Constructing buyout-ready portfolios for the endgame

DB: Approaching an inflection point

With dramatically improved funding levels, thanks in large part to the significant rise in gilt yields over the past 18 months alongside a partial recovery in risk-asset prices, the DB market is approaching an inflection point. The demand from schemes that are already – or soon will be – in surplus on a buyout basis is a multiple of the annual capacity of the pension risk transfer (PRT) market.

To put this in context, The Pensions Regulator estimates that over a quarter of all DB schemes could now be more than fully funded on a buyout basis[1], which could amount to £350bn of demand versus an estimated annual pension risk transfer market capacity of around £60bn, according to estimates by LCP[2]. Indeed, the volume of insurance policies that insurers may be able to write each year feels like a rounding error when it comes to the c.£1.4 trillion of DB pension scheme assets[3], given that over 75% of schemes have now recognised buyout as their likely ultimate end state[4].

In addition to the capacity constraints, there are two further reasons why schemes may be unable to buy out in the near term:

• Data issues need to be sorted – records must be complete and accurate
• Illiquid assets in the scheme that insurers won’t accept as payment, or will only accept with a hefty haircut, need to be run off or sold

While many pension schemes therefore are, or soon could be, fully funded on a buyout basis, they may not be able to transact immediately. As a result, we’re likely to see schemes adopting a holding pattern as they prepare for a potential buyout. The fundamental question is therefore: How should schemes invest as they approach their buyout endgame?

In this paper, we discuss some of the options available to schemes, and present a quantitative modelling framework that can help inform schemes as they consider their DB endgame strategy.

We find that buyout-ready strategies are scheme- and belief-specific but normally might opt to have high interest rate and inflation hedge ratios, a sizeable allocation to investment-grade public credit and, in many cases, other diversifying sources of excess return potential.

Please read our full paper on constructing buyout-ready portfolios for the endgame.

[1] Source: TPR Annual Funding Statement 2023

[2] Source for figures: Insurance enters a new phase – a skyrocketing market | Lane Clark & Peacock LLP (lcp.com)

[3] Source: PPF 7800 index as at 31 July 2023

[4] Source: Hymans Robertson Risk Transfer Report 2023