Run-on, self-sufficiency or buyout? How to prepare for your long-term endgame

The roundtable – chaired by PP editor Jonathan Stapleton and held in association with Columbia Threadneedle Investments – compared and contrasted the investment and governance requirements of each of the main options, run-on, self-sufficiency or buyout; and identified the principles that apply equally to all scenarios.

Specific questions it discussed included:

• What endgame options are currently on offer?
• What might make a scheme choose one option over another?
• Do schemes have a clear idea of how long they might run on for and how often should they review the decision to run-on?
• Proposals for supporting run-on span both the old Conservative government and the new Labour administration. What are you hoping to see under the new administration? 

Panellists agreed it was positive that improvements in funding levels meant many schemes could now consider endgame options. They said, however, while there were "lots of discussions happening" around endgame, understanding the various options was still a "work in progress" for trustees and they were taking care to get the decision right.

When it came to run-on specifically, roundtable participants said the strategy "could be the answer" but noted it was not the only one out there – also adding the need for a clear "run-on strategy" should trustees choose this option. Panellists also noted that legislative and regulatory clarity were needed on the run-on framework to enable schemes to better commit to the strategy and make sure investments are as effective as possible.

What endgame options are currently on offer?

Simon Bentley (Columbia Threadneedle Investments): There are three main options: An insurance solution (buyout or buy-in), self-sufficiency, and run-on.

Most schemes target buyout, but people are beginning to assess the benefits of the new run-on option. When we held an event recently, 30% to 40% said they were beginning to consider run-on as an option.

Fewer schemes are choosing self-sufficiency. Typically, it is the very large schemes that have an in house team and want to continue running the scheme down. Run-on is certainly the new option on the table and the one on which people are spending the most time weighing up the pros and cons.

What are the endgame objectives your schemes are looking at?

Colin Richardson (Zedra Governance): They are looking at all the options. There is a fourth option available, however: exploring a consolidator, but that has small capacity.

In the last 12 to 18 months, run-on is in the conversation more than it used to be. It is not available for all, because there are practicalities in terms of size, scheme rules specifics and how they define the potential usage of surpluses.

All the schemes I am involved with have, so far, chosen buyout as their target if they have considered it. However, there is a live debate about run-on.

Simone Lavelle (Pi Partnership Group): A few schemes are changing over to run-on. But, if you want to consider it, you need to look at your trustee rules and whether you can even do this, rather than getting excited about this new option and just moving ahead. 

You also need to be thinking about the governance because it will change. For instance, you need to have a lot more expertise on covenant input and monitoring when you go for a run-on solution.

Vassos Vassou (Dariada Trustees): 12 or 24 months ago, buyout was the only game in town. That all changed following the Mansion House speech. And corporates have primarily taken the lead when it comes to thinking about run-on. 

Bob Hymas (BESTrustees): It is perhaps worth just giving thought to all of the nuances. There are different ways of run-on – it might well be that you are in a good funding position, and run-on is just a holding pattern while you wait for the buyout market to be ready for you, or for you to be ready to go to the buyout market. It might well be, for instance, that all you want a scheme running on to do is to cover the costs, so you take that burden away from the sponsor if they have been paying it previously. You need to think about it in different ways.

Tracey Deeks (Canada Life UK Staff Pension Fund): There are arguments that buyout is best for the members and that protection of an insurance company is good, but once you have given your surplus over to the insurer, it has gone from the members, so there is another side of me that wonders if that really is best for the members.

While you keep it in run-on, there could be enhanced benefits like discretionary increases. There is more pressure on the pre-1997 increases in the press. Some schemes are starting to push for the pre-1997 accruals, especially given the cost-of-living crisis. 

The employer covenant is also very relevant in this. You would probably go to buyout if your covenant is weak. It is not a one-size-fits-all by any means.

Tim Giles (Independent Governance Group): I agree it is something to decide on a case-by-case scenario. The benefits for members are key. There has been a move away from targeting buyout to most schemes wanting to have enough money to be able to consider buyout - that is still the safer funding standard as it removes covenant and governance risk.

But buyout is not necessarily the best endgame. The term used freely in the past around insurance being a ‘gold standard' has almost disappeared because it's possible to get better administration flexibility for a large scheme with your own arrangements. However, you must manage the covenant and investment risk.

There is a scheme size point here, but consolidation is possibly the solution to that.

Finally, when you are setting run-on up, you must understand how to manage the covenant and investment risk, what you want from the administration and what member flexibility benefits you are looking for, then design the system to deliver that. 

What are the specific features of a scheme that might make them choose one endgame option over another? 

Vassos Vassou: The industry is starting to understand how much money we are giving up to the insurers. Once you and the corporates understand that, it puts it much higher up the agenda of the finance team. That is why they are looking run-on as an option.

Is there a degree of risk and hassle involved for smaller schemes when considering run-on?

Colin Richardson: Scheme size is crucial as is the way in which you construct the investment portfolio. This must be reasonably low risk so there's only a very small chance of this putting you in a worse position compared to solvency. But it also has to be constructed in a way that gives you a fairly good probability of a return that is meaningful. Portfolios must additionally cover the expenses of running the scheme and leave a net surplus. 

Those expenses are proportionally higher for smaller schemes - This is why, if you are below a certain size, your investment profit generated might not cover your running expenses.

Bob Hymas: In smaller schemes, it is harder to justify run-on. The only case I have is where it is a holding pattern, but the primary aim is to cover the expenses.

Is run-on predicated on that strong sponsor covenant?

Simone Lavelle: It is, but it also hangs on an understanding that the trustee and the corporate are making decisions togethers. If you decide on a run-on, you need to monitor the covenant very closely. 

You also need a scenario analysis of what happens in different situations because a surplus can disappear, or you may not have hedged it properly. Many things can change that situation, so a scenario analysis about what you would do in certain circumstances and whether you would continue for buyout is needed.

How important is sponsor covenant, continual monitoring and scenario analysis?

Tim Giles: It is very important, but we still see schemes with a weaker covenant run-on. Surplus is clearly one of the protections that you have against a weak covenant.

The other point is how you mitigate the covenant risk. In terms of innovation, we are seeing things like insurance against covenant reduction. If the covenant is strong, it is now fairly easy to take out some form of surety and protect against the covenant disappearing. However, it is very hard as we have seen some great failings of covenants in recent years – with them going from very strong to fairly weak over a short space of time.

How should schemes hedge liabilities?

Simon Bentley: The approach to hedging does not differ significantly between the various endgame options. Run-on requires a very robust risk management approach with an awareness of covenant risk and you want a considered, relatively low-risk growth strategy. When it comes to liability hedging, schemes target full hedging, whether they are running-on or going to buyout.

The only difference when looking at running-on is what you regard as full hedging. In the other scenarios, you are targeting 100% of the liabilities. If you are running-on, you want to be targeting 100% of the threshold above which you can extract the surplus. 

How strong is that hedge? 

Simon Bentley: That comes down to the data that asset managers have been given to assess and model the liabilities. Assuming that the data was accurate and up to date, we would expect the portfolio to track the liabilities closely. Some clients will give us new data every year, so the hedge is always up to date. Whereas other clients might only provide data every three years. With those sorts of arrangements, there will still be a pretty good hedge, but there will be some drift.

What do you see as the different approaches to credit investing, depending on how long you are running on for? And is now the right time to invest given where spreads are?

Simon Bentley: The two core areas that we see would be your longer-dated, more cash flow-matched credit, where you ultimately buy and hold to maturity. That is very well aligned with self-sufficiency and a clear commitment to run-on for a period of time. The other area is holding a much shorter-dated portfolio. Shorter-dated is going to be global and probably around three years of average maturity or so.

Shorter-dated can be a slightly lower-quality portfolio as well, so to the extent that you are trying to eke out a bit more return, that might steer you towards a shorter-dated portfolio. The shorter-dated portfolio is going to be more liquid and more flexible, so if you are running on by default and you have the idea that you may need to firm up the decision, and maybe it is going to be a buyout within two or three years' time, the shorter-dated portfolio gives you a bit more flexibility in that scenario.

Moving on to your final question about whether now is the right time, the backdrop to that question is that credit spreads are pretty tight at the moment, certainly on a historic basis. Credit valuations are reasonably punchy, but that is probably not the entire story. If you look at the technicals of supply versus demand, there is a bit more demand than there is supply, which is supportive of credit markets. If you also look at credit fundamentals, the quality of corporate balance sheets is pretty strong, with low leverage ratios, pretty high cash levels and, in the investment-grade space, a good ability to pay back debt. Those things are supportive of the credit market, which means that, although credit valuations are quite high, there is a justification for it, and we probably would not expect credit to cheapen anytime in the immediate future.

What does that mean for going for long-dated versus short-dated credit? With long-dated credit, you do not have any reinvestment risk. You are buying and holding to maturity, but you are locking into the prevailing market level today for the entirety of the investment. With shorter-dated credit, you have all the reinvestment risk, because you are going to see stuff maturing and you are going to need to reinvest it, but the reinvestment risk today is probably in your favour.

The final point is a word of caution: if you think that credit markets are expensive, ignoring the other two points that I have made, be very wary of not investing at all, because the act of not investing for a year means that you miss out on what we call the carry, and credit markets can be expensive for several years at a time. That is not unusual, so that can be a very painful thing to do. We would certainly advocate, if you are looking at allocating to credit, going ahead and doing so and aligning to your longer-term objectives.

James Edwards (Columbia Threadneedle Investments): I agree credit looks expensive. While it would be hard to advocate large additional allocations to credit at this stage, not owning credit is a very expensive thing to do and can be very painful through time.

Tim Giles: Liquid credit is relatively expensive now and involves reinvestment risk. Therefore, there may be better opportunities.

Most schemes are running-on not by default, but without any clear view of how long they are going to run-on for. Unlike equity, the credit market is far more diverse. If you are willing to tie up liquidity and understand how long you are going to run on for, the opportunities expand to higher carry and not less investment quality. People need to think about this in their choice around run-on.

Do schemes have a clear idea of how long they might run on for?

Simone Lavelle: That is a discussion that people are now starting to have. If we are running on, how do we plan how long that will be for and make a plan in terms of the scenario analysis? No one has a blueprint of what that could look like because there are many things you need to tackle to have those discussions – covenants, stakeholder management with the sponsor, trustees understanding their own liability in the process and trustee rules. There are a lot of boxes to tick when you discuss this further.

Vassos Vassou: As trustees, we are finding it very difficult to get clarity from the corporate about how long they want to run on for. The answer that is coming back is: ‘We want to keep going as we are then we will see'. If they want to run-on for three, five or 10 years, the important thing is to be ready to buy ut at the point that we all agree is now.

A lot of schemes are ready to buyout financially, but not in any other way. My job is to get the scheme ready to buyout, so that at the drop of a hat, I can do that buyout.

How often should you review the decision to run-on? 

Simone Lavelle: Probably annually. Even before a pension fund starts to do a buyout, it becomes a whole feasibility study in terms of ‘Can you buyout? Does everybody understand what this means?'

Run-on is more a decision the moment you are buyout ready. You could buy out and have everything ready to go, but then you decide to keep going. It depends on when you are going to do your covenant assessments, what happens in the markets and how your hedge is performing. 

Simon Bentley: You always want to do periodic check-ins for your risk management work. The key thing that could affect the decision to run on is change. You should always be alert to everything that has changed – a market change, change with the demographics of the membership, or corporate sponsor changes. Any change should be a trigger for a more detailed, ad hoc review. 

Tim Giles: The periodicity of your review should be linked to your risk tolerance. If you are planning to run a scheme on for 10 or 20 years, you should be thinking about risks over that period. 

Proposals for supporting run-on span both the old Conservative government and the new Labour administration. What are you hoping to see under the new administration? 

Vassos Vassou: Make the buyout market easier and more competitive for smaller schemes, which have historically suffered a lot more than the bigger schemes. A public sector consolidator might be an answer to that.

Colin Richardson: The new government is as keen as the former government on Mansion House to get more pension scheme investment into UK assets. Therefore, it would seem likely that they will take forward proposals to make run-on easier. It may take on the state consolidator idea as well.

Tim Giles: There are three things. One is productive finance. Not much is happening for DB schemes with this regard, it feels more Local Government Pension Scheme (LGPS) and DC-focused. 

The second is that, if all the pension schemes ran headlong towards insurers, that would have issues for the government bond market. That is not a place where the government wants to introduce instability.

The final thing must be the surplus. I expect that somebody in the Treasury is constantly seeing the £200bn surplus and thinking how to access it. To get to that, there has to be greater clarity around how members and the company can participate in surplus without having to wind it up.

David Farmer: There is more flexibility to access surplus than perhaps the debate in the industry gives credit for, but it would be a lot simpler if the government said you can access that surplus.

Bob Hymas: I agree with a continuation of exploring the current initiatives on surpluses. I do not think that the public sector consolidator, as intended, is the right idea, because the market is not dysfunctional, although it has a role to play in connection with distressed schemes and situations.

We also don't want too much mandating from the government. Let trustees be trustees.

Simon Bentley: We have been told it is critical for Rachel Reeves' economic mandate for the UK to get the concept of run-on working for DB. Philosophically, it is aligned to her productive capital approach.

Although it was started under a Conservative leadership, the Labour leadership are totally aligned with the concept of the Mansion House discussions and are going to push ahead with it.

What are your key takeaways or concluding comments from this discussion?

Simone Lavelle: The industry is changing so much and so quickly, and it could possibly snowball. If there is legislation around consolidation in the local authority space, for example, it will have a huge impact. There are still 5,000 schemes in the UK. 

I am Dutch. In the Netherlands, it went from 1,000 to 170 over only a few years, and it surprised the whole market at the time in terms of how quickly that went. That was very much driven by putting in regulation, so the real pressure will come through regulation, and so it is very important to stay on top of what is going to be regulated in this space.

Bob Hymas: I would say that it is work in progress for government and trustees to understand the options and establish clear objectives.

James Edwards: There is a lot of discussion happening. The government has been in place for only a few months but things move ahead at pace, so they really need to move forward. If the government wants to get DB funds doing things, they need to hurry it up, otherwise people will make long-term decisions that are hard to unpick.

Vassos Vassou: The run-on option is relatively new but is starting to command a significant amount of time on trustee agendas as part of wider discussions. The education piece is really important. As part of that, we, as trustees and as corporates, need to understand the pluses and minuses of the different options, given the circumstances that we find ourselves in within specific schemes.

Tracey Deeks: One of the big things for me during this discussion has been around the need for a run-on strategy, be it, ‘I plan to run on for five years, because that is when I think the buyout market will be more structured, or pricing will have moved', or, ‘I intend to run on forever' – but the need to have that very clear strategy to give you the flexibility on investments is the key point for me.

Colin Richardson: We should always remind ourselves these are very positive discussions. The fact that a greater proportion of schemes are in a position where they could choose to go to buyout, or consider other options, is a very positive place to be in. If other options have superior merit, they can be taken advantage of. It is a good starting point that more schemes are in that position, but trustees need to take a lot of care in these discussions and need to think the options through carefully.

David Farmer: There is an amazing opportunity here. I have been looking at this since I joined IGG over a year ago and it is amazing how this debate has progressed in that time. Many people are saying that there is a way to run these schemes on. However, it is not the only option, so it is important to approach this without a fixed viewpoint and ask: "Where are you now?" The corporate and the trustees both need to think: "Where can we get to, what is that strategic opportunity, and how do we build that?" Run-on could be the answer, but there are other options out there – it is not just a binary decision between run-on and buyout.

Tim Giles: It is a very individual choice and, as others have said, it has to be driven by the members. Why you are doing this to the members has to be the trustees' starting point. There is a degree of uncertainty within this that makes some decisions hard, but that uncertainty is also an opportunity.

If the regulators could increase the clarity, that would be fantastic, but the thing that we have to be doing as trustees, ultimately, is to be certain about what you are trying to achieve. If, for instance, you are just trying to get to transaction readiness, you are in run-on it for five to 10 years. Know that and take your decisions in that context.

Simon Bentley: I would probably echo a few of those points. Run-on is clearly here to stay, for a number of good reasons. I am not sure that it fundamentally changes the investment approach for schemes in terms of high hedge ratios or high allocations to credit, but I agree that the sooner we get some legislative clarity on what that run-on framework looks like, the more committed we can be to each scheme's chosen endgame and, therefore, the more effective the investment strategy can be.

This roundtable was held on 18 September 2024 in association with Columbia Threadneedle Investments