UK pension schemes that are being offered a new type of deal by private equity firms, hedge funds and asset managers find themselves at a crossroads.

So-called capital-backed journey plans promise a way to reach funding targets more quickly. And investment firms willing to make such deals have been approaching pension schemes with growing frequency to put the case for what they can offer.

The hoped-for activity, though, has so far failed to occur.

“There has been no lack of capital or supply for the solution,” says Adolfo Aponte, head of risk solutions at Cardano, an investment management and advisory firm. “The constraint has been, how do you marry up the supply abundance with the demand requirements.”

The constraint has been, how do you marry up the supply abundance with the demand requirements

Adolfo Aponte, Cardano

Practitioners blame a combination of economic conditions and inertia. 

UK schemes now find themselves unexpectedly well-funded after interest rate increases. Scheme trustees, meanwhile, have proven nervous about making bad deals, and about regulatory risk.

And yet providers remain positive about the idea. Davidson Kempner is looking to strike deals in the space, as is asset manager M&G. Private equity firm Carlyle has partnered with pension consultancy Punter Southall to source and structure deals. Hedge fund Aspinall Capital Partners has joined with PwC. 

Apollo may be seeking to enter the area, according to two people familiar with the firm’s plans.

These firms are betting they can win schemes over, despite the reservations encountered so far. Multiple new projects are in the planning stages, trustees, consultants and providers say.  Some reckon a dearth of deals gives trustees leverage to push for more tailored, and so more attractive, terms.

Catching up

On paper, the appeal of capital-backed journey plans to both schemes and providers seems clear.

Individual structures are bespoke. In broad terms, though, investment managers are looking to partner with a pension scheme and effectively underwrite its investment returns. The plan provider rewrites the scheme’s investment strategy to pursue higher returns, often with the idea of investing more heavily in less liquid private assets.

The promise is that schemes can reach their target funding status more quickly and reduce reliance on the sponsor company.

Consultants and providers say those most likely to adopt the structure are schemes that are reasonably well-funded but with a sponsor company that may struggle to support them. 

Normally, the provider puts up a capital buffer – in Carlyle’s case, around 25% to 30% of scheme assets, for example – which can be used to help schemes meet the agreed target if the investment returns fall short of expectations. Some providers may put up a smaller initial buffer, with the option to provide further capital in case of realised losses in the portfolio.

The manager is prepared to put their money where their mouth is

Matthew Cooper, PwC

The buffer, providers say, helps ensure a scheme will meet its target with a high degree of certainty.

For schemes considering a capital-backed journey plan, the approach can be a way to prepare for a buyout, in which an insurer would take on the pension liabilities for a fee. Alternatively, trustees might wish simply to improve a scheme’s funding ratio and allow it to run-on while reducing reliance on the sponsor company.

As for why investment managers are pushing the idea, they stand to earn any returns over the target outcome. If an agreement aims to reach a funding level suitable to pursue a buyout within seven years, say, the provider will take returns above that level as profit once the seven years is complete.

The provider puts up a slice of the scheme’s total value as capital and earns the excess return on a larger pool of assets. One trustee refers to this as a form of “backwards leverage”.

At the same time, pension scheme assets can be channelled into the investment manager’s own funds, earning the firm additional fees.

“The manager will believe that they can manage these assets to achieve greater outperformance than the scheme would otherwise,” says Matthew Cooper, head of alternative risk transfer at PwC. “And they’re prepared to put their money where their mouth is by putting a capital stack alongside [the scheme].” Cooper works in a separate part of the business from the unit pitching the firm's own capital-backed journey plans.

One and only

Providers are keen to do deals at scale. “The investor appetite is there for a £10 billion deal if we needed to raise that money,” says Richard Jones, managing director at Punter Southall.

Risk.net understands that Apollo hopes to target only the largest of schemes, with assets worth several billions of pounds.

And yet the first capital-backed journey plan was completed in 2020, and no further deals have been signed since. That deal was between PwC and Aspinall Capital Partners, and an unnamed £50 million pension scheme.

Pension scheme liabilities move inversely to gilt yields, so rising rates have supercharged many schemes’ funding ratios. The average UK defined benefit scheme’s ratio improved by 25 percentage points from early 2021 to reach an average of 112% in February 2024, according to data from XPS Pensions.

The jump in funding levels, exacerbated by the 2022 gilt crisis, pulled the rug from beneath the feet of providers that were in discussions with pension schemes.

There is flexibility to agree to guidelines up front in terms of asset allocation restrictions, though providers typically want to run the whole asset book

David Barnett, Barnett-Waddingham

Some trustees, meanwhile, have turned out to be wary of complex new products.

Targeting higher returns typically involves higher allocations to less-liquid assets. For example, schemes partnering with Punter Southall-Carlyle would likely invest around 50% in diversified private credit, and 20% in diversified infrastructure, property and private equity, Punter Southall’s Jones says.

Consultancy Barnett-Waddingham has said certain providers propose to invest as much as half of a scheme’s assets in credit hedge funds, with the other half allocated in investment grade bonds and liability driven investment strategies.

Trustees typically agree broad rules around investment management, such as target hedging levels and asset allocation limits. But the manager has discretion on how assets are invested within these boundaries.

“There is flexibility to agree to guidelines up front in terms of asset allocation restrictions, though providers typically want to run the whole asset book,” says David Barnett, partner at Barnett-Waddingham.

That leaves trustees wary about slipping up in agreeing return targets. The trustee wishes to dial-up risk just enough to reach the agreed target. The investment manager wants to exceed the target, so as to benefit from the excess returns.

“Your worry is you do a bad deal as a trustee and that someone outsmarts you,” says one professional trustee, who talks of “embarrassment risk”. He fears signing up to such a deal only to discover the scheme would have fared better without it.

For one group of trustees, the proposed asset mix may simply be too exotic. “I see few schemes that are actually wanting a particularly racy investment strategy,” says Cardano’s Aponte. And others may see investing in funds managed by the provider as a step too far – leaving the scheme with too much concentration risk in one manager.

Trustees can push back on which funds are used, but plans are likely to favour the relevant manager’s own vehicles. Jones at Punter Southall says the provider has a “strong preference” to invest in funds and assets originated by Carlyle.

Grey area

Regulatory uncertainty has also given trustees pause for thought.

The Pensions Regulator (TPR) has yet to publish guidance on how schemes should use capital-backed journey plans, leaving the structure in a regulatory “grey area”, Aponte says.

Trustees worry that a scheme might sign a deal with the provider, only for the regulator to demand the arrangement be unwound. That could be costly, not least because of the haircuts incurred in divesting from illiquid assets. “Without a defined framework, there is regulatory risk,” says the professional trustee.

Capital-backed journey plans are not captured by regulation covering ‘superfunds’ – private enterprises that consolidate multiple defined benefit pension schemes into one larger scheme.

Also unclear is what happens should a pension scheme’s sponsor company become insolvent. Ordinarily, in such cases the Pension Protection Fund would absorb the scheme’s assets and liabilities. Some providers are open to keeping the structure in place if the sponsor company fails. Other proposed structures are designed with clauses that would allow them to be unwound.

The Pensions Regulator previously indicated it would expect journey-plan providers to unwind. One deal that was nearing completion towards the end of 2023 was abandoned after the regulator raised concerns about the solvency of the sponsor, Risk.net understands. But speaking at a conference in April, a UK regulatory executive said there were situations in which the structure could remain in place.

TPR has asked schemes to work closely with the regulator if they plan to put in place a capital-backed journey plan, and is due to publish firmer regulatory guidelines later this year.

In the meantime, schemes might question the logic of moving forward, says the professional trustee. “Why adopt a complex structure with regulatory risk rather than deploy capital in relatively safe places and earn a decent yield?”

Market participants say a narrow range of use cases for capital-backed journey plans is also hindering uptake. Schemes with a weaker sponsor, healthy – but not full – funding ratios and a trustee board willing to grapple with the complexities of a new product are scarce. “I guess it could work in certain situations, but I've never had a scheme in that situation,” says a second professional trustee.

A final concern relates to offers of extra capital buffers that could be deployed if the original capital buffer were eroded – a part of the PwC-Aspinall offering, for example.

“Trustees are concerned that unless they know funds will be available with a very high degree of certainty, such as [being] set aside in an escrow account that will pay out, they haven’t got clarity and certainty that recapitalisation will happen,” says Iain Pearce, head of alternative risk transfer at Hymans Robertson.

In the works

Despite the obstacles, practitioners remain optimistic about the prospect of plans being agreed. One trustee reports fielding three or four calls a month from providers.

Pearce says there is “a hunger from providers to get deals done”. And David Farmer, a former PwC executive who worked on the 2020 deal and now works as a trustee at Independent Governance Group says plenty of negotiating is taking place: “There are loads of things in the works.”

Ups and downs are not new for this idea, meanwhile. “The pipeline has disappeared more than once,” says Aponte.

Some trustees are more bullish about investing in less liquid assets, noting that most schemes already invest in private credit. Capital-backed journey plans simply require schemes to increase their allocation to the area.

I think there’s more flexibility on [sharing profits] than on changing the investment strategy

Adolfo Aponte, Cardano

“When you look at what's under the bonnet of these, a lot of the investments are the sorts of assets you'd anticipate a pension fund would invest in,” says Farmer. 

How deals are structured, though, may need to change.

With providers keen to get deals done, consultants say schemes have more power to demand bespoke structures. Trustees could demand, for example, that excess returns are shared with the scheme, or they could ask the provider to put up more capital.

The providers seem open to the idea. PwC’s Cooper reckons firms could be willing to split profits with the scheme above a pre-determined return target. Cardano’s Aponte agrees. “I think there’s more flexibility on [sharing profits] than on changing the investment strategy,” he says.

The number of schemes that might use the product to accelerate down the path to buyout may be shrinking. “My prediction is that we will see a deal done in this space this year, and potentially multiple deals if the market accelerates,” Barnett says. “But it’s always going to be a relatively niche part of the market.”

But a new use case may also be emerging. The UK government has laid out plans that would encourage more pension schemes to run-on rather than going to buyout. Surplus sharing could allow schemes to do that while minimising the risk that their funding ratio falls.

Whichever direction this corner of the market should take, providers, schemes and the regulator may need to decide which course to follow soon. “The reality is, if that clarity isn’t provided in short order, we might find that all the good effort that has gone into this space just doesn’t materialise,” Aponte says.

Editing by Rob Mannix