Investment for mature schemes The London & SE Region of the Occupational Pensioners' Alliance February 2007 Simon Jagger MA FIA Jagger & Associates Ltd

Structure of a typical mature scheme Usually closed to new members and to ongoing accrual – i.e. deferreds and pensioners only “Active” deferred members may have salary linked benefits Need to consider age-by-age reserves profile, and associated matching asset allocations - duration of liabilities will influence strategy Examine future cashflow pattern [Sample charts follow later] Consider how any strategy will evolve over time, and at what speed, plus materiality Compare size of Scheme to financial size of sponsoring employers - Trustee concerns over employer covenant

General Considerations Benefits go up broadly in line with RPI So do payments on index-linked Government Stocks So I-L gilts are a natural “match for these liabilities BUT – the match is not perfect …. Inflation can (in theory) be negative (unlike pension increases) Pension increases typically have a ceiling Index-linked gilts are not “long” enough, and too sparse at longer dates Too many pension schemes want them, therefore very expensive! Not a match for salary increases

Gilts and Corporate Bonds Sources:Financial Times, Barclays Capital

Example Cashflow Projection A typical closed scheme pattern Scheme Actuary will normally update data as part of valuation NB – a generic scheme

Another cashflow example, this time with ILG “matching” Spikes are the years when the 11 ILGs mature Not much of a cashflow fit, so you have to realise a lot of capital as you go along NB – a generic scheme

Cashflow Projections Assumptions Pension increases (RPI?) Salary increases where relevant (RPI+2%?) Mortality – much more a subject of debate now Note that investment returns do not figure at this stage

Example Liability Profile NB – a generic scheme

The Problem Cashflows have to be met from: Investment proceeds, and/or Employer contributions More of one means less from the other Can work out “required yield” from current fund (which is where the investment return starts to enter the situation) Often very sensitive

Example Fund Projection A mature scheme, almost at the contracting stage, and with a sizeable FRS17 deficit Implied required investment return NB – a generic scheme

The XYZ Pension Scheme If assets are sufficient on basis of gilt yields, why risk failure by investing elsewhere? But there is still exposure to mortality risk. Very few schemes are in the luxury of having this as an option.

The XYZ Pension Scheme Most schemes rely on ongoing contributions from the employer What investment return was assumed in calculating the contributions? Does this force the trustees to look for higher returns? If not, do the trustees want to “help” the employer? (e.g. charities or non-profit employers)

The XYZ Pension Scheme What are the options? Corporate Bonds High Yield (sometimes still called junk bonds) Property UK Equities Overseas Equities Private Equity Hedge Funds

Example Risk-Return Profile NB – a generic scheme

Equity Risk Premium Based on market and earnings levels, plus bond yields Want the result to be well above the “trigger” to justify holding equities

Commercial Property Long run of strong returns – too good to be true? Still a good income generator for many schemes Sources:IPD, UBS

“Period to deficit payoff” analysis – allowing for investment risk Little chance of eliminating deficit in the early years Initial peak is around the term used by the actuary, assuming no investment risk Material risk that the deficit is still outstanding after 25 years

Conclusion You need to understand many things for a mature scheme before you can begin to assess what the investment strategy should be! These include: The shape of a scheme, and how it is expected to evolve, both in liability profile and cashflow terms The employer covenant, and scope for support via direct contributions or other methods Make sure you focus on material aspects first!