The most recent IMF Global Financial Stability Report gloomily suggested that a combination of slow-moving structural factors, notably aging populations and slower productivity growth, is generating a background of lower economic growth and interest rates across developed economies.
This outlook, which flattens yield curves and presents other long-lasting challenges for defined benefit (DB) pension funds, is driving asset allocation decisions and therefore the demand for transition management services. Meanwhile, the increasing prevalence of defined contribution (DC) funds means that transitions are more frequently occurring, but these bring a different set of challenges.
DB pension funds are continuing their gentle retreat from the workplace savings scene. In the UK, for example, only 21 companies in the FTSE 100 are still providing DB benefits to a significant number of employees (defined as the cost exceeding 5% of payroll) according to JLT Consulting. Those schemes that do remain are maturing, trying to de-risk where possible.
Despite their decline, DB funds remain a very important client group of transition managers as there is still plenty of reallocation work to be done as member profiles mature. There has been a remarkable shift in the average fixed income allocation from 34% ten years ago to 62% at the end of 2016. Although the flow into bonds slowed to just 1% during 2016, further de-risking is expected to resume when conditions become more conducive.
Many companies are still running large mismatched equity positions in their pension schemes. This creates unwelcome volatility for the sponsoring company’s balance sheet, further fuelling the desire to de-risk. Three FTSE 100 companies changed their bond allocations by more than 10% in the past 12 months alone.
De-risking is high on the agenda, if not at the top, for pension schemes, said Andrew Williams, investment consultant at Mercer. However, total de-risking is still not an option for many schemes due to the need for investment returns to bridge funding gaps. Indeed, funding positions are weak and have become weaker over the past 12 months, leaving relatively few with the option of moving wholesale out of growth assets. Nevertheless, some are doing it progressively.
“De-risking is more complex than it was 10-15 years ago, when it would probably just entail moving into a gilt fund,” said Williams. “Now it will more likely involve transitioning into an LDI portfolio with complex derivative and bond arrangements. Gilts may be overvalued right now but, for a lot of pension funds, it is still the best hedge for their cash flows.”
Certain investment managers have introduced the concept of liability-responsive asset allocation for de-risking. This brings in more frequent monitoring of key financial measures such as the funding status and surplus volatility, rather than a focus on individual managers and their relative performance.
Transition managers will have an ongoing role to play in this area, according to Chris Adolph, head of transition management, Emea, Russell Investments. He said that some asset owners will periodically want to partially de-risk as funding status improves, often calling on the expertise of transition managers for the task. The transition management team will work alongside a LDI completion manager, who looks at the fixed income programme relative to the LDI programme and makes adjustments.
There is also a regulatory push relating to trustees’ responsibilities. Tightening UK regulation means they need to understand far more and bear far greater responsibility, which is prompting them to seek additional third-party support.
Max Lamb, head of transitions at Willis Towers Watson, said that the main trend he is seeing is for DB schemes to move to fiduciary management arrangements. Fiduciary management takes the investment decision-making strain away from trustees, but usually means significant portfolio restructuring with targeted liability matching. “Legacy assets need to be transformed into a better set of assets,” he adds.
Lamb said that the challenges are different for every scheme, but the skills required of a transition manager remain largely the same. Transitions invariably involve trading a large amount of the scheme’s assets and, as ever, transition managers need to be very careful about how it is done.
That said, compared to the options available 10 years ago, transitions are more complex today. That is partly due to low bond yields but also the range of investment options available to pension funds. As such, transitions need more detailed planning. Consultants can help the pension fund trustees decide whether they need the services of a transition manager, based on the complexity, cost and exposure involved.
Lamb said that a key change for pension funds in recent years is the number of investment mandates they award. Previously, they may have had between five and seven managers – one for UK equities, another for overseas equities and so on. It has since become common to diversify more broadly and schemes may have as many as 40 managers.
“This means they have a lot of transition projects to organise,” he adds. “Each investment manager mandate needs operational due diligence, legal review and a project timeline.”
Transition managers can add more value when the mandates are larger and more complex. With an investment below £30m there are relatively few trading challenges and it may not be worth employing a transition manager to make the change, he adds: “It is often best made in cash.”
The move to buyout
Buyouts are another key area for DB schemes. A number of high profile schemes have been bought out over the past 12 months. Legal & General completed a £1.1bn pension buyout for the Vickers Group Pension Scheme – part of the Rolls-Royce Group – covering over 11,000 members in 2016. Engineering giant GKN also offloaded pension liabilities to a specialist insurer in a deal worth £190m.
Likewise, pension buyout specialists are booming; Pension Insurance Corporation (PIC), for example, raised £250m from Chinese investors less than a year ago. Specialist provider Chesnara has seen its share price more than double and hit new highs in August 2017.
However, buyout remains an option open only to those schemes that are fully funded, or where the sponsor is willing to pay. “It tends to happen where the schemes can afford it, if their funding level is strong and the premium quoted by the insurer looks suitably attractive,” said Williams. “The decision to move to a buyout is more of a strategic decision. We have a specialist team advising on buy-out transactions.”
The pension fund agrees the price with the insurer for the buyout based partly on the desirability of the makeup of its existing assets. Up to £100m, the transfer tends to be entirely in cash. In larger funds, of £1bn+, insurers are more willing to take on the assets of the client. In the latter case, it becomes more a project management exercise.
There may be two asset transitions involved in a buy-out. “The first is to move assets into a portfolio that better matches the asset profile the insurance company might want – for example a big, equity-dominated portfolio would be moved into government and corporate bonds,” which would therefore reduce the premium. “Then there is the actual transfer of assets to the insurance company.”
Williams believes that transition managers will be looking to play a greater role in buyout business in the future.
Transition management for defined contribution DC schemes is still a relatively small part of the business entrusted to the industry. Such schemes, where the eventual pension payments are determined by the individual’s investment returns, have typically been established for a shorter time period and have smaller AuM. They are also buoyed by fresh flows and have a longer maturity profile.
Where DC transitions occur, they tend to be to swap platform providers to those with a broader product set. “There is more DC activity in transitions these days, a lot of which involves platforms,” said Williams. “The platform approach is very popular, so the trustee’s decision tends to be more around choosing the right platform provider, and choosing default and lifestyle strategies.”
Transition management for DC is often more akin to project management, as it is with a pooled fund transition, rather than physically trading the assets during a transition. For example, transition managers can co-ordinate trading in unitised funds to build a new target structure.
“A DC transition is mainly operational,” said Mercer’s Williams. “Specialist transition managers tend to operate through trading portfolios of individual securities. Trading isn’t generally required for DC as the schemes are invested in pooled funds, so specialist transition managers generally haven’t handled them. Consultants have taken on the project management instead.”
The key stakeholder in DC transitions is the scheme administrator. “They maintain the records for each member’s stake. Making sure the administrator is centrally involved in the project plan is vitally important. The administrator updates every member’s records once the transition has taken place – ensuring that each one has exactly the same share of the assets after the transition as they did before.”
DB schemes are still the bread-and-butter business of transition managers. In particular, the transition into bonds, de-risking strategies and adoption of fiduciary portfolios are creating demand for the services of transition managers and consultants. Buyout business is building for selected well-funded schemes.
DC scheme transitions remain in their infancy and, as things stand, are largely providing business as much for consultants as transition managers. However, the pensions market is constantly evolving and the proportion of DC transitions will inevitably increase over time.
Simplification proves complicated
The combination of a rationalisation of a pension scheme sections and an overhaul of its investment strategy presented a complicated task for a transition manager
A reduction from 13 sections to four sections – coupled with a review in investment strategy – resulted in a complicated, multistage transition for a medium-sized UK DB pension scheme.
The trustees and its investment sub-committee, chaired by Melanie Cusack, client director of independent trustee firm PTL, had a strong, established relationship with their investment consultant and decided to use the investment consultant’s in-house transition management team to handle the event. The total asset pool was approximately £700m and was predominately in pooled funds.
Before embarking upon the transition, the transition manager provided an estimated timeline and details of all costs, setting out those that were manager transaction costs, investment consultant costs covering advice and transition manager costs. It was helpful that the upper end of these costs were provided, noting that where efficiencies could be found the costs would reduce.
The key challenge was that each of the remaining four sections required a combination of managers from the original 13 and some managers were removed completely. In addition, the dealing dates and notice periods for the different investment funds were not aligned. Therefore, a great deal of paperwork across all sections had to be prepared and checked, and since many transactions were dependent upon earlier transactions, there was little scope for slippage.
The most significant elements that ensured the transition proceeded smoothly were:
(i) A clear detailed project plan setting out the key dates for each transaction. This ensured the money to be invested with one manager was already disinvested from another manager within the tightest possible timescales.
(ii) The trustees and investment sub-committee delegated the signing authority to two trustees a t the start of the process based on availability over the period.
(iii) The documentation required by each manager to provide the necessary instruction was agreed in advance of the transaction. This ensured there were no delays due to incorrect signatories or AML checks.
The transition manager provided updates on the transition throughout and produced a full report at the end of the project, setting out all the costs incurred against the budgeted expectations.
Cusack said the trustees were pleasantly surprised at how smoothly the transition went and that the overall costs were lower than expected. The only change to the original planning was the date the transition started, but this was partly for pragmatic reasons rather than a view on market conditions.
The trustees had a subsequent transition when they chose to appoint a liability-driven investment manager for one section. They did not hesitate to use the same transition manager although this was a more straightforward transition.