Pensions investment outlook: What does ‘sufficiently liquid’ look like?

At the start of 2022 there was consensus that bond yields would rise as pent-up demand post-Covid would lead to a “transitory” spike in inflation. Vladimir Putin’s decision to invade Ukraine and the rapid pivot of western countries away from Russian energy supply made this rise both acute and longer-lasting. The infamous UK government ‘mini-budget’ then triggered a crisis in an already fragile market with profound impact on UK corporate sponsored defined benefit (DB) pension schemes. Meanwhile, workplace defined contribution (DC) schemes have been hit by a synchronised fall in both equities and bonds. These schemes are increasingly considering how they can access more diversified returns from private markets strategies. 

Below we highlight some of the themes that we’ll explore in more depth in the coming months:

1. The DB end-game: Buyoutⁱⁱ  is closer but a lot of work remains to be done
   
   Higher funding levels: 
   
   Over half of schemes may be close to affording full buyout on paper. However, demand may be slow to materialise due to capacity pressure. On the supply side, private capital is available (albeit pricing may need to widen), but capacity will be constrained by staffing, reinsurance capacity and new asset sourcing. We expect market capacity to remain no higher than 5% of outstanding DB liabilities a year in the next few years. And so the end-game for many schemes remains over a decade away.
   
   Accelerated rebalancing into “middle-ground assets”:
   
   Calls for cash from LDI managers have left many schemes’ asset allocations unbalanced. In many cases this has hollowed out allocations such as investment grade credit, which could deliver both income to pay pensions in the short term, and duration to more closely match changes in buyout pricing over the medium term.
2. Liquidity: The LDI crisis has focused minds on what “sufficiently liquid” looks like
   
   Understanding asset liquidity during market stress:
   
   The speed at which assets were required to meet LDI collateral calls caused considerable challenges.  While many schemes had a plan place for such an event, in some cases even “liquid” assets could not be accessed in time. Liquidity was particularly poor in areas such as asset-backed securities, Sterling investment grade credit and UK property, given the concentration of defined benefit investment in these areas.
   
   Higher returns from less liquid assets are still needed:
   
   Regulators in Dublin and Luxembourg are already looking at restricting the ability to increase leverage.  This means larger, less leveraged, gilt portfolios and therefore residual assets will need to target higher returns even if the overall return target is lower. Global and higher-yielding fixed income assets will therefore be needed to deliver income and hit these return targets. And so we expect “buy and maintain” credit and private debt strategies (see below) to be in demand.
3. Outsourcing: Consolidation will gather pace
   
   We believe we have passed the point of “peak complexity”:
   
   Governance of multiple investment managers was brought into sharp focus by the LDI crisis of 2022. A growing array of outsourcing options are now available: Superfunds and capital-backed journey plans support a scheme with additional private capital, fiduciary management and outsourced-CIO services take care of investment functions to varying extents, while a sole trustee or a master trust approach provides full governance outsourcing. However, full outsourcing can take considerable time to do well, and once in place can be difficult or costly to change.
   
   Partial outsourcingⁱⁱⁱ  is likely to gather pace: 
   
   We expect more schemes to pursue an approach of appointing multi-portfolio mandates focused on a particular group of asset classes. For example, LDI & cash; income-generating public and private credit; and legacy growth assets. Dividing up the portfolio in this way can retain specialist focus while simplifying governance to deliver benefits in full and on time.
4. The case builds for private markets in DC plans
   
   A source of diversification and returns:
   
   What may have appeared to be well diversified glidepath strategies have suffered significant falls in 2022 due to the high correlations across public assets. Private market asset classes have generally performed better, as returns are derived from different risk premia. While attention is needed to avoid industry concentration in niche asset classes, the sources of return from a well-constructed private markets portfolio are likely to persist.
   
   Implementation is tricky:
   
   In the short term, many schemes will need to reduce their private markets allocations to replenish liquidity buffers. DC schemes or master trusts also face challenges from fund selection, liquidity terms, fees, and fund platform infrastructure. The introduction of the Long-Term Asset Fund (LTAF) vehicle, and the development of multi-alternatives funds by fund managers, are welcome additions, which we expect to provide easier access points in 2023.