23 April 2021
We are often asked the question: how should I invest to “hedge” against changes in buy-in pricing.
Investing just like an insurer, on the face of it, feels like it should be the answer to this question. However, intuitive as this may sound, I argue that in practice this may not be a good idea for schemes targeting the insurance market.
Why? First let’s briefly look at how insurers typically invest. A typical insurer portfolio consists largely of debt (in one form or another). Corporate bonds, private loans and equity release mortgages are all relatively common, as well as government bonds.
Note: the simplified portfolio above is for illustration only; to see each insurer’s investment portfolio please refer to pages 33-36 of our annual de-risking report.
To “hedge” insurer pricing, in theory a scheme would need to invest in the assets that its chosen insurer will ultimately invest in. Beyond sharing some broad “credit-like” characteristics, insurers pricing portfolios can vary widely. Furthermore, even if you knew which insurer you were going to select you wouldn’t know the exact assets they will use to back your liabilities, as an insurer’s future asset investments will not necessarily match past investments.
There may also be practical challenges at the point of transacting in transferring some of those assets to the insurer, particularly in respect of private loans, given most schemes access these through pooled funds. We see most transactions funded by a transfer of gilts and corporate bonds, which are a lot simpler to transfer, and still provide a good hedge to pricing.
Imagine also that you knew exactly which assets your insurer would ultimately invest in and you could overcome any practical barriers in terms of transferring to them, it still isn’t clear to me why a pension fund that is not constrained by Solvency II regulations would constrain itself to invest exactly like an insurer. As regulations encourage insurers to invest in certain assets it could be argued that this results in an already crowded space, meaning better returns may be available in asset classes less favourable under Solvency II.
How should I invest instead?
Rather than focus on exactly how insurers invest, another angle is to ask ‘in the insurer’s opinion what is a scheme’s ideal asset allocation at the point of transacting’? Being invested in their preferred manner would help them to put their best foot forward when quoting on a transaction, leading to potential benefits on the headline price. This provides a more practical portfolio to target, and then working backwards, can inform a scheme’s investment strategy when targeting full insurance in the medium term.
We put this question to all the bulk annuity providers recently. The most common answer was a simple portfolio of gilts and high-quality buy and maintain credit, with the exact balance varying by transaction size and insurer, with high interest rate and inflation hedging ratios.
So for a scheme that is say 5 years away from buyout, high hedging ratios through an LDI portfolio and a high quality buy and maintain bond portfolio should be key components of your strategy, with a plan to target a simple portfolio of gilts and credit as funding improves. The rest of the portfolio will likely be invested in suitable growth assets. Here the key will be to ensure that they are liquid (to not constrain a transaction, should the opportunity arise sooner than expected) and expected to deliver sufficient returns to achieve the target level of funding within an acceptable level of risk.
In my view, a portfolio setup in this manner will be able to achieve both a broad match to insurer pricing, while targeting sufficient returns to achieve the desired level of funding.
So in conclusion: understanding how insurers invest and their preferences at the point of transacting can be useful tools in helping shape an investment strategy to ensure a scheme is well prepared for the insurance market. However, in my view, pension schemes do not need to go as far as aiming to invest exactly like an insurer, particularly in relation to insurers’ illiquid assets. Going too far down the route of trying to mirror an insurer’s strategy may in fact be counterproductive.