What lies ahead for DB schemes?

The following is an extract from our 2024 Solutions outlook.

Assessing the state of play

We believe that the year ahead will continue to see significant focus from trustees on the core DB scheme purpose of paying pensions. However, as pension funds continue to mature (with average liability duration now around 13 years[1]) and with funding levels much higher, it's important to note that the question of 'how to pay pensions’ does not have a single right answer.

In this overview we set out our themes for 2024, covering interest rates, credit and equity, while also picking out a handful of interesting areas to investigate in more detail. In our view, the accompanying market dynamic running through all these asset classes and feeding into investment strategy is the potential for ‘peak rates’. Specifically, if we have indeed reached the peak bank rate for this cycle then what next? And what does that mean for pension fund allocations and strategy?

Continued bid for credit

Investment grade corporate bond allocations remain an important part of portfolios (currently around 25%[2]) but we see continued investment in this area given that this is lower than the expected insurer allocation of around 50% of the total interest rate exposure.

On the one hand, credit could have a rocky road ahead given the volatile macro environment and the effect on both the consumer and cost of debt from what central banks have termed ‘restrictive’ rates. At the same time, we believe credit may continue to benefit from positive technical supply and demand factors for at least a portion of 2024 and increasing market conviction in a ‘soft landing’.

Our view is that building credit allocations in 2024 is likely to benefit from averaging in and a holistic approach to matching portfolios as schemes seek to ‘bridge’ the gap to their endgame. We discuss this more in Future themes for well-funded schemes.

Meanwhile, we cover ESG and other implementation considerations in Innovating in credit strategy as well as how schemes can seek additional resilience via synthetic credit and ongoing credit collateralisation strategies.

Interest rates, inflation hedging and hedge ratios. Where next?

We estimate that DB scheme interest rate and inflation hedge ratios are currently around 85%,[3] which is, broadly speaking, a 5% increase over 2023 and leaves levels of hedging at all-time highs.

The hard yards have been made but we believe there is likely to be more discussion around refining hedging strategy and considering residual risks that were historically small in relative terms. In particular, we expect more Limited Price Inflation (LPI) hedging, especially LPI(0,5), for those pension funds who have material amounts of LPI in their liabilities.

We also note that, all else equal, liabilities are likely to fall further (and hedge ratios increase) as the latest longevity tables are reflected in liability benchmarks. We dive deeper on the potential impact of this shift in Assessing the impact of lower life expectancy.

What about the potential for further hedge increases? At these higher hedge ratios, many pension funds will be factoring in the outlook for interest rates. Our interest rate strategists have a central expectation of 10-year yields for 2024 in both the US and UK dropping back into the 3.5-4.0% range. As such, both strategic and tactical aspects look aligned for continued hedging increases in our view.

Tailoring equity strategy

We believe that a core equity allocation remains relevant for many pension funds irrespective of their final goal. In a nutshell, equity allocations in our view can offer important diversification benefits,[4] as well as the potential for significant upside and increased liquidity.

We estimate that a growth allocation of between 7.5% and 15% could potentially be sensible for schemes, depending on whether the goal is a buyout in the near term (within three years) or a longer-term, low-dependency basis.

In Options for equity and derivative strategy we consider how pension funds can seek to harness the ‘soft-landing’ narrative currently being priced in by markets, by planning to mitigate downside risk without foregoing the potential for upside in the event of a significant move higher in equities.

We hope you find our latest thinking valuable as your pension scheme prepares for the year ahead.

The above is an extract from our 2024 Solutions outlook.

[1] Source: LGIM analytics, as at 30 October 2023, based on average liability benchmark durations across LGIM clients

[2] Source: PPF Purple book 2023 weighted average asset allocation

[3] Source: LGIM analytics, as at 30 October 2023, based on average hedging across LGIM clients

[4] It should be noted that diversification is no guarantee against a loss in a declining market.