A panel of senior investment professionals from a range of UK-based life firms joined Milliman in early November of 2022 to exchange views on various current themes in investments and asset management, against a challenging and fast-changing economic backdrop.

This discussion was conducted under the Chatham House rule (comments are anonymous and non-attributable) and below we summarise key points from the hour-long call. We would like to thank all those who took part for their time.

Participants

Douglas Nicol – Head of Investment Strategy at Phoenix Group

Stuart Nicholson – Director of Loan Investments & Shareholder Assets at Scottish Widows

Keith Goodby – Head of Shareholder Investments and Strategy at Aviva

Moderated by Russell Ward and Matthew Ford of Milliman

Notes

We have seen significant increases in nominal interest rates and inflation. What implications do you feel this will have on life insurers’ investment strategies in future?

Some participants thought that the funding levels of many pension schemes would have improved, leading to an increase in the size of the bulk purchase annuity (BPA) market, although it was also noted that asset “fire sales” at discounted prices will have adversely impacted the funding level of some schemes. One participant also noted the high levels of leverage that had applied in the liability-driven investment (LDI) strategies used by some pension schemes.

Attendees felt that this could result in the use of more public assets, such as corporate bonds, to back BPA liabilities in the short term, with a lower proportion of illiquid assets being used. This is partially due to a lower illiquid asset supply, as the cost of debt has increased and because some borrowers are taking short-term funding from banks, with the option to refinance into longer-term fixed rated debt if and when rates fall and spreads tighten in the future. A second factor discussed was that illiquid asset spreads haven’t widened in line with the widening seen on corporate bond spreads, making the latter more attractive whilst trustee pricing targets can remain achievable even with a lower proportion of illiquids.

In our previous illiquid asset survey, almost all firms indicated that they would expect to increase the allocation to illiquids in their portfolios over the next few years. However, do you now believe that illiquid asset allocations will go down?

Attendees had mixed views. The supply of illiquid assets is likely to fall, but one panel member felt that public debt such as USD bonds would work to back BPA business and hence there would be less need for illiquids. The proportion would decrease for now, noting that it could be increased in future should conditions change. Another attendee was less sure, and noted that companies buy illiquid assets for diversification, for better security and for other reasons, such as the green nature of certain infrastructure assets.

One attendee felt that, due to the cost-of-living crisis, demand for equity release might continue even at higher interest rates and lower loan-to-value sizes, though prepayment risk would, consequently, rise if interest rates subsequently fall back. It was noted that house price decreases are allowed for when the product is priced.

Moving on to defined contribution (DC) pensions, have we seen the end of the lifestyling strategy of moving into bonds as retirement approaches? Will something else be offered? We note also that, while annuity rates have come up and annuity sales have slightly increased, drawdown even so continues to be the most popular option. What are your views on this?

One attendee noted that there might be an increase in annuitisation. Another noted that there might be a switch of focus from capital gains to income from assets, as assets now offer more income than in the past, and this should be beneficial for retirees.

Our panel also commented on fluctuations in asset values. One felt that asset falls do not necessarily mean that investment strategies are wrong in the medium term, though they have taken a short-term hit. It was noted that equities and credit have both reduced in value together.

We have relied for a long time on equity and bond diversification but recently we note they have moved together. We touched on investing overseas, and central banks are now starting to intervene in currency markets. Is that also affecting the landscape for investing, when you factor in the geopolitical risk including the Ukraine crisis and China?

Participants felt they would continue to invest overseas in e.g., Western Europe, North America, Australia, New Zealand etc., though companies would likely avoid exposure to Russia or China. Another participant noted that this was partly due to challenges in sourcing a sufficient volume of suitable UK fixed interest assets in the primary and secondary markets. There was concern that the recent foreign exchange (FX) movements have affected collateral positions, and one participant felt that, in future, there might be more stringent stress testing of derivative positions in relation to collateral, given recent impacts. One participant felt that companies’ 1-in-200 liquidity stresses might need to be updated to reflect recent experience. As a result, the additional costs of funding any additional liquidity will require a larger differential on overseas yields to make them worthwhile. Corporate bond credit support annexes (CSAs), for example, or bank liquidity can also be used to improve liquidity.

We note that there is a shortage of sterling bonds that you would like to invest in. What are your views around liquidity, as increased liquidity risk goes against an increased proportion of illiquid assets?

Participants noted that liquidity is now more of a priority than in the past, with companies looking for collateral beyond gilts and cash, and one looking beyond corporate bonds. Participants noted that they need to weigh up the costs and benefits of different measures to maintain liquidity buffers.

We note that environmental, social and corporate governance (ESG) investing has been a hot topic for some time. In our previous illiquid asset survey, it did not seem to hugely impact what people picked in the illiquid space. It feels like, with the current government, there has been a shift and refocus to production volume rather than to how things are produced. Will this constrain the supply of green assets over coming years?

Our panel did not feel this would lead to a change in prioritising ESG within insurance companies and the demand for these assets. However, there may be a reduction in the availability of ESG assets. One participant noted that some of the badly performing ”E” items might outperform others in this period of time.

Recently the Bank of England predicted that there will be five to eight quarters of recession—will that reduce risk appetite for credit?

One participant did not think it reduced the appetite for credit, but it is harder to find investments that met the necessary criteria, which is part of the definition of a recession. Another noted that they were long-term investors looking at 20- to 30+-year periods, and do not invest in names which are weak or cyclical. Another noted that more stress tests were being run now in the wake of big events such as Brexit and the pandemic, to see where potential weak spots are. However, each crisis is unique and affects different assets.

Do we have a more fragile global economy, and do we think the interactions between risks are now complex?

Our panel identified several reasons for the current situation of a looming recession, and the fact that recent events shone a spotlight on the UK economy—UK indebtedness, the aftermath of the COVID-19 pandemic, the Ukraine conflict and Brexit making trade difficult, as well as other drags on the economy, e.g., an aging population. One participant felt the US was in a slightly better place than the UK although has its own political issues, but Japan is in a similar position with similar fundamental long-term problems.

One attendee felt that there were long-term structural issues in the Western world whereby labour cost is high compared with other countries, and that the Western world would need to take a pay cut over the next few decades, which might lead to intergenerational issues.

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