Michael Winchester (L), Head of Strategy, and Shang Wu (R), Associate Portfolio Manager for Retirement Strategy, Aware Super

Michael Winchester (L), Head of Strategy, and Shang Wu (R), Associate Portfolio Manager for Retirement Strategy, Aware Super

Aware Super Secures Landmark DB Deal

The Anatomy of Portfolio Immunisation

In July, Aware Super announced a deal that will offset the current and future liabilities of its defined benefit scheme. In this article, we delve into the making of this landmark transaction.

Today, Australia’s pension system is largely a defined contribution system and increasingly more countries around the world are switching to this model.

But it wasn’t that long ago the defined benefit (DB) model was the dominant system in the world.

DB schemes have a distinct advantage over defined contribution ones in that they can pool the money of members into one fund and smooth out the volatility of the individual experience.

It takes away sequencing risk and provides certainty to members in retirement.

But DB plans also have significant drawbacks.

To estimate the end benefit for a member, actuaries have to make a number of assumptions about the life expectancy of a member, the growth of their salary and the duration of their employment.

And as physicist and Nobel Laureate Niels Bohr is supposed to have said: “Prediction is very difficult, especially if it’s about the future.”

Often this means the plan sponsors, and sometimes even members, have to make additional contributions or readjust the end benefit to keep the scheme affordable. This creates uncertainty and places a significant financial burden on employers that are running these schemes.

Ideally, plan sponsors would offset their liabilities with an income stream that ensures benefit payments to current and future retirees in the plan. It is a process that is called ‘portfolio immunisation’ and typically involves the purchase of an annuity that offsets the liabilities.

These transactions are frequently seen in Europe and the United Kingdom, where DB funds are more prevalent. In 2022, around 200 such transactions took place in the UK alone with an estimated value of £25 billion, according to data from Mercer.

But in Australia, these immunisation transactions are rare, especially large-scale ones.

So when Aware Super reached an agreement with Challenger in July to offset the lifetime pension liabilities of its DB scheme through the purchase of a group lifetime annuity policy in a $619 million deal, the industry took note.

Aware Super inherited the DB plan when it merged with Health Super in 2011.

“When we merged with Health Super, the funded status [of the DB fund] was around 102 per cent,” Michael Winchester, Head of Investment Strategy at Aware Super, says in an exclusive interview with [i3] Insights.

“We gradually started de-risking it, applying the same kind of techniques that we use for the pension members of our defined contribution scheme, including lower risk equity strategies and tail risk strategies through liquid alternatives.

“We managed that fund successfully through time and got through periods of market volatility, such as last year, quite well. So when real bond yields moved from negative to positive, we were in a situation where we could actually start investigating the immunisation of that fund,” he says.

But to make a decision on whether Aware Super should immunise the fund, the investment team had to have a better understanding of the scheme’s liabilities and funded status. Typically, the fund’s actuary calculates the funded status only once a year.

“Two years ago, when we had a good look at the SAA (strategic asset allocation) and started to think that an immunisation strategy was possible, we realised that to manage it we needed to have a much better way of understanding the funded status of the fund in real time,” Winchester says.

Shang Wu, Associate Portfolio Manager for Retirement Strategy at Aware Super, ended up building a model to calculate the funded status from scratch.

“Shang built a real-time model of the defined benefits scheme, the assets and the liabilities, so that we could monitor this through time,” Winchester said. “Having that model meant that, when real bond yields moved from negative 50 to positive 100 basis points in the first six months of last year, Shang realised that there was an opportunity to potentially immunise the fund,” he says.

Wu says there are two parts to the model. “One is to understand the financial position of the fund in real time. And secondly, once we get market data into the model, we then need to understand how close we are to immunisation,” he says. “Is there a gap? How large is the gap?”

“So when the yield went up, we found it was actually something that we could start exploring,” Wu says.

Tackling Longevity Risk

There are three main problems a fund tries to solve when immunising a DB portfolio: investment risk, inflation risk and longevity risk. Managing the first two risks is the bread and butter of any pension fund, but longevity risk is a trickier problem and typically involves some kind of insurance solution.

Of course, Aware Super could simply sell the DB scheme, since it had knocked the investment portfolio into good shape, but Winchester says that would involve ending the relationship with 3000 members.

“We could find somebody to take [the fund] off our hands, but that wasn’t really appealing to us because we wanted to continue to serve those members and employers. We didn’t want to outsource the relationship,” he says.

Eventually, Aware Super landed on the purchase of a wholesale annuity, but there wasn’t really an established market in Australia for such a solution. And so it called in the help of Mercer, which is the actuary to Aware Super’s DB plan. Mercer has extensive experience in designing tenders for such deals in the UK.

Tim Jenkins, Partner with Mercer and actuary to Aware Super’s DB plan, says the rise in interest rates starting last year paved the way for the transaction to take place.

“With the increase in interest rates, for the first time for many years there was now a situation where you were able to purchase annuities from an insurer at a cost that was not that different from the level of the reserve assets that you’ve been holding in your pension plan,” Jenkins says in an interview with [i3] Insights.

“Whereas historically it would have [required] a big uplift which then needed to be funded, in the new, higher interest rate environment the uplift may actually not be anything at all.

“So in that environment it became possible for Aware to consider: ‘Do I go to market and actually see if I can lock in the price of paying the pensions to our 3000 lifetime pension members?’,” Jenkins says.

Relying on Mercer’s experience in the UK, the consultant went to work on establishing a tender process and in doing so helped create a market for portfolio immunisation in Australia.

“With the transfer of some of our staff from the UK to Australia, we believed we could really help [Aware Super] here establish a market to get a competitive tender,” Jenkins says.

“Whilst there were definitely one or two providers who were ahead of the market, including Challenger which was ultimately appointed, there was interest from a lot of insurers and reinsurers to assist with this, either looking at the whole deal or just at the longevity risk component.

“In total, there were eight or nine insurers and reinsurers that expressed an interest to tender,so it became very competitive which is really a good thing for Aware,” he says.

Under the deal, Aware Super pays Challenger $619 million, while Challenger pays pension payments every fortnight to Aware which it passes on to members for the lifetime of the last living member. The deal includes a so-called ‘true-up’ process that adjusts payments if the lived experience of the member base differs from the modelled experience.

The youngest member of the DB scheme is in their 50s and so it has the potential to run for another 30 or 40 years, although it will become significantly smaller after 15. Aware Super will continue to service the members.

The deal allows the fund to release its reserves for lifetime pensioner members, thereby increasing the funded status of the scheme in respect of its remaining liabilities.

“The interesting thing about that is it significantly reduces the risk that the employers would be required to make extra contributions,” Winchester says.

“And what is quite exciting, I think, is that it brings forward the prospect of them not needing to make additional contributions at all.

“I think the role of an employer in the defined benefit scheme is to make contributions in line with the schedule of the actuary. If the fund is well managed, those contributions don’t go up. And, in fact, if you do a really good job, then they come down and you might even get a [contribution] holiday.

“With the funded status approaching 120 [per cent], the likelihood that the scheme would be deemed to be fully funded is increasing,” he says.

Winchester believes the whole process has also given the fund an edge in future merger discussions.

“We’ll be active in the merger space in the future, and a lot of funds looking to merge will also have defined benefit schemes attached. Having that capability around managing defined benefits is a real asset for the fund,” he says.


[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.