment losses.
Technical Provisions
The Technical Provisions are the statutory measure of a scheme’s liabilities used for the triennial valuation and
usually for funding purposes.
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Important Information
For professional investors and advisors only. This document is not suitable for retail clients. This document is intended to be for information
purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale
of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment
recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness
or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its
customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed
its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when
taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA,
which is authorised and regulated by the Financial Services Authority. Company registration No 1893220 England. For your security, communications
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