Episode 3: What do we mean by journey planning for pension schemes?

Episode 3: Transcript

Raj Mody:

Hello, welcome to this episode of PensionsCast. Today, we are going to be talking about journey plans, every pension scheme needs one. In fact, there is regulation coming down the track, that means the pension scheme trustees and sponsors have to have one. At the same time, there has been loads of innovation around supporting people, who run pension schemes with coming up with better journey plans. We're going to be trying to make sense of all of that in this episode. I am your host, Raj Mody, and I am a pensions partner at PwC. I am joined today by two of my colleagues from the pensions team, Swapnil Katkar, who is PwC’s head of pensions risk transfer; and Matthew Cooper, an actuary, who leads our advice to clients in the new world of third party backed journey plans. We'll be looking at what that means as well. In fact, Matt let me come straight to you to start us off with some definitions. Let's start with the basic one. What do we mean by a journey plan?

Matthew Cooper:

Like most journeys, you need an end destination and to know what that is at the start of the journey. My view when it comes to pension schemes, is that the end destination is the place where members are going to expect to receive their pension benefits in full. Now this could be a variety of places. It could be running the pension scheme on until it's sufficiently well-funded, so it can pay members all their benefits. It could be getting the pension scheme to a place where it can afford to pass the responsibility to paying benefits over to an insurance company, and we commonly refer to that as an insurance buyout. There are other solutions, such as DB superfunds that sit in between. So, that's an end destination, but today, we're talking about the journey to the end destination, or as we define it, the journey plan. In answer to your question, Raj, I like to think of the journey plan as a strategy that, a, gets you to your end destination, i.e., maximizes the chance of members getting their pension benefits; and b, does this in a cost-effective way.

Raj:

That's really helpful, Matt. What you're saying is the journey plan effectively is just the plan to get you to your destination, but you need to define your destination in order to define the strategy to get you there. Let's just come up with a specific example to try and bring that to life a little bit more. Take insurance buyout as you mentioned, now we know that's not for everybody, it's certainly not going to happen for every single defined benefit pension scheme out there, but if buyout was your target, if buyout was your destination, what would a journey plan look like in that scenario?

Matt:

Yes, that's a really good example, because lots of pension schemes are targeting insurance buyout as their destination. The journey plan is made up of five key levers, and maybe we will just walk through those now. The first key lever is cash, how much new money does the pension scheme expect to receive. The second key lever is investment return, how much will investment return contribute over the journey plan or how much will it not contribute. Linked to this is the third lever, risk, and really what happens if we don't get that investment return we're planning for, or if other factors change the cost of insurance buyout, and key one being that life expectancies increase. The next key lever is time, how long have we got or how long would it take to get to this end destination. Finally, covenant, how much or how little funding could there be in the future, and importantly, what is the implication if the covenant is no longer there before buyout is reached.

Raj:

That's really helpful again. Matt, you've talked about those five levers. Equally, you could think of those as the five features that any journey plan needs to be explicit about and needs to have clarity on, to make sure that it's a well-defined journey plan, and that it works, that's really helpful. Swapnil, I'd like to bring you in, because we wanted to spend some time looking at recent market innovations. It's fair to say, historically, a lot of the burden has been on the people that run pension schemes, the trustees and the company sponsors, to work out their own destination and to define and implement their own journey plan, but perhaps unsurprisingly, the market, the investment industry and the pensions industry has realised that and there've been a raft of new ideas, new innovations that are designed to help trustees, can you make sense of some of those?

Swapnil Katkar:

Yeah, that's a good point Raj, and makes a lot of sense. We are seeing a significant innovation in this space with number of new solutions coming to the market. As you’ve pointed out, the traditional approach has always been where trustee take the responsibility for delivering this journey plan, which means with the help of their advisors, they will decide what is an asset or location, where the asset managers, who are managing the assets, and also decide ongoing changes to these assets, does the trustee take a day-to-day responsibility of implementing as well as monitoring the journey plans as they progress. This approach has a lot of flexibility, but it also means it will bring substantial governance burden on the trustees in terms of managing all these various levers, which Matt just mentioned. Where we are seeing some ongoing innovation in this space is where the pension schemes and their trustees will let the external parties manage these day-to-day responsibilities while retaining an overall control and oversight on their journey paths and how they are progressing.

Raj:

Let's just delve into that a bit more. What you're talking about there, this concept of outsourcing management to the assets. There's various labels for that in the pensions industry, and listeners might be familiar with some, some people call it fiduciary management, others call it OCIO or outsourced chief investment officer. The whole idea, though, in either of those terms is that the person you give or the firm you give that responsibility to, has really substantial discretion in terms of what they do with your assets, and the idea is that reduces a burden on trustees, who may be less experienced or just less expert with some of the latest market innovations. The thing I'd like to ask you, Swapnil, is this concept of fiduciary management, or whatever you call it, that's been around for a while now, what is different recently, why is it that people who run pension schemes should be looking at that topic again?

Swapnil:

Absolutely, as you said, there are a number of new solutions in the market, and with that, the concept of fiduciary management is also evolving. Fiduciary management, if you look at now, is responsible for close to 200 billion of assets under management, which is around 10% of the UK DB pension assets. Historically, fiduciary management has focused on what we call liability driven investing (LDI), where the main attention was to manage and hedge interest rate and inflation risks. However, the fiduciary managers have and continue to adopt, and improve their offering in line with the concept of journey plans and how the trustees are approaching the journey plans. An example of that, where nowadays in the fiduciary management is embarked upon and manager is appointed, the trustees and the fiduciary manager may sit together and review the journey plan, and including agreeing how the asset portfolio should be awarded and manage over a period of time to achieve the ultimate goal under the journey plan.

Raj:

Historically, and until actually quite recently, the offering from fiduciary managers was quite plain and simple, but now it's broadened out and expanded into dealing with the variety of journey plans that trustees of pension schemes need to have, and then the offering available from those fiduciary managers has been upgraded to deal with that. Plus, it sounds like there is a closer involvement of what used to be perhaps more of an arm's length instruction. It's now more intimate in terms of all the parties being at the table running that plan. I can see why that's changed and your point about it now being 10% of the market is interesting, it certainly wasn't that size in terms of coverage until quite recently, but that looks like it's a rapidly growing area. What characteristics or schemes would make them relevant to look at fiduciary management and then let's turn to some of the other solutions, which is the final question to you Swapnil?

Swapnil:

Yeah sure, there is a broad range of pension schemes, who have utilised and adopted in a fiduciary management for several reasons. However, you can ask for a typical scheme or the schemes where this is more suitable, typically a medium-sized scheme, which range from few 100 million in assets to four or five billion pound in assets, is where fiduciary management has mostly been used. However, starting with this some of the changes we're seeing in the market, we're now seeing even larger schemes, larger than five billion in size are now also increasingly looking to utilise fiduciary management.

Raj:

Sure, and there were a couple of very large examples just in the last few months of schemes north of 10 billion looking at fiduciary management structures and the advantages it could bring to them. That's definitely an area to watch. Thanks for that for now. Matt, I want to come back to you, because Swapnil has covered that area, which maybe some listeners will be familiar with, I suspect that a less familiar area is this concept of so called guaranteed journey plans or sometimes people talk about them as capital-backed journey plans. This is the idea where you've got some other third party providing their own capital to somehow support the journey plan. You started off by defining what a journey plan was, can I come back to you now Matt to define what exactly is a guaranteed journey plan or a capital-backed journey plan, how do they work?

Matt:

Okay, of course. Firstly, I just think this is an incredibly exciting and interesting space of innovation in pensions right now. At a very high level, guaranteed journey plans work as follows. The trustees agree to an investment strategy up front and pass the management of the schemes assets to the third party. The third party, as you say, then puts up more money, i.e., their own capital, alongside the scheme's assets at that point, when they start to take control of the new investment strategy. As part of doing this, the third party promises a level of investment return to this pension scheme or goes even further and promises that the scheme will be fully funded on some pre-agreed target. That could look like an agreement, whereby the third party is guaranteeing the scheme to be fully funded on buyout in say 10 years, but what’s in it for the third party, well they're effectively trying to beat the promise that they've made to the pension scheme. If they can outperform the investment return they have promised, the third party gets to keep the upside and that's the upside on their own capital, but also the upside on the pension scheme assets. However, we need to ensure that the capital being put up is adequate to underwrite any downside. Finally, it's really important to highlight that these solutions don't change the existing trustees or the sponsor. The pension scheme covenant stays in place throughout the guaranteed journey plan.

Raj:

Matt, that's all very well and I have to say I was having to hold myself back from jumping in as you're explaining that, because of this point. Anyone who has been in the pensions industry for any length of time, will probably have lots of red flags going off in their minds when anyone talks about the concept of a promise or guarantee. That seemed to be a major feature of what you've described. I am going to be sceptical for a moment and push you on this point, it sounds too good to be true. Tell us more about how a guarantee or promise could possibly work given the experience that those who are ‘old in the tooth’ will have situations where that concept goes badly wrong in the pensions industry.

Matt:

Yes, and of course Raj, you're absolutely right, it's not a guarantee per se, as you do have the risk that the third party gets it wrong. However, when structuring these solutions, you would look at them such that the pre-agreed outcome that you're agreeing to is delivered with a very high degree of certainty, and that comes down to the adequacy of the capital buffer being set. The other key piece here is that the capital buffer needs to be structured in such a way that if things do go wrong, then that capital becomes the property of the pension scheme and does not go back to the third-party investor.

Raj:

Okay, it sounds like there are some protections in place, perhaps I am not the only one to be right to be sceptical about the use of the word guarantee, it's not necessarily a cast iron guarantee, but that shorthand label is used to describe the concept. Certainly, I want to be careful if I was talking about that concept, and the words I use, but we get the gist of it enough for now. It does sound like there is more due diligence involved from everyone involved to go forward with these kind of solutions, but I'll ask the same question to you Matt as I asked Swapnil earlier for fiduciary management, what type of schemes might benefit from this, let's call it capital-backed journey plan?

Matt:

I think these solutions are going to be far more bespoke to specific pension scheme circumstances. They only make sense if they are better than other journey plans when you're doing a comparison. So, the two key areas I would look at are: A. does this solution enhance the chance of members getting their benefits in full, and B. is it more cost efficient than alternatives? An example where I could see this working is where a pension scheme has adopted a low-risk investment strategy. In this case, adopting one of these solutions could benefit the scheme by allowing it to target greater expected investment returns and hence allow the pension scheme to reach full funding on a buyout measure either in a shorter time horizon, or with a higher probability of success. This could be attractive, where trustees have confidence in the covenant today, but less confidence as to how the covenant will be in the future.

Raj:

You've come up describing the types of schemes with different dimensions actually, and a different access to how we were looking at fiduciary management, which to some extent felt to be a little bit more size driven, your criteria are different. That's interesting, because it does mean that there will be schemes out in the market that want to look at a range of options and it's not at all just universal that certain schemes have to go down one route, that does definitely make the picture very interesting for the more standard solutions and the more bespoke ones.

Swapnil, let me bring you back in, taking a look at putting all of that together, there are about two trillion pounds worth of UK defined benefit pension liabilities out there. When you put together everything that we've talked about, do you have a feel for how much of that two trillion will eventually end up in the kinds of different solutions we've talked about, the fiduciary management, some of these third party journey plans, there's obviously buy-ins, buyouts insurance as well and indeed other solutions that these schemes that just run on of their own accord, is it possible to break down how the market is going to divide up across these solutions?

Swapnil:

Yeah, sure Raj. I like to say it is possible to predict that, but it's a very hard thing to predict as these liabilities continue to change, market solutions continue to change, and as a result the journey plans continue to change. But overall, there is a rule of thumb that we can utilise and then everybody can little bit come out with some ballpark answers as how these liabilities could be split in terms of these various solutions. If we look at the size of the DB market of two trillion, there are number of very large schemes, who make a good proportion of this liability, and for many of those schemes, fiduciary management could be a right solution. They can self-invest, or they can utilise fiduciary management, and in the process achieve their journey plan, whether it is self-sufficiency or buy-in or buyout. But then there is another large proportion of schemes which are few 100 million to hand full of billion in size, where the guaranteed journey plans, as Matt mentioned earlier, those could be more suitable solution where they can achieve the right objectives over the long term. Many of those solutions as we pointed out, effectively are built to provide the bridge to eventually buy-ins and buyouts for this scheme. Again, depending on the journey at various points in time, you could be looking at guaranteed journey plans, which itself would then become full buy-in and buyout. But overall, what we think is that in the context of overall liabilities, sizable risk could be managed as a combination of fiduciary management and guaranteed journey plans.

Raj:

That's really clear in some ways, as much as it can be clear. The point you're making there is that it's too dynamic an area to lock down and predict in advance. In fact, if anything, there'll be situations where some schemes are using a whole suite of the ideas that we've talked about across different stages of their maturity and their journey plans. Thank you for that.

Final question back to you Swapnil in that case. If you're listening to this now and at whatever stage of journey plan you might be for your pension scheme, what would you advise the listener to think about today?

Swapnil:

Yeah, I will like to make couple of important observations, Raj. As Matt very well pointed out at the start of our discussion, that it is important that the purpose of the journey plans and variety of the solutions to support this journey plan is to make sure that member benefits are secured and get paid and that is delivered in a cost-effective manner as far as possible. But as such given the range of solutions available, including fiduciary management and guaranteed journey plan, it is important that the trustee and the corporate sponsors familiarise themselves with a full range of options that are available in the market to support their journey plans. Even where the pension plan has an existing journey plan in place, it might be worth considering if it needs further navigating, given ongoing developments in the market.

Raj:

That's the key point, isn't it, that there have been loads of innovations lately plus as you said earlier, pension scheme circumstances are changing all the time. Wherever you thought you'd got to, you might want to refresh your analysis. Thank you both Matt and Swapnil for that really good discussion. This brings us to the end of this episode. However, there is more if you'd like to know more about this topic. If you're listening before the 31st of March, you can join our live event on that day, it's a virtual event. We call it the virtual ideas exchange. You can find out more about that via our website pwc.co.uk and search for virtual ideas exchange, and we'll put details in the notes to this episode. If you're listening after that date, don't worry, you can get on demand versions of that event and in fact all of our virtual ideas exchange events, once again, just go to the website and search for virtual ideas exchange. You have been listening to PensionsCast. Thank you for joining us, goodbye for now.

Participants

• Raj Mody
• Swapnil Katkar
• Matt Cooper