The market for UK defined benefit (DB) pension schemes to transfer their liabilities to insurers is set to skyrocket, according to analysis by consultancy LCP.

The recent market turmoil has created short-term challenges for pension schemes, but the silver lining has been a huge boost to funding levels, with combined scheme liabilities tumbling by close to £1trn (€1.1trn) in a year.

LCP’s research shows that the average DB scheme has seen a 15% improvement in funding over the past year relative to the cost of transferring to an insurer, also known as the “buyout cost”.

Nearly one in five of the approximate 5,000 DB schemes in the UK are now estimated to be fully funded against the buyout cost. The average projected period to reach full funding on buyout has reduced by over five years as schemes have made a huge leap forward over the past year.

The total aggregate buyout cost has tumbled by close to £1trn from £2.3bn to £1.4bn over the year to 30 September 2022. To put that in context, the reduction in pension liabilities of close to £1trn equates to nearly half of the UK’s annual GDP.

LCP’s analysis predicts that, as a result, there could be over £200bn of liabilities transferred to insurers over the next three years in a market that has seen around £30bn transferred in each of the past two years.

This unprecedented wave of demand reflects a concentration of schemes that were previously projected to reach full buyout funding in the late 2020s now being able to move to insurance much sooner.

The main driver in the acceleration in funding has been the rapid rise in long-term yields, which insurers use to determine the buyout cost. This rise accelerated sharply in the wake of the ‘mini budget’ on 23 September 2022 and, even in current slightly calmer markets, yields remain higher than they were over a decade ago.

Charlie Finch, partner at LCP, said: “The economic upheaval of the last few weeks has led to a staggering change in the financial position of pension schemes. The combined cost of transferring Britain’s defined benefit pension schemes to an insurance company has fallen by close to an astonishing £1trn in the past year – an amount equal to nearly half the size of the UK economy being wiped off company pension obligations. We expect this to trigger an unprecedented wave of transactions between defined benefit schemes and insurers as UK plc seeks to shed their legacy pension liabilities.”

He noted, however, tha the “skyrocketing demand” for pension buyouts is likely to run up against market capacity buffers.

LCP is warning that the insurance market faces a huge challenge to deal with this unprecedented wave of demand from schemes over the next few years. Data from the insurers indicates current annual capacity of £45bn. With projected demand of up to £60bn next year, a potential “capacity gap” could open up in 2023.

This could lead to constraints, particularly operationally, but the insurers do have the ability to flex capacity to an extent and the largest transactions are increasingly being treated like one-off M&A opportunities rather than as part of an insurer’s normal annual capacity.

“The industry simply does not have the operational bandwidth to process the potential number of schemes moving to insurers,” Finch said.

“Once schemes have navigated the recent market turmoil they should re-assess their strategy. Many schemes had planned for a journey lasting five years or more to reach buyout and will now be finding that recent events have significantly truncated that timeline,” he added.

Trustees targeting buyout before market volatility

Professional trustees of DB pension schemes were increasingly eyeing up buyout via an insurer as their long-term funding target this summer, according to a new study conducted by Charles Stanley Fiduciary Management.

The research polled 70 professional DB trustees appointed on schemes with total assets of more than £60bn in July this year, just a couple of months before the Gilt market made endgame a far more realistic prospect for many.

Funding targets have changed dramatically since last year, with buyout growing in popularity – 34% of trustees said their schemes were typically targeting buyout, up from 19% who said the same last year. 71% of those who are opting for buyout expect to hit their target within 10 years, the research disclosed.

However, there is a disconnect between expectation and long-term planning. Three quarters (76%) of professional trustees are yet to set a long-term funding target at all, making no progress from last year, it showed.

Looking at other long-term targets, two fifths (39%) of trustees say their long-term funding target is going or likely to be self-sufficiency. This has become a less popular option for trustees, with last year’s research finding 51% of professional DB trustees were targeting this approach, the analysis noted.

It added that 27% of participants said that superfund consolidation is their long-term funding target, which echoes last year’s findings (26%). This lack of change is surprising though, given Clara-Pensions was successfully assessed by The Pensions Regulator in November 2021; despite now being a feasible option, there remains a lack of confidence among trustees in superfunds as a long-term target, harles Stanley stated.

DB pension schemes have been subject to a number of regulatory consultations and amendments in the last year, with a new DB funding code expected in 2023 but not finalised. A majority of trustees have evidently continued a ‘wait-and-see’ approach until there are concrete proposals from the regulator. Last year’s research also found that the same number (76%) trustees were yet to set a long-term funding target, revealing absolutely no headway in long-term planning during this period of flux.

Despite volatile markets throughout 2022, confidence is high among trustees, with 71% saying they are confident their scheme will achieve its long-term funding target objective. Of those, 21% are very confident and 50% are somewhat confident. In especially good news, 100% of those with a set funding target are confident they’ll achieve that objective.

Bob Campion, senior portfolio manager at Charles Stanley, said: “The last few weeks have thrown a huge amount of uncertainty at pension scheme trustees, with dramatic volatility in the gilt market having a seismic impact on scheme funding. This follows a record year for buyout deals in 2021, and a massive drop in buyout prices due to rising gilt yields in the run up to summer 2022. It’s no wonder that some trustees had already moved their goalposts towards buyout. Now, with many schemes benefiting from recent events, I’m sure more are planning to do so. Buyout is currently a cheaper, more viable, route to endgame than it has been for years, and the gradual emergence of superfunds will keep the pressure on insurers to keep their prices affordable.”

The latest digital edition of IPE’s magazine is now available