Core DB strategy: Revisiting assets that pay pensions

All defined benefit (DB) schemes still need to pay pensions as they fall due. What’s the right balance between cashflow-driven and ‘barbell’ investment approaches? And how should schemes’ strategies differ given low-dependency or buyout objectives?

While many DB schemes are at or near full funding on a buyout basis, it’s crucial not to lose sight of the ongoing need to pay pensions as they fall due as the market backdrop evolves

Broadly speaking there are two ways to pay pensions:

1. Use cashflow-driven investment strategies that harness credit and credit-like contractual cashflows, with LDI to plug the gaps
2. Invest in a diversified multi-asset growth portfolio and LDI, which we call a ‘barbell’ approach¹

There are several interesting arguments in favour of each approach that we outline

Circumstances and beliefs matter, however, and it doesn’t have to be an all-or-nothing decision. Overall, we find that a bias towards cashflow-driven investment often makes sense in the endgame

Keeping the DB show on the road

As is well known, many DB pension schemes are now well funded and aim to buy out within the next few years. In our previous paper: Constructing buyout-ready portfolios for the endgame, we outlined a potential quantitative framework for DB endgame, assuming buyout was on the cards relatively soon. However, approximately two thirds of FTSE 350 DB schemes are still not yet fully funded on a buyout basis.² Furthermore, buyout is not the target for all DB pension schemes and even schemes planning to buy out are likely to need to adopt a ‘holding pattern’ as they await their opportunity to transact with an insurer. Keeping sight of the core scheme objective – to pay pensions as they fall due – therefore remains of paramount importance.

Even with this backdrop in mind, ‘Assets that pay pensions’ may seem like a strange title for a paper! All assets held in a pension scheme are intended to pay pensions as this is the primary purpose of a scheme. So, what do we really mean? The phrase is sometimes used to refer to cashflow-driven investment (CDI) strategies which provide reliable contractual cashflows, such as buy and maintain credit, that can be used to pay pensions. They also contribute to liability hedging and can potentially offer a higher expected return than gilts. Other examples include secure income assets which, given their lower liquidity, may be more appropriate for schemes with less leverage.

1. A multi-asset growth and LDI strategy will not be barbell in the sense it includes mid-risk assets such as corporate bonds. However, we still use this name to reflect that these assets are only held for diversification purposes, and not for cashflow matching. 2. Barnett Waddingham estimated a third of FTSE 350 defined-benefit schemes were fully funded for buyouts as of 31 May 2023.