Pension schemes have similar liability payments to annuity companies, so why aren’t they adopting the same investment strategy?

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There is plenty of discussion in the pensions industry over the potential benefits of investing like an insurance company. So why have so few schemes adopted this approach? To date, perhaps it is because it has been seen as only relevant to well-funded schemes.

We, however, don’t believe this is the case, and many underfunded pension schemes could benefit from this approach, as well. 

Meeting liability payments as they fall due is as critical to pension schemes as it is to insurance companies. In this respect, pension schemes would benefit from following a similar approach to investment as insurers, or more specifically, annuity providers.

To do this effectively requires a more holistic approach to strategy design, rather than relying on benchmark indices.

Pension schemes, by virtue of the fact they are not subject to onerous insurance regulations, can make even greater use of this approach than their insurance counterparts if they take advantage of a wider asset universe.

As a consequence, pension schemes have a unique ability to implement a ‘best of both worlds’ solution. In other words, they should think like an insurer and invest like a pension scheme.


Out of all the different types of insurers, the liabilities facing an annuity provider most closely represent those incurred by a pension scheme.

The diagram below shows the typical liability profile of an annuity provider.

The liability cash flows are split between deferred and current pensioners and will be subject to the same risks as those of a closed pension scheme, for example, interest rates, inflation and longevity.


Let’s now consider an annuity provider and a pension scheme with the same liability profile and examine the investment strategies that they typically follow.


Pension schemes have traditionally separated assets into two buckets, consisting of return-seeking and risk-reducing (or simply liability-driven investment ‘LDI’) assets. This is sometimes referred to as a barbell investment approach.

The return-seeking bucket is designed to provide a return that helps close the funding gap, whereas the risk reducing bucket aims to hedge liabilities without producing any material upside.


A typical UK pension scheme will have most of its return-seeking assets invested in equities and will also run a significant underhedged position in interest rate and inflation risks.

The total investment risk (represented by the red bar, and which could be defined as Value at Risk) could be broken down into the main underlying risk factors as shown below.

Unhedged liability risk (shown as yellow bars) represents the largest scheme investment risk, closely followed by equity risk. The other risks are small by comparison.



An annuity provider, meanwhile, structures a strategy that hedges and closely matches liability cash flows. The overarching objective is to ensure that all the pensions are paid while enough profit is generated to cover longevity risk, pay ongoing costs and deliver profit for shareholders.

An annuity book is fully invested in ‘matching’ assets, which generate cash flows and hedge liabilities.

The diagram below provides a stylised representation of all the matching asset and liability cash flows of an annuity provider.

- Credit is invested in long-duration corporate bonds, which are managed on a buy-and-maintain basis.

- Privately traded alternative income assets generate predictable and stable cash flows, whilst providing attractive riskadjusted returns.

- LDI, an overlay of government bonds, cash and swaps to shape the profile and hedge out any remaining interest rate and inflation risks, forms the remainder.


Given the stringent regulatory regime that annuity providers operate within, there is limited scope to invest in anything else apart from these assets.

Consequently, the major investment risks are broadly split equally between credit and alternative income. Small rates and inflation positions may be taken, but they are marginal by comparison, as shown below.

Given the regulatory constraints, there are no other risk exposures in the portfolio.

Accordingly, most of the return contribution (vs liabilities) is expected to come from credit and alternative income.

The liability discount rate is continuously linked to the spread available on the credit and alternative income assets. Therefore, the accounting value of the liabilities is reduced and benefits from a significant reduction in volatility as spreads move. This translates into a lower overall level of risk (shown as ‘discount risk benefit’ as part of the diversification bar).


The next table summarises the key differences between a pension scheme and an insurer’s way of defining, designing and implementing an investment strategy. For illustrative purposes, a set of parameters for a typical pension scheme (‘average’ underfunded scheme) and a typical annuity book are also shown.




Free of the regulatory constraints faced by insurers, we believe that pension schemes should move away from the two bucket or barbell approach towards a more holistic strategy of using a wider range of asset classes, which are unconstrained by market benchmark indices. This involves placing less reliance on equities to generate excess returns and more emphasis on absolute return and a wide range of matching assets.

The diagram below provides a representation of all the asset and liability cash flows of a pension scheme that adopts this approach.

For cash flow projection of the growth assets, it is assumed the investment is akin to cash (i.e., has zero duration), although contractual income, such as from property, can be included in alternative income.















- Credit: Long-duration corporate credit, managed on a buyand maintain basis and focused on defensive companies.

- Alternative Income: Privately-traded credit and other illiquid assets such as infrastructure, long-lease real estate etc. All generate predictable and stable cash flows.

- LDI: An overlay of government bonds, swaps and cash, typically levered. The overlay takes into account the hedging contribution from credit and alternative income assets.

- Growth: Make use of a range of growth assets such as absolute return funds and equities (as managed relative to cash benchmarks).

The use of a wider range of matching assets and the ability to invest in growth assets could lead to much more attractive risk / return profiles than is currently the case.

This is particularly true if the liability discount rate can be directly linked to the spread available on suitable credit and alternative income assets.

An example of the risk decomposition is shown below. As is the case with an annuity approach, credit and alternative income risk becomes more dominant. However, there is also a contribution, albeit to a smaller degree, from growth assets.


Small rates and inflation positions need to be taken while still achieving similar scheme returns. Overall risk is lowered as the majority of the interest rate and inflation risks are hedged.



The overarching objective of any pension scheme’s investment strategy is to meet liabilities. Adopting similar approaches to their insurance counterparts should be a natural evolution for pension schemes, particularly closed schemes where there is a finite time until all the pensions are paid out. Whilst this approach can clearly be applied to fully funded schemes, most underfunded schemes could benefit, as well.

As a rule of thumb, an insurer-style approach could be particularly effective for pension schemes where the return objective is gilts + 250bps pa or below. For higher-return targets, more reliance has to remain with return-seeking assets, leaving less to be invested in the ‘matching’ assets typically associated with an insurance approach.

For a pension scheme to adopt this approach, three key changes should be made to their existing strategy:

At Aviva Investors, we believe that most pension schemes can benefit from an insurer-style approach to investing.

If implemented properly, thinking like an insurer but investing with the wider asset universe available to pension schemes, can significantly improve the risk and return profiles of pension schemes’ investments.

A number of major UK consultants and some pension schemes have already expressed their support for an insurance-style way of investing. Like us, they can see the benefit of this outcome oriented approach.

As the asset management arm of one of the UK’s largest insurance companies, and an institutional investor in our own right, we are in a unique position to work with pension schemes and their advisors in developing an outcome-oriented solution that meets their specific requirements.

If you would like to learn more about how an insurance-style approach can be used, please contact Boris Mikhailov on 020 7809 8749 or