Head of strategy for institutional retirement sets out how the business identifies attractive asset classes and where he sees opportunities
Legal & General’s institutional retirement business helps companies to de-risk their legacy defined benefit (DB) pension schemes while providing greater security for members. It then needs to manage the matching assets in a highly regulated sector, including in high-quality private market asset classes.
A pension risk transfer, or bulk annuity, effectively removes pension liabilities from a corporation’s balance sheet, allowing it to focus on its day-to-day business. It provides stability to pension scheme trustees and guarantees members receive their final salary benefits, regardless of the fate of the sponsor.
Sumit Mehta is the head of strategy for institutional retirement at L&G. He works across the business, assessing its opportunity set and future strategic direction. A big part of his role is working with the asset side of the business.
How do you approach your role?
Being able to source good assets is a critical advantage for pricing competitively in this market. In this regard, I work with the CIO and other stakeholders, both within the institutional retirement division and in our in-house asset management business at L&G, on how to strategically keep sourcing the right assets for our portfolio and maintain the right asset origination capabilities.
What principles underpin your strategy?
First and foremost, we focus on our ability to sustainably pay our policyholders. This means seeking enhanced risk-adjusted returns for our portfolio. A big aspect of this is risk appetite. We ensure we are not only focused on today’s yields and spreads, but also on reducing risk over the long term.
Secondly, we’re strongly driven by social purpose – it underpins our investment strategy. We invest in the real economy and want to help rejuvenate cities and regions across the UK. We think about the impacts of our investments. A big part of that is net zero, and we’re laser-focused on ensuring our portfolio decarbonises in line with publicly stated targets.
Thirdly, as our investments are mostly covered by the Solvency UK regime, regulatory efficiency. It’s an important overlay when we assess asset classes.
We’ve traditionally been able to extract an illiquidity premium that gives us and our investors a benefit unavailable to those with shorter time horizons or greater liquidity requirements.
Sumit Mehta, L&G
How restricting are these regulatory constraints?
Mehta: The key regulatory constraint is around the fixity of cash flows. Traditionally, assets that directly back liabilities need to be eligible for matching adjustment [under Solvency II] and that means they need to have fixed cash flows for their entire lifecycle.
There’s been some reform in the UK, allowing ‘highly predictable’ buckets. A portion of the portfolio now doesn’t need to have fixed cash flows – only highly predictable cash flows. That expands the universe of assets that we can buy. It’s a small part of the portfolio, but a step in the right direction.
It is obviously very important not to breach our responsibility to secure and pay retirement benefits, so we have an appropriate risk appetite and operate within those constraints. That said, as our liabilities are illiquid, we benefit from being able to take illiquidity risk.
We’ve traditionally been able to extract an illiquidity premium that gives us and our investors a benefit unavailable to those with shorter time horizons or greater liquidity requirements.
Which private asset classes are you invested in?
Mehta: We started significantly allocating to illiquid private assets about 10-15 years ago primarily in real estate long lease income – sale and leaseback structures with blue-chip tenants and long leases.
Over the last five to 10 years, we’ve expanded to other areas including private debt, which involves lending to blue-chip corporates in a private bilateral form. It’s a typical example of an asset class that provides a liquidity premium over a public equivalent, so it works well for us.
Infrastructure is another area where we’ve been able to structure assets to fit our requirements, in terms of duration, fixed income and risk appetite, and also aligns well with our social purpose.
We’ve traditionally operated in parts of the sector with less economic risk, in regulated assets that are underpinned by contractual cash flows or prices. Those have been the best classes for us.
Like many of our UK competitors, seven years ago we entered the equity-release mortgage market. It is efficient from a regulatory perspective and fits with our focus and customer base, and creates synergy with our retail business.
Over the last few years, we’ve looked to expand geographically beyond the UK in North America and Europe.
What is your view of the macro environment?
Mehta: After all the market volatility in Q2, public credit has gone back to being quite tight relative to government bonds on a historical basis.
In this economic environment, we are cautious about ensuring that we are appropriately rewarded for taking long-dated credit risk, especially on the illiquid side. We may invest selectively, but broadly the rewards are not sufficient from risk management, diversification and asset-sourcing perspectives. We see greater opportunity in the shorter duration space, where there is less crowding and the premium is not so compressed.
One example of an asset class is that we had not explored very much until now is the asset-backed financing space. It’s interesting due to the shorter duration of assets and the relative value compared to long-term assets. In many cases, these assets have better performance than unsecured corporate lending and we like their risk profile. Some are backed by collateral, which improves their recovery rate profile. Overall these can be an interesting diversification to the rest of our portfolio.
More broadly, US insurers allocate significantly more of their balance sheet to structured finance than UK insurers, whether ABS, CDOs or other public or private forms. US insurers allocate in the region of 15-25% whereas UK and Europe insurers allocate a single-digit percentage. We are excited about the opportunity to expand in this space.
Why do UK and EU insurers lag so far behind?
Mehta: From a regulatory perspective, US insurers have traditionally found it more advantageous to invest in these asset classes. In addition, Europe has been more bank-led than the US, so the evolution of the market to become asset-owner-led has taken longer.A 25% allocation is not necessarily a target to aspire to – but the levels in the UK and Europe do feel quite low so it feels like there is an opportunity.
What’s your outlook for the UK’s economy and investment prospects?
We are positive about the future of the UK. There is an important role for us to invest and help drive economic growth. That can happen in a variety of ways. We’ve had some great successes in real estate, from regenerating Cardiff and Newcastle town centres to building to alleviate the UK residential housing shortage. We’ve been quite active in build-to-rent and affordable homes. We look forward to working with the government in private-public-partnerships to help unlock the way forward.
Is the government creating attractive investment opportunities?
Mehta: Asset owners like us need to invest to meet liabilities. We need to operate within our risk appetite and look for the right conditions to deploy capital. The question is always, how can we unlock those opportunities?
That’s where the government can come in. Governments can potentially de-risk sectors enough for them to become investable for a wide group of investors. They can also enact regulatory change to incentivise asset owners to invest. In future, I don’t think the government will always need to build on its own when there are asset owners to support, with capital to invest. Let’s use our firepower to help the economy.