M&G INSTITUTIONAL INVESTMENTS November 2018 Building your own annuity book Cashflow solutions at M&G For Investment Professionals only 2 M&G Investments Achieving the attainable “Tantalus’s punishment was being forced to stand in a pool of water, underneath a fruit tree, for all of eternity. Every time, he would reach for fruit from the tree, it would grow beyond his reach.” Tantalus was a son of Zeus who Reaching the unattainable? committed a grisly set of crimes. Meanwhile, many analysts point After being caught stealing to the current valuations of ambrosia from the gods and traditional risk premia versus incurring their wrath, he tried to historic averages and make gloomy ingratiate himself once more by predictions on returns. This is one killing his son, cooking him and of the reasons many pension serving him up at a banquet schemes are moving allocations for the gods. away from equities towards Even by the pretty low standards fixed income and other matching Jeremy Richards, Fund Manager of the Greek mythological gods, assets, with the effect of de-risking this was deemed to be poor their portfolios. parenting. So, Tantalus was forever Even when buy-out and buy-in punished with reaching for the has become cheaper, there has unattainable and this story gives not always been a corresponding rise to the word “tantalise”. change to the underlying bond This feeling of trying to attain rates, leading some schemes to something that seems to forever question the quality of those move out of reach is familiar guarantees. The implication is to many UK pension schemes that self-sufficiency is what many and their trustees. Meeting their pension funds should instead cashflow liabilities is becoming aim for in order to manage their an ever-increasing challenge.* pension commitments. 56% of pension plans surveyed A further challenge facing schemes by Mercer are currently cashflow is that the use of liability-driven negative and, of those that are not, investment (LDI) swaps, used to 83% are expected to become so hedge out duration risk, will soon over the next 10 years. become more expensive under the As pension schemes endeavour regime of central clearing. Thus, to reach a better funding position, the certainties that the trustees of they realise that the cost of a fully many schemes rightly seek in order insured buy-out is much further to obtain security in matching their away than they first thought. liabilities appear to recede from They know that the buoyant attainability. growth in equity markets is offset by rock-bottom discount rates and that the expense of such a solution could remain well beyond their reach. 3 Building an annuity book The long answer is what this paper addresses, as we set out It is for such reasons that many why building your own annuity pension schemes have been book involves being flexible and asking us what our annuity books asset agnostic, what assets we look like. If these, run on behalf have used as the building of Prudential plc, have been blocks and the process of meeting pension payments for putting together such portfolios. many decades, then how have From a pension scheme’s we been doing this? What assets perspective, the good news have we used? What lessons is that they do not have to have we learned? In short, is it adhere to the same regulation possible to help schemes close regime that insurers do, their funding gaps, reduce so we can help them to reliance on synthetic duration build their own, more solutions and still pay pensioners commercially efficient, by delivering the right level version of an annuity book. of cashflows when required? The short answer to this last question is “Yes”. Lightsource, UK • M&G provided nearly £250 million in debt refinancing 'I• in 2015 for a large portfolio of fully operational ' ' I I I ' I solar plants , I I . • • The portfolio had a total installed generation capacity of just over 100 MWp – enough to power over 30,000 homes : ; i • Long-term inflation-linked cashflows generated are backed by the government solar feed-in-tariff, a form ' : j . I I of UK renewable energy subsidy ' ! • Security of cashflows provided by seniority i i • I . i' • Conservative covenant package, including I : I prepayment protection ' .. I ! I -·- - - __.., ~- - ______ J .•• I •. 4 M&G Investments Is it time for a different kind of certainty? on creating bespoke solutions that evolve through the life of the scheme to match changing cashflow Matching a pension scheme’s liabilities primarily through requirements efficiently and as better value assets physical assets can achieve a different kind of certainty, emerge. This bespoke approach puts a scheme’s specific hedging risk not via swaps alongside a growth portfolio, cashflow needs at the heart of the process, ensuring but by using a mix of assets to ensure pensioners’ that every asset selected for inclusion fulfills a specific payrolls are met, sponsors are protected and the scheme outcome. is de-risked over time. This is how we have managed our annuity books successfully for many years. As a scheme becomes more mature and has greater numbers of pensions in payment, the predictability Physical asset exposure offers an alternative route to of cashflows becomes more certain, while the need tackling some of the risks, such as interest rate risk, that for liquidity is less important, as vulnerability to are met with traditional LDI portfolios and importantly, transfers-out decreases. For these schemes, we would it can fulfil a wide range of outcomes. LDI using long- usually consider blending a variety of private, very secure dated government bonds does not typically deliver the assets with high-quality cashflows, with more liquid level of cashflows when required. While we can help public debt assets. reduce a scheme’s reliance on swaps, it is likely that some exposure will still be necessary, especially for For younger schemes, high levels of liquidity and inflation risk. We therefore work closely with our clients’ flexibility are important, and therefore the illiquid assets LDI providers to ensure all of their requirements are met used tend to be of a shorter maturity and it is not as by building cashflow solutions asset by asset. important to be utterly prescriptive when matching assets to precise liabilities. A much greater reliance upon Each pension scheme’s funding deficit and cashflow public debt assets is usually a feature of the portfolios requirements are different and so one size does not we would build for younger schemes. fit all. When working with clients in this area, we focus Alder Hey Children’s Hospital, Liverpool, UK • M&G Investments provided funding for the redevelopment of Alder Hey Children’s Hospital, which treats 275,000 children each year • Annuity-like repayment profile provides stable cashflows with revenue derived from the NHS trust • Conservative covenant package provides lender protection • Structure provides credit support and additional security www.mandg.co.uk/institutions 5 Building you a matching portfolio This investment process involves considering each asset individually to evaluate the risk/return trade-off, beyond We build matching portfolios from a broad range of the headline benefits or if they in vogue. For example, reliable, cashflow-generating assets. These encompass rather than using private assets because they offer extra different forms of financing, which are public, private, security and are fashionable, balance up the illiquidity fixed, floating, index-linked, secured, unsecured, junior, they possess with the extra returns and security and senior, asset-backed and so on. The common theme is then ask, “Are we being properly compensated for the a contracted cashflow and the flexibility to use a wide risk and what outcome is intended?” Private debt, for variety of assets which allows schemes to, in effect, build example, can be used to hedge inflation risk, with assets their own bespoke annuity book. offering long-dated, inflation-linked cashflows. Without access to all of the assets sourced across In the illustration below is a non-exhaustive sample set public and private markets, any portfolios built will have of the asset types we consider on behalf of our own potentially significant inefficiencies. If you only have annuity books and our external cashflow clients: a hammer, then every job will look like a nail; if you have only public debt, then every solution you find will potentially overlook more appropriate solutions. Pan-European markets Developing European markets 'I 14 I I I I I Pan-European markets Key Key Distressed Debt/ I 12 I Fixed Rate AA Complex Sectors ■ Specialist Situations I I I Floating Rate A Bank Replacement trades ■ BBB 10 Inflation Linked - Developed Sectors Junior Real Estate Debt Specialty Finance ■ BB Fixed Rate/Inflation ■ Longer-dated assets with .... ■ Linked B ‘matching’ characteristics Regulatory Capital Trades 8 Complex - CJ Fixed Rate/Floating Rate ■ Non rated Direct Lending ■ ♦ Corporate Direct Lending Return (%) 6 Ground Rent Ownership ~ Ji,; CLOs/Mezzanine ABS Long Lease Property ■ ■ Leasing • • Trade Social Housing Income Strips 4 Receivables ....Leveraged Loans Ground Rent Debt ♦ Infrastructure Debt ♦ ♦ • Senior Corporate Private Non-Corporate Private Real Estate Debt ■ ■ ■ Placements Placements Swap Refinancing• Local Authorities 2 - High Grade .... ABS 0 ' I I I I 0 5 10 15 20 25 30 35 40 Investment Horizon (Yrs) Source: M&G illustrative, Bloomberg UK Sovereign curve. Graph indicates total return of asset classes. 6 M&G Investments Flexible asset agnostic approach three years’ time that it may take to source complex, private assets that fulfil a specific task. We recognise that risk mitigation is the first objective of any cashflow-driven solution, as simply adding This means we only take risks for which our clients credit risk is not a straightforward answer to generating are being compensated and reduce the risks in their higher cashflows.