This is the second in a series of blogs that aims to build understanding defined benefit funding by examining investments, covenant and funding and the impact these items have on the finances of a very simple defined benefit pension scheme.

Part 1 dealt with investing and covered cash-flow matching, interest rate risk and equity risk for a fully funded scheme. Part 2 examines a scheme in deficit and shows how leveraged LDI can reduce risk.

The ABC Scheme

As before, the ABC Scheme is due to pay a lump sum benefit of £10,000 in ten years’ time.  However, this time the Scheme has just £4,000 in assets and it is in shortfall.

Short and long-term interest rates remain at 2.36% per annum and, based on this, the Scheme is about 50% funded on a ‘self-sufficiency’ basis. The employer has agreed to pay £4,400 in five years’ time to make good the shortfall.

The trustees are carrying out a review of investment strategy. The investment options they’re considering are; 1) cash, 2) equities, 3) gilts or, 4) leveraged LDI.

Invest in Cash

The trustees could invest in cash.

At the date of review, banks were paying 2.36% per annum interest on deposits. If this remains unchanged, the assets and contributions will grow to £10,000 exact in ten years’ time and the trustees can pay the benefit in full.

The risk with a cash investment is, of course, that deposit interest rates fall. If this happens the trustees will not earn the return needed to pay pensions in full. Investing in cash leaves the Scheme exposed to risk. Specifically, to the risk of a fall in interest rates.

Invest in Equities

The trustees could invest in equities. They expect equities to earn a return of 5% per annum. Should this happen then the assets, contributions and investment income will be more than enough to pay the lump sum benefit, with a surplus returned to the sponsor.

This strategy is risky. The trustees may end up having a surplus to return to the employer, but there is also every chance that their bet on equities doesn’t pay off and they can’t pay the benefit in full.

Invest in Gilts

The trustees could invest in gilts. Specifically, they could invest the current asset in a ten-year zero-coupon gilt and, in five years’, invest the contribution in a five-year zero-coupon gilt. This would allow the trustees to arrange their investments to exactly match their benefit outgo.

Unfortunately, this strategy still leaves the Scheme exposed to risk.

Consider, for example, if interest rates fall from 2.36% to 0%. If this happens then:

• The current asset increases in value by 26.3% from £4,000 to £5,050
• As interest rates are now 0%, the total assets after the £4,400 contribution is paid is £9,450 and the asset in 10 years time will be £9,450
• This is less than the £10,000 lump sum and the trustees are unable to pay the benefit in full.

Under this strategy, if interest rates fall anytime within the next five years, the assets and contributions will not be enough to pay the lump sum benefit.

Invest in LDI

The trustees decide to use LDI to obtain leveraged exposure to interest rate movements. The asset of £4,000 is invested in a ten-year zero-coupon gilt with 1.5 times leverage. In year five, the deficit contribution is invested in a five-year zero-coupon gilt and, at the same time, the ten-year zero-coupon gilt is restructured to remove all leverage.

This time, if interest rates fall to 0%, then:

• The current asset increases in value by 40.0% from £4,000 to £5,600
• As interest rates are now 0%, the total assets after the £4,400 contribution is paid is £10,000 and the asset in 10 years time will be £10,000
• the trustees are able to pay the benefit in full.

Under this strategy the trustees can be certain that they will be able to benefit in full. This will be the case whatever happens with interest rates and equity markets.

Real-World DB Pension Schemes

This demonstrates how leveraged LDI can reduce risk in a simple DB scheme with a single lump sum benefit and a single deficit contribution. As a DB scheme is just a series of cash-flows, the same technique can be applied to all the future benefit and contribution cash-flows in a real-world DB pension scheme. Allowance can also be made for pensions that are linked to inflation.

That said, this simple example does make two significant assumptions that do not hold up in the real world:

1. We assume that the deficit contribution is guaranteed. This is not the case in the real world. Deficit contributions are only payable if the sponsor remains solvent. If the sponsor’s covenant is weak, there is a very real chance that the sponsor becomes is insolvent before the deficit contribution is paid.
2. We assume that the sponsor has chosen to fund on a risk-free self-sufficiency basis. Again, this is not what happens in the real world. Sponsors are only obligated to fund on a ‘prudent’ basis. Most chose to do exactly this.

In part 3 we introduce covenant and technical provisions and examine the complex interplays between investment, covenant and funding and the impact these items have on a very simple DB pension scheme.

Please contact us if you would like to discuss this.

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