Defined benefit funding levels haven’t looked so healthy for years, buoyed by the recent sharp rise in interest rates. While this presents an opportunity to progress the journey towards a “low risk” portfolio of gilts and credit, most schemes still need additional returns before this journey can be completed. There are many different ways to get there.
A common approach is to retain a diversified ‘growth’ portfolio, switching this incrementally into the low risk portfolio as this becomes affordable. But there is a risk that growth assets are held for longer than necessary for returns that may never arrive. Equities can present an uncomfortable risk of capital loss and uncertain income yields, particularly for schemes which are maturing.
Alternative income – private credit, bank loans, distressed debt, real estate debt, infrastructure debt and specialist financing – can offer a stepping stone.
DB schemes are now looking to private markets for asset growth as well as high and predictable income. While this type of investing may not be appropriate in the eventual low risk portfolio, it has several advantages on the journey.
The first is sequencing risk. A declining asset pool will run out of cash sooner if assets need to be sold before losses from poor returns can be recovered; investing in funds which are either closed-ended or which can be put into run-off to mature over time means that assets do not need to be sold at unknown prices.
Alternative income can also mitigate regret risk. The risk of a funding gap re-opening after getting close to full funding can be reduced by diversifying into assets ranking more senior in companies’ capital structure.
It can also aid future de-risking. The closed-ended (or run-off) features of many alternative income options mean the proceeds can naturally be invested into credit and gilts in future years.
Finally, alternative income asset classes can be beneficial to the discount rate. From an actuarial perspective expected return assumptions for asset classes must be prudent and a haircut is applied based on how dispersed the return outcomes are likely to be. Alternative income can offer a lower dispersion of returns and therefore may require a lower reduction for prudence than equities. As a result, more de-risking can occur sooner without jeopardising the funding level in the process.
The need for high and predictable income is best illustrated by considering how the funding level may evolve. We modelled a typical UK DB Pension scheme valued on a low-risk basis, consisting primarily of growth and liability matching assets with a typical set of de-risking triggers. Liability cashflows are deducted each year as they fall due, from income and asset sales as required.
This leads to wide dispersions in funding level outcomes – in our model there is a 5% chance that the funding level has not improved after 10 years, which could require either unaffordable contributions or an irrecoverable shortfall.
By contrast, an asset allocation with a significant allocation to alternative income exhibits a much narrower range of potential funding levels, with the same expected return. This is firstly due to income and natural principal repayment reducing the need for asset sales at unknown prices, and secondly due to the greater ability an alternative income manager has to work with the borrower to alleviate any funding difficulties which may emerge.
We expect lower returns from public markets in the next 10 years compared to the last 10 years, as the lift to asset prices from government and central bank injections are unlikely to be affordable in every crisis. We are yet to see the same compression in return premia from alternative income, as returns are driven by different drivers.
It is these alternative drivers of return which schemes may benefit from, such as direct origination, liquidity premium, restructuring flexibility, smaller size and specialist underwriting. The importance of repeat lending and deep knowledge of borrowers means alternative income manager performance tends to persist across fund vintages, while the flexibility to work out of credit issues means that credit loss can often be mitigated.
While there are many potential benefits of including alternative income within portfolios, implementing private market investments can be hard. But the need to de-risk, the need for high income and the rapid growth of the asset class post the 2008 Global Financial Crisis, mean that alternative income is no longer so alternative.
