Excess cash, improved funding levels, increased end-game planning are three big themes facing pension schemes. In this brochure, we look at why liquid credit can be a suitable option for schemes across a range of circumstances.
A lot can happen within a year in the pensions world and the past 12 months have been no exception. 2019 proved to be a defining period for pension schemes from the perspective of:
- Excess cash: Falling yields (long term interest rates) have meant a number of LDI managers have returned an unprecedented amount of excess collateral in the form of cash to pension investors.
- Improved outcomes: DB funding levels have been the highest they have ever been, and consequently schemes are looking to de-risk where possible.
- Flexibility: With improved funding levels, the endgame is in sight for many. The volume of schemes either approaching or getting prepared for buyout/buy-in transactions was at an all-time high.
As we begin a new year, what are some of the key learnings trustees can take from 2019? For example, where should pension schemes be investing across these scenarios? Do trustees need a pool of cash to meet these requirements, or is there another investment that can help meet these needs? In this paper, we will look at alternative solutions that can be suitable for schemes across a broad range of circumstances, including:
- A pension scheme that is de-risking and needs to maintain attractive risk-adjusted returns - Trustees require the right asset classes and instruments in place to de-risk optimally. Typically, schemes move away from equities and other risky assets and move towards less volatile assets such as fixed income strategies and then to liability driven investment (LDI) and cash as the final step. However, many trustees are still required to maintain some risk and return to achieve their funding objectives while accelerating their de-risking programme. Is there another stepping stone in the journey that schemes should consider before investing into cash?
- A pension scheme that is considering or approaching the endgame - Getting prepared for the endgame strategy is becoming an important consideration for trustees. Increasingly, schemes are approaching insurers for buyouts or buy-ins and require suitable assets to ensure that the final step is not derailed through adverse market movements. Are there steady, low-risk investments available in the toolkit that can be used in these circumstances as alternatives to cash?
- A pension scheme with excess cash and/or LDI collateral - Trustees are increasingly looking for a home for excess cash and surplus LDI collateral holdings. Many schemes have had to re-balance their portfolios in order to redistribute excess cash held. However, the appetite for trustees to materially re-risk is typically low. So where do trustees go with this cash in the long term?
Demand for liquid credit as a solution
As trustees navigate the changing pensions landscape of lower yields, greater buyout affordability and improved funding levels, there has been increased investor demand for liquid fixed income solutions. This has resulted in great success for Absolute Return Bond (ARB) and Multi-Asset Credit (MAC) managers who have captured the increased investor demand.
However, ARB and MAC strategies typically seek relatively high returns that also attract higher fees, leaving investors with fewer options for such broad strategies at the lower end of the return spectrum (Cash +1% - 2%, for example).
Furthermore, at lower return targets there is a strong rationale for investors to focus on a less complex, high-quality, income-driven solution that still offers diversification across the liquid credit universe. But the range of funds is limited, with many investors settling for single strategy concentrated solutions that may be sub-optimal. Following analysis undertaken at Aon, we have identified areas of the liquid credit universe that offer attractive risk/return payoffs for investors. We discuss two of our favoured low-cost income-driven strategies below- short-dated credit and asset-backed securities.
Short-dated traditional credit
Short-dated credit focuses on purchasing securities that are relatively senior in a company’s debt structure with a typical maturity of less than six years.
With a shorter term to repayment comes greater certainty of outcomes. This means less day-to-day market volatility in values compared with longer-dated credit and, subsequently, better risk adjusted returns.
In addition, we believe that through a mixture of bottom up and top down analysis, managers can add value compared to a passive fund.
High-quality asset-backed securities
Asset-backed Securities (ABS) are simply bonds (or notes) that are secured on financial contracts which are typically loans. For example, residential mortgage-backed securities (a type of ABS) are bonds that pay interest and principally backed by many home loans (the financial contracts) which are each secured on residential property. Individually, the home loans are not economically viable to trade. However, the grouping process turns them into tradable securities with differing levels of risk and return depending on investor risk appetite.
Asset-backed securities have three attractive investment characteristics compared with traditional investment grade corporate bonds. First, for a number of technical reasons the securities typically offer an additional yield compared with investment grade corporate bonds of an equivalent term and credit rating. Second, they are often issued with a floating interest rate and therefore do not suffer the same degree of volatility we see from traditional bonds due to changing interest rates. Third, the underlying consumer-based loans provide diversification from corporate default risk many schemes are exposed to through traditional equity or bond allocations.
Liquid credit investments offer strong return potential, although risk-adjusted returns can vary between the different strategies. The chart below shows our expected performance of the liquid credit universe (represented by the grey dots) over the next ten years based on current market conditions.
As you can see, short-dated credit and asset-backed securities strategies fare well from a risk/return perspective versus other strategies. They provide a solution that can blend our favoured strategies at different points in time, such as those mentioned above.
A key consideration for liquid credit strategies is whether to take a single or multi-manager approach, with both having their pros and cons.
Our preferred implementation is the multi-manager approach, allowing diversification across asset classes, consumer and corporate credit, investment styles and managers.
A single manager would deliver a simple low governance implementation approach, although likely only giving exposure to one of asset-backed securities or short-dated credit, limiting the levels of diversification.
We can consider our preferred multi-manager approach where there are two options available to trustees.
Option 1: 'Get Busy'
(Otherwise known as the ‘DIY’ approach) This option requires trustees to spend time and resource to agree and implement a diversified liquid credit portfolio. Trustees would need to select the managers from those available in the market, negotiate suitable terms, and establish their own monitoring framework to ensure the allocations remain appropriate over time as market conditions change. This approach has historically been preferred by larger pension schemes that have the governance budget required, such as in-house resource to support trustees.
Option 2: 'Get Simple'
This popular option sees trustees investing in a single manager that has been delegated the responsibility of investing in a diversified portfolio of strategies. By delegating, the pension scheme will likely get exposure to a more diversified, more dynamic and lower governance solution than if they took a DIY approach. By pooling with other investors, the benefits typically come at a similar (and often lower) cost to the scheme too.
During 2019 and as yields continued to fall, we saw improving scheme funding levels and significant amounts of cash being released from schemes’ LDI mandates. As funding levels improve, we expect an increased appetite from trustees for low-risk, liquid credit. These income-driven strategies are low-cost, straightforward and an ideal home for schemes looking to de-risk or invest excess cash or LDI collateral.
To meet this growing demand from trustees we brought together specialists from across Aon to form the Liquid Credit Team. We asked the team to develop a solution that gives trustees access to lowcost, income-driven returns though investments in our favoured liquid credit asset classes at any time. The solution launched offers a ‘Get Simple’ approach through a single fund, with daily liquidity; has an income option to support benefit payments and overall fees comparable to those that a large investor would achieve through a DIY approach.
This document contains marketing material about our fiduciary management service. This document does not represent impartial advice on this service. In certain cases, you are required to conduct a competitive tender process prior to appointing a fiduciary manager. Guidance on running a tender process is available from the Pensions Regulator.
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