Every pension scheme is unique. Each differs in its current position, where it is looking to go and also by the constraints it faces.
That said, there are commonalities which can help schemes understand where they are now and prepare for where they go next. Using the language of chess, we believe there are three distinct and progressive stages in which all schemes operate:
- Opening Game
- Middle Game
- End Game
(You can download a PDF version of this article here.)
A misunderstanding of this bigger picture can mean decisions are focused on the wrong areas and the scheme may end up further from its goal than when it started.
José Capablanca, a famous Cuban player, once said:
In order to improve your game, you must study the end game before everything else.
As in chess, the key to a successful outcome begins with the End Game in mind. Working backwards, decisions to be taken in the Opening and Middle Game can then be made with reference to the desired End Game.
Who needs to know?
Knowing which stage a scheme is in is important for both schemes and sponsors, as well as negotiations between them.
For example, a sponsor could move the scheme from Opening to Middle or Middle to End Game through increased contributions, rather than increasing investment risk/return in the scheme.
What decisions does it influence?
Understanding which stage a scheme is in helps across a range of decisions faced by trustees and sponsors, from setting Investment strategy and risk management to sponsor contribution negotiations and assessing insurance solutions.
From an investment perspective, it enables schemes to set-up portfolios which take appropriate risk to generate sufficient returns. This allows the scheme to so make the most efficient use of its risk budget, i.e. how much risk the scheme is able and willing to take.
What are the risks of getting it “wrong”?
Believing you are in a certain stage when you’re actually in another can lead to sub-optimal decisions.
For example, if a scheme is in End Game but is running an Opening Game portfolio it’s likely it has:
1) Too much risk
2) Insufficient bias to contractual cashflows
This would mean the scheme is blowing its risk budget or moving away from its End Game objective.
Conversely, schemes with End Game portfolios while they need to achieve Opening Game return objectives may not be taking enough risk to generate sufficient returns. This would result in it moving away from its End Game objectives rather than towards them.
What proportion of UK pension schemes are in each stage?
Based on data from tranche 8 of The Pension Regulator’s data, we can estimate the proportion of UK schemes in each of the three stages. The analysis assumes a 2030 full funding target on a buy-out liability basis and uses Redington’s proprietary ALM modelling and investment return assumptions to calculate the return required to reach the target.
The categorisation is based on the required return, assuming both no sponsor contributions and average contributions:
- Opening = Gilts + 2.5% or higher
- Middle = Gilts + 1.5% to 2.5%
- End = Gilts + 1.5% or lower
Components of Opening, Middle and End Game
There are different objectives and decisions for a scheme at each stage.
Importantly, the stage a scheme is in is NOT related to [the duration of] its liabilities. Rather, it depends on the level of asset returns the scheme needs to achieve to reach its goals.
The key metric to calculate and aim for is “required return” – i.e. the return needed from investments to meet objectives, taking into account sponsor contributions and time horizon to reach the goal.
Another key parameter to understand is the basis behind the liability calculation. Importantly, the stage a scheme is in is not determined by reference to its Technical Provisions (TP) liabilities. While this is an important basis to determine sponsor negotiations, the TP basis is often a stepping-stone to the pension scheme’s longer term investment objectives, rather than an end in itself.
For the purposes of determining the stage a scheme is in the scheme should use a liability basis consistent with the long-term objectives of the scheme. For example, if the long-term objective is self-sufficiency (as is the case for many UK schemes) the relevant liability basis would be a gilts curve plus a small spread. For a buyout basis the reference liability basis may be set with reference to the swap curve.
At each stage, the main differences are:
- Return required from investments to reach objective
- TP liability basis
- Bias towards risk premia or contractual cashflows
- Investment strategy and asset allocation
What should pension schemes be aiming for at each stage?
- Required return higher than cash + 2.5%
- Highest required return of any stage
- High leverage, illiquidity, complexity to meet return target
- Bias to return, i.e. how can scheme make it more efficient to generate returns? Through changes to equities, leverage, illiquidity, complexity, or contributions.
- Not most efficient as bias towards return greater than towards efficiency
- Sponsor may need to underwrite increased risk budget
- Aim to move from in deficit on TP basis, to full funded on the same basis
- How far away from efficient frontier can you be? If in Opening Game, greater scope to reach target so can be further away from frontier (through leverage, liquidity, complexity)
- Required return of cash plus 1.5% to 2.5%
- Most efficient portfolio (subject to client filters and complexity)
- Objective is to move towards and prepare portfolio for chosen End Game (self-sufficiency or buy-out)
- Aim to move from fully funded on TP basis to self-sufficiency or buy-out
- Manage risk to avoid falling into TP deficit
- Required return lower than cash plus 1.5%
- Lowest required return
- Low leverage, illiquidity and complexity
- Less efficient than Middle Game portfolio
- Bias to contractual cashflows to manage risk of returns (eg investment grade corporate bonds – not high yield as these would raise the amount of risk)
- Objective is crucial – e.g. buyout or self-sufficiency? Portfolios will be very different and dependent on overall objective. The goal is to build a portfolio with an excess return above gilts whilst allowing you to pay all your members
- Aim is to execute the buy-out, or invest with an insurer’s mindset (but without the constraints) until the last benefit is paid
You can download a PDF version of this article here.