Episode 2: How should pension schemes invest their assets?

Episode 2: Transcript

Raj Mody:

Welcome to this episode of PensionsCast, a podcast where we discuss topical pension issues being faced by companies, pension trustees, and pension scheme members. I am Raj Mody, and I'll be your host for this episode. I am a partner at PwC, leading our pensions consultancy business globally and I am also lucky enough to work with a range of fascinating clients on their day-to-day pension issues. We are going to be talking about one of those today, and the subject will be what pension schemes do with their assets. There are two facets to that which we'll look to cover. One is, where they put those assets and a growing trend actually to consolidate how they organise those assets with a single provider. And the second, which we think is linked, is whether they're changing the type of assets that they need anyway to deliver their pension obligations, the benefits that they need to pay members. We are going to explore whether actually those two trends are part of an overall trend that is fundamentally changing the way that the investment markets work.
I am delighted to be joined today by two experts in the area in our virtual studio here. One is Keira-Marie Ramnath, who oversees what's called our fiduciary management function, and how pension schemes go about outsourcing their assets; and the other is Sam Seadon, who is an investment portfolio expert. Welcome to you both.
Let's dive straight in. Keira, I am going to start with a question for you. We position this as a trend that we've spotted, which is that increasingly pension schemes seem to be looking at the opportunity to consolidate all of their assets with one provider. Can you just explain that a bit more though, what's going on in the market, and why might this be happening?

Keira-Marie Ramnath:

Very happy to Raj. Just to put this into context, you might say I am a bit eagle eyed when it comes to the UK market. What I have seen is an industry that's grown from being around 2 billion of assets 15 years ago, so that would be in the mid-2000s, to one which is now over 200 billion. There are two things which have been driving this growth in the market. The first one is one which has impacted quite a number of small and medium-sized pension scheme trustees, and that’s in relation to schemes who use fiduciary management having to re-tender their fiduciary arrangements. That's been driven by regulatory intervention into the market, the Competition and Markets Authority investigation into the whole of the investment consultant market under fiduciary management market. Then on the other side of this, we've also seen a trend, which is that quite a number of larger pension schemes, who have traditionally done a lot of their investing in-house considering whether there is merit in outsourcing some of those functions. Traditionally, we've thought about those schemes as being too big to outsource, but the challenge is, does this still hold true in a world where those schemes are de-risking, and the type of assets that they need to hold are becoming more bond-like and liability driven.

Raj:

We will definitely come back to the question of whether the type of assets is changing the way they operate, but let's just explore a bit more the decisions they're making around structure. That’s quite a change in market dynamics, as you said, for a market that was 2 billion 15 years ago to now be 100 times bigger. You really need the whole of the industry to be showing some directional trend in order to see growth like that. Can we just unpick that a bit? Are we saying that this was relevant to small-to-medium sized schemes anyway, because of pressures around competition, and best practice, and so on, but it has also cracked the really large scheme market, because even though historically people may have said, why would they bother with a trend like this, they are actually moving in that direction as well. It's quite rare to have a trend where you are seeing it at the same time across all sizes of schemes, from small to large. Is that a fair analysis, what do you think about that?

Keira:

That is a fair analysis. The benefits, though, of why the schemes look at it do differ depending on size. Traditionally, it has been a market that has been more attractive to the small and medium sized end, and the reason for that is because the benefits that come from the consolidation trend, which you mentioned earlier. the benefits of pooling assets you get better economies of scale, schemes don't get restricted by their size when they want to invest in some more, let's call them, fancy assets, alternative asset classes, and you just get some operational efficiencies as well. Whereas, when you look at the larger end of the market, I would say that those schemes have been traditionally very good at having the bargaining power with the market, but the operational side, and in particular the direction that regulation has taken those schemes in, where operational costs only appear to be going up and up, there is real benefit there. The other thing as well with the large end of the market is, we used to think of those schemes as being really large, but when you look at them, when you extract away the assets, which they might have secured with insurers, the reality is the assets held by those schemes is becoming quite small. They are becoming more like medium-sized schemes, and by medium-size, they're around the 1 billion’ish mark.

Raj:

Really interesting, the point there and this actually brings us neatly into the de-risking topic we wanted to cover, but what you're really saying is even though schemes can appear large on the face of it, the residual assets they really have left to play with freely, if you like, and invest freely, were becoming increasingly lower in terms of value. That's the perfect time to bring Sam in. Sam, another trend that we've seen also over the last 15 years is the change in the types of assets that pension schemes need. That's arguably inevitable. They've got more and more pensioners, pension schemes are now actually focused on paying out those benefits as they fall due every month, instead of just investing for the very very long term. That's a shift change that may be catalysing the earlier trend that Keira has already talked about. Talk us through that, if you will, how does that change in terms of the type of assets which pension schemes need, how has that been affecting the overall attitude and approach that they take on how to structure their assets?

Sam Seadon:

That's right Raj. To that point, LDI or Liability Driven Investing managers have been gathering assets for over 15 years as well, and that's happened as pension schemes have de-risked. That’s a relatively small cohort of organisations, who manage fairly mundane portfolios for schemes of largely government bonds, sometimes derivatives as well. That’s not really what people might traditionally think of as investment, I suppose, where you might be trying to pick a company to outperform the index or make some call about macroeconomic issues, like which way are interest rates or inflation going to go, or which way is this market or that market going to go. These portfolios are much more about matching the pension payments that schemes have to make in the future. LDI managers started there, and those portfolios have gradually grown and grown just because people have been de-risking, but at the same time, these managers have also been adding competencies to their toolkit.

Things like FX hedging as well. Hedging of currencies is a portfolio that most schemes will need and can often be done by the LDI managers, so they've tended to pick that up. Sometimes also equity exposure can be gained in derivative form rather than buying the physical equity assets, and so that's another competency that these managers have added. The final one that you've seen in the last few years is really putting alongside the UK government bond portfolios, corporate bond portfolios. Corporate lending, and trying to manage integrated portfolios of government bonds and corporate bonds, which if you look at industry level aggregate statistics are up to, maybe, three quarters of the assets that the schemes in the private sector hold. You get this effect where these managers are managing asset portfolios that are just growing and growing. I expect that to continue, because schemes will keep de-risking, although de-risking has run a fairly good course already, but also, because they're adding competencies and will continue to add competencies.

Raj:

It's really fascinating to understand that. What you're saying is, you had a segment of the market, a range of providers that started out with a fairly plain vanilla offering, but innovation or observing what the market demand was, led them down a path, where they expanded that capability. As you say, they might have just been dealing with government bonds, but then decided to branch out into corporate bonds, or they might have been increasingly managing overseas currency risk, or they might have looked into some of the more esoteric asset exposures you can get out there, like you mentioned, derivatives and so on. Just as those providers, who are originally managing some quite plain vanilla portfolio, started expanding the range of their capabilities, that happens to come at a time when pension schemes are looking at, ‘well is there one place I can put all of my asset portfolio in.’ It just so happens that the pension scheme asset portfolio matches up quite well with that range of expertise.

This is exactly the point we wanted to unlock here, isn’t it, the idea of was there a general trend anyway because of cost or efficiency or regulation for pension schemes to be looking at the model, if you like, the construct of where they put their assets, but was there a catalyst to do with the way that their portfolios shape up, combined with the fact that providers are expanding their capability. Suddenly, everything comes together, when you get this perfect match. Going back to your comments right at the start, an industry that has enlarged 100 times over the last 15 years, what else Keira? It sounds like a fascinating trend. Do you think this will continue, have we seen the limits of innovation and regulation, or what more do you think is coming down the pipeline that pension schemes should be aware of?

Keira:

We definitely haven't reached the limit of innovation in this market, this is what is driving the market at the moment. What's really interesting is, I expect there to be more providers in this market. Within those providers themselves, I expect there to be really interesting solutions in terms of the end game stuff that Sam has spoken about. What’s really pleasing for me is, how to actually invest pension scheme assets is now getting the attention it deserves, and I am really excited for what the next 15 years holds.

Raj:

Brilliant, thank you, and Sam, I do want to bring you in on one more angle to this, which is that we've talked about the range of providers of assets out there in the market. There is another category of institutions that you can arguably say, in one way or another, end up providing the assets for pension schemes, and they are the insurers and the consolidators. Every time a pension scheme makes a decision to buy-in or buy-out, as we talk about it, or potentially now, a new emerging trend to move their assets into one of these consolidation vehicles, that vehicle effectively becomes the asset manager. What should pension schemes or indeed insurers and consolidators be thinking about when they are constructing asset portfolios, if you've gotten that end game, that strategy in mind?

Sam:

Yeah, that's right Raj. The insurers will want fairly simple portfolios. It's up to the pension scheme to set their time horizon to give the portfolio to an insurer. They shouldn't tie up the capital in their portfolio beyond the point where they want to give it to the insurer. If they have no objective to give it to an insurer at all, and they simply want to run off and pay the cashflows to the members themselves, then they might have very long term, locked up illiquid assets. Like for example, infrastructure debt so that the debt of infrastructure projects tends to be quite a long term illiquid asset. You might not do that if you had an objective to give the assets to an insurer; however, if you still wanted the pension scheme to access this illiquidity premium, but over a shorter period, because your objective was to give the scheme to an insurer in five years, then you might look at using shorter-term alternative or illiquid assets to try and earn that premium over short period of time, things like collateralised loan obligations, asset-backed securities, which are slightly more esoteric assets, but generally a bit more short term. One interesting dynamic as well, for both the insurers and the pension schemes is that the UK Government is really trying to encourage investment in UK-based infrastructure projects and trying to get the pension schemes themselves, but also the insurers to invest in those assets and so schemes have a decision to make. The first order decision is about their time horizon to ultimate settlement with an insurance company.

Raj:

I am sure that's the topic we could explore in much more depth. In fact, it might merit a whole another episode to talk about the right pension scheme asset strategy if you're running up to an insurance event, but let's leave it at that for now.

Thank you so much Keira and Sam for a really interesting discussion. Of course, thank you to everyone who has been listening. If you would like to explore and understand this topic further, please feel free to visit our website, which is at pwc.co.uk/pensions, or of course get in touch with me or either of the speakers, our contact details should be in the episode notes. Please also subscribe to keep up to date with future episodes, and we would love to hear your feedback, including on what topics you might like us to cover in future episodes. You've been listening to PensionsCast with PwC, bye bye for now.

Participants

• Raj Mody
• Keira-Marie Ramnath
  
• Sam Seadon