Unlocking the buyout market
The UK's pension buyout sector has generated attention and controversy in almost equal measure. Joseph Mariathasan discusses business models and future trends with leading players
"Within a decade it will have become anachronistic for a retailer, engineering company or airline to be managing on balance sheet the significant responsibility of providing income to pensioners for the rest of their lengthening lives," the UK pension buyout firm Paternoster states on its website. It is certainly true that if you were designing a pension system for a country from scratch, it would appear absurd to tie the fortunes of an individual's pension scheme over periods that may extend to 40 years or more to the corporates that individuals work for, whose fortunes may fluctuate wildly during that period, and which may have little expertise or interest in the management of a pension scheme.
Despite this, the defined benefit (DB) pension plans developed in the UK can also claim to have been an enormous success in developing funded pensions for a large proportion of the working population over a number of decades. But the future for DB schemes is definitely one of decline, with defined contribution (DC) plans now becoming the favoured choice for most corporates. With companies becoming keener to offload the responsibilities and risks of their pension fund from their balance sheets, the pension buyout industry has experienced a rapid boom over the last few years, with many new entrants and much more capital entering the market.
However, as Gareth Derbyshire, managing director in the pensions advisory group of Lehman Brothers, points out: "If you believe what you read in the press, a substantial proportion of the UK pension market has already been bought out. The reality is that the amount of business is smaller than you would imagine from reading the press reports."
While Paternoster's timescales may have to be extended by a decade or two, its CEO Mark Wood argues: "One ongoing theme is that there will be a move from corporate balance sheets to insurance companies. The assets in DB schemes in the UK are of the order of £1.2trn [€1.6trn] so the growth potential is tremendous."
As Arno Kitts, chairman of the investment council of the National Association of Pension Funds and director of institutional business at Henderson Global Investors, asks: "At what level of pension scheme size does it make sense to have all the paraphernalia of trustee boards and so on? This is a valid question and increasingly being posed."
Wood sees several reasons why corporates would consider offloading their pension schemes from their balance sheet:Rapidly accelerating life expectancy; The volatility introduced to company balance sheets by the accounting standard IAS19 (FRS17 in the UK) which requires market valuations of pension assets and liabilities to be part of the corporate balance sheet; The increasing burden of the UK's Pension Protection Fund (PPF) levy to which all pension schemes have to contribute at a rate dependent on an assessment of the risk of shortfall inherent in the scheme; and The existence of the Pensions Regulator in the UK and in particular its power to intervene with the cash flows when there is a deficit. Pension issues can be real obstacles, particularly when a company is being restructured.
A key drawback in undertaking a full buyout of a pension scheme is that it has been seen as expensive. Given the complexities of making quotations on a portfolio of pension liabilities, which involves modelling mortality projections, inflation rate assumptions, benefits and interest rates, even making a quote is a non-trivial and expensive exercise. The influx of new players has brought new competition to pricing. "In one case that we bid for, there were over 25 quotes from competitors," says Charlotte Crosswell, a partner at Pension Corporation. There has also been some confusion as to the business strategy of some of the players in cases where pricing has been seen to be very aggressive.
"Historically, buyout liabilities have often been estimated at around 135% of accounting liabilities, although this varies by scheme and depends on many factors such as AA spreads at the time," says Derbyshire. "Increased competition has brought this multiple down significantly but full buyout remains out of the reach of many, given that most schemes currently have assets that are less than 100% of accounting liabilities." The new players have brought the pricing down which will lead to more schemes being prepared to complete a transaction, although buyout prices are probably still significantly above an economic valuation.
There are also alternatives to a full buyouts which can reduce risks to the corporate balance sheets by undertaking partial buyouts of portions of the pension liabilities which are identified and analysed as being suitable and cost effective for removal from the corporate sponsor's responsibilities. Paternoster has also undertaken transactions and given quotes for schemes that are in deficit, according to Wood. "In situations where the pension scheme has a value above the PPF minimum level of support, but below the level required to fulfil the full obligations to the beneficiaries, the payouts would need to be scaled back to the members," says Wood. "If a sponsor's covenant is fragile but the trustees feel they have the ability to persuade the sponsor to give money today above the PPF funding limits, then by transferring the scheme to an insurer today, they are better off."
The competitive marketplace
Until a few years ago the traditional buyout market in the UK was dominated by Prudential and Legal & General. But new entrants have not solely been insurance companies. Pension Corporation, originally set up as an insurance company called Pension Insurance Corporation in October 2006, added a separate company in 2007, giving itself the ability to take advantage of the opportunity to buy the Thorn Group and the Threshers Group in June 2007, selling some of the operating assets onto the private equity firm Vision Capital, but becoming the corporate sponsor to the pension schemes, according to Crosswell.
Citi also took on the pension scheme of the firm Thomson Regional Newspapers onto its own balance sheet, which baffled much of the marketplace. Wood declares that he "did not see how they derive value from the transaction they did".
Francis Fernandes, head of pensions actuarial at Citi, would not comment on the pricing of the transaction: "Citi's approach is not based on taking aggressive risks with the pension scheme assets, which after all are there to provide members' benefits. In fact, we find our objectives on asset strategy - built upon a belief in reducing interest rate and inflation risks - are typically more prudent than the current strategy," he said.
"I think Citi's TRN deal last year gave a fresh impetus to the market-place," continues Fernandes. "On the one hand, there was a realisation by employers and trustees that securing the pension liabilities with a strong counterparty was now a genuine option on the table. On the supply side, providers have sharpened their pencils or re-invented themselves to meet the increased demand for an exit solution. As more and more schemes mature, there will be further innovation."
As Kitts points out: "My understanding of the players is that they are targeting different parts of the market. It depends on where you think you can make money as to where you play. If you think you can play the mortality risk that will lead you to certain areas, if investments, others."
While Paternoster may have earned a reputation for focussing on smaller deals, Wood argues that the reality is very different: "We did four deals last year greater than £140m and in December did a deal greater than £800m."
Certainly in terms of numbers of schemes completed in the last few years, Paternoster stands out. "We have completed 33 schemes, with 22,000 members and pay out £7m a month," Wood says. "Assets under management with 15 months trading total £1.7bn, so when we meet trustees, we can speak with the benefit of practical experience."
Paternoster says it has two key characteristics give it the ability to have both higher operational efficiencies and lower capital costs. Unlike Legal & General, which has its professional staff and back offices in the UK, 70 of Paternoster's 110 employees are in Mumbai and it is the largest employer of actuaries in India, Wood says. "All of our life assurance analysis, cash flow modelling and the back office are done in India. This gives us the ability to be much faster - we can complete multi-billion pound quotes in 10 days."
Paternoster's second advantage over quoted insurers is rooted in the efficient deployment of capital, according to Wood. "The capital structure is efficient in that we have a low amount of shareholder funds, but everything is invested in risk-free assets and we are fully matched in terms of duration, cashflow and inflation, and we take out all currency risk," he says. "People say that if we price so aggressively we cannot make money. But if you have private shareholders you are much more disciplined. Our shareholders are in it for the long term rather than looking for dividends so we can build up reserves and hence have less pressure on the capital. If we are prudent in terms of matching we need less reserves. The spread we get can be split into profit and reserves and we are not interested in having a high profit, as we are not paying dividends."
While Paternoster is certainly the leading insurance player in terms of number of deals, Pension Corporation is the clear market leader in becoming the corporate sponsor to large pension schemes, Crosswell argues. It has been responsible for three out of the four completed transactions with a market value of the pension schemes of £4.4bn. The Thorn deal was the first corporate transaction of a pension scheme in the marketplace with £1.2bn of assets. Its subsequent deal was for Threshers (First Quench) and the last, with GEC pension scheme Telent with £3bn in assets, was the most controversial, attracting a large amount of press comment arising from the fact that when Pension Corporation put in an offer, it did so
without approaching the trustees.
Given that it clearly understood the marketplace, the fact that it did not approach the trustees is interesting. In the end, the regulator appointed three trustees and, as a result, Pension Corporation lost control to the regulator and trustees. "We were presented with the opportunity for Telent," explains Crosswell. "An insurance solution had not been affordable and we were presented with the opportunity to buy the operating assets of the company and so went ahead with a corporate transaction instead."
Crosswell adds that Pension Corporation now consists of three businesses: Pension Corporation Investments, which is essentially a vehicle that can own the corporate sponsors of a scheme; Pension Insurance Corporation, which is an FSA-approved insurance company; and Pension Security Insurance Corporation, which is a Guernsey approved reinsurer.
While the firm has yet to complete an insurance deal, Crosswell says it is ready for business. "In insurance we compete on fewer deals but we pride ourselves on providing niche solutions, such as leaving companies with tail risk, perhaps only insuring deferred or active beneficiaries," she adds.
The firm's target market is deals larger than £100m: "We first look at companies in surplus and these can be a wide range of companies, perhaps small companies with large pension schemes in relation to their market capitalisation or very large companies with small schemes that can be insured for relatively small amounts compared to market capitalisation."
The business model is that the operational capabilities are outsourced to Paymaster. "We have 50 people within the company, including a team looking at longevity risk," adds Crosswell. "It is surprising how many pension schemes are not accounting for longevity risk. We undertake longevity analysis which is very detailed and complex and can be driven by various factors, each of which needs to be examined in turn. We work closely with actuarial consultants as well as a host of other players who may be buying a company and don't want to take on the pension scheme. Our opportunities often come in those instances from one of the company's advisers."
Players such as Paternoster have also introduced new business models and risk management strategies that have led to very different pricing and some confusion as to the fundamental economics underlying the pricing process. As Derbyshire explains: "One key distinction is between insurers and non-insurers. The capital requirements imposed under insurance regulation tend to constrain investment strategy. However, the idea that insurers are pricing annuity business using an ultra-conservative discount rate well below gilt yields is misplaced - pricing largely reflects the fact that the buyout providers have a more realistic understanding of mortality risk. By contrast, most companies have tended to underestimate life expectancy when calculating their accounting liabilities."
Market participants are sometimes baffled by how the pricing of the newer insurance participants can occasionally be so much better, since they are subject to the same regulatory regime as the long established players such as Legal & General and Prudential. Some have argued that traditional players were in an uncompetitive world so that they could get away with anything and Paternoster is just undercutting on margins.
One hurdle facing many of the new names is that of brand awareness. In the case of a traditional buyout, the pension scheme's trustees would approach Legal & General, pass over the assets and liabilities and would then be able to sleep soundly, comfortable with the safety of a well-known brand with a big balance sheet. But would trustees be as comfortable with Paternoster? "Branding is important," says Derbyshire. "Many trustees start with a natural preference for long-established names with a big balance sheet and the newer participants need to address this at an early stage of their discussions."
There is clearly an education process required and the more sophisticated pension schemes may be more ready to accept the new players. Wood gives an example: "In the case of the Chartered Accountants Scheme, the board of trustees was extremely competent. Before appointing us it commissioned an independent assessment of us, covering operational competence, strength of management, prudence of life expectation reserving and financial strengths. We are a typical boutique competing with generalists, but we have a strong governance structure. Our board is chaired by Ron Sandler and has Howard Davies as a member. The management team consists of people who have spent their careers in the insurance industry."
It is the trustees that ultimately determine whether a buyout transaction should be undertaken or whether the status quo is preferable. Given the complexities of the analysis required, are trustees comfortable and do they have the expertise to make decisions without external advice?
"The whole question of security is a challenging one for trustees," says Derbyshire. "At one level there is a need to assess insurance versus non-insurance solutions and within this to assess the difference between offerings of a similar type. In some cases the non-insurance route works very well. For example, the trustees of a struggling manufacturing company might see a strong sponsor as something of a white knight." This is a view that could well describe the Citigroup acquisition of Thomson. But trustees may have some fears in the case of transactions that are not undertaken through an insurance company route, particularly when there is no guarantee involved, unlike the case of an insurance company, where 90% of the pension is guaranteed.
The better funding positions for pension funds, following the rise in equity markets over the last few years, combined with the influx of new pension buyout players with finer pricing has meant more buyout transactions have been possible. However, if markets drop, funding positions can reverse. "In the medium term, the momentum towards buyout will depend on capital market conditions," says Derbyshire. "If funding levels deteriorate, buyouts simply become unaffordable - at least until markets recover or additional contributions eliminate the deficit."
But for fund managers, investment banks and other intermediaries, the future of the buyout industry and the speed at which it grows is critical to their own long-term business plans. "In 20 years time, if there are few DB schemes left we'll all be focused on the same underlying liabilities but with the buyout providers as our clients," Derbyshire concludes.
The main UK's pension buyout players include Prudential, Legal & General, Paternoster, Synesis, Goldman Sachs and Citigroup.
Activity has also been noted from Standard Life, Aegon, in conjunction with UBS, and Aviva, while ex-Prudential chief executive Jonathan Bloomer has set up Lucida backed by the US hedge fund, Cerberus Capital Management. Paternoster led by Mark Wood and Howard Davies is widely regarded as the leading player amid widespread reports of deals of as small as £10m.
Paternoster's Mark Wood sees his main competition, particularly for smaller schemes, as Legal & General which he estimates has in the order of 40% of the market against Paternoster's 45%. "We have tried to create a very efficient model and our competitive edge against Legal & General is our competence and speed of response for quotations, which is particularly important in an M&A situation," notes Wood.
Backers of the new buyout firms include Royal Bank of Scotland, which is an investor in both Pension Corporation and Synesis Life, Deutsche Bank and the private equity firm Eaton Park, who are investors in Paternoster, while HBOS, ABN Amro, Union Banque Privée, Sampo Life and Swiss Re are all investors in Pension Corporation.