Running away from running on? How short-term run on is the best game in town

By the 9th July 2023, it was beginning to look obvious that a large proportion of the £1.4 trillion of UK pension scheme assets would end up being transferred to bulk annuity providers by the end of the same decade. Meaningfully higher interest rates, prompted by events during the latter half of 2022, have led pension scheme funding to heady heights and closed, maturing and de-risking schemes mean that insurance of promised benefits is the only option ... right?

Roll forward just one day, to the now oft quoted Mansion House speech by chancellor Jeremy Hunt, and perhaps we had momentum for another train of thought. Could, even should, there be a case for well-funded, and well-governed, pension schemes to run on beyond the point that they could feasibly insure?

The (current) Government's point of view is clear … reverse the trend of c.£1tn+ in assets tracking down the risk spectrum (depending on your view of Gilts of course) and have them reinvested in "productive" assets, all for the wider benefit of UK plc.

It may not be explicitly the role of occupational pension schemes to drive economic growth, but I don't think we should be immune to the wider societal benefits of £1tn+ of capital being well invested. And certainly, we should be very aware that a future government could offer meaningful incentives that could significantly benefit members and sponsors of defined benefit schemes.

Now, and here's the crux of the question, why would pension schemes that can access the security of the insurance regime not rush at the opportunity? Right now, in advance of future political outcomes around surplus overrides and taxation, it is not immediately clear - but that's the point. What is clear, however, is that tripping over one's own feet in the rush to insurance, can have needlessly negative consequences. This is especially true when you consider that there is clearly stated political will, across both the Conservatives and Labour, for things to change for the better.

I do a lot of work in the secondary asset space, helping pension schemes, and other investors, to trade in illiquid assets. One defining feature of this recent "insurance trend" is that money good assets are trading at serious discounts to fair value or NAV (net asset value). Economically that can't make sense. Why would the best funded of our pension schemes be willing to give up their prize assets in what is tantamount to a fire sale? We know why, of course - insurance and insurance immediately irrespective of the upside forgone - possibly driven by a view that any “upside” is out of reach, or not within the remit of trustees. The consequence of this is that value is leaving the UK pensions system and being hoovered up by overseas pension schemes and sovereign wealth funds - the buyers of the illiquid assets being sold by schemes.

This is absolutely not to say that insurance isn't the right ultimate destination for many, but my challenge is why rush when the cost of coming out of some assets now is potentially extremely high. Pension promises and patience should go hand in hand, surely?

And this is where, even in the absence of an exact understanding of future changes in surplus regulations, it is possible to see the very clear merits of a "short-term" run on. By this, I simply mean holding off from insurance in the short-term to maximise the potential within the current investment strategy. One obvious example of this would be deferring the purchase of insurance until after the point that all of the current illiquid assets have naturally amortised - completely removing the need to incur a sale involving a material discount. An extension of this idea might be the purchase of an illiquid asset mid-life cycle, picking up an asset with c.4-5 years left to run, and at a material discount which can directly improve the funding position.

Many of you reading this will be thinking "ahh yes, but..." and in response to that I have tried to capture some of the concerns that I see raised around the Trustee table.

1) My buy-out deficit has fallen from a lot, to only a little - surely now is the time to lock-in?

The idea that pricing may never be this good again is a common one, but also somewhat misleading. Pricing versus scheme assets is at the most positive level within my career,  but a lot of that has been driven by sponsor contributions and higher interest rates, not insurers slashing prices. As such, maintaining a robust investment strategy should provide protection against many of the likely adverse movements on buyout funding, and more likely than not result in gains against that position over time.

2) Regret risk - how can trustees justify not insuring benefits where it is affordable?

There is no general regulation requiring schemes to purchase insurance. In fact, most schemes were set up to “run-on” and pay benefits as they fall due and that is what the majority of the pensions industry is still busy focussing on. Trustees are also required to act in the best interests of members and be aware of other stakeholders - and the potential outcome of a surplus could be to augment member benefits and/or return surplus to sponsors which can be covenant enhancing. These interests should not be quickly dismissed.

Clearly all of the above must be underpinned by a suitable covenant. Trustees need to be satisfied that the sponsor is able to support the scheme in whatever state it is "run-on". This element may soon change to a certain extent, with the PPF thinking very hard about how it might offer 100% protection of benefits. I, for one, would welcome this and think it could be an affordable alternative to “having to insure”.

Trustees and sponsors also need to be open to exploring the ideas around short-term run on and how that might map into a longer-term strategy. Helpfully our recent survey found that over half (57%) of sponsors are keen to explore the potential benefits of running-on their scheme and 75% of Trustees would be happy to govern a scheme with the goal of running-on.

Really every scheme should be considering this and not solely assessing their options in the current regulatory world, but rather the possible regulatory world that might exist when the majority of their members will be taking their benefits - ie the future! And we might not have to wait all that long for that future to be a reality. Time will tell.

In my next piece, I will be writing about the current opportunity in purchasing illiquid assets in the secondary market, alongside a contribution from a Trustee with first hand experience.

Until then I leave you with a quote from the drama series "Billions": "There's always only upside in pressing your advantage. That's the whole point of having an advantage to press."-- Bobby Axelrod.