The deficits at UK defined benefit (DB) pension schemes have risen over the past 12 months, from £104.9bn (€130.8bn) to a current estimate of £109bn, according to the Pension Protection Fund (PPF). However, funding levels have increased – the PPF estimates that the average funding ratio is 91.5% from 91.3% a year ago, although this can vary on a monthly basis.
This high average level means DB schemes are on course to full funding, which constitutes a major driver towards de-risking. Trustees are considering and implementing de-risking strategies across the whole spectrum, from LDI to longevity swaps, regardless of their assets and liabilities.
Improving funding ratios are due to asset appreciation linked to rallying equity markets, and higher discount rates caused by rising interest rates.
With further interest rates rises due, there is no sign to suggest that this trend will be reversed.
Data shows that the demand for de-risking solutions is rising, following a 2008 peak. The buy-in and buyout markets, in particular, are expected to grow significantly. Hymans Robertson estimates the buy-in and buyout markets will reach between £15bn snd £20bn in 2014, with buy-ins accounting for 80%. The firm sees the longevity swap market reaching £15bn, up from the £8.8bn in 2013.
This is in line with other estimates, such as those of Lane Clarke & Peacock (LCP), which notes that the market was worth £16.3bn in 2013, including buy-ins, buyouts and longevity swaps. It predicts that the buy-in and buyout markets will exceed £10bn in 2014.
Guy Freeman, head of business development at Rothesay Life, says: “The pipeline for transactions is as long as it has ever been and we have seen a shift towards pensioner buyouts. Two thirds are now buyouts as opposed to buy-ins, in recent years that has been the opposite way round. Even where the opportunity being explored is for buy-in, most are stating that this is very clearly a first step to securing a buyout as soon as funding allows.”
At a glance
• Funding levels are improving, which leads DB schemes to plan and implement de-risking strategies.
• The de-risking market, including buy-ins, buyouts and longevity swaps is back on its feet and breaking records.
• Buy-in and buyout pricing may face some pressure in the short term as many schemes want to de-risk but insurance capacity will come from a declining retail annuity market.
• Large, innovative de-risking deals are being done but the options for small schemes may still be limited to LDI.
Aggregate growth of de-risking is not the only positive news. This year, some of the UK’s largest corporate pension funds completed ground-breaking transactions. Earlier this summer, the British Telecom Pension Scheme (BTPS) announced it had completed a £16bn longevity swap with Prudential Insurance Company of America (PICA). The transaction, which allowed the scheme to offload 25% of its longevity risk, was one of the largest to date and featured an innovative structure whereby BTPS formed a capitve insurance company, and transferred the risk to the reinsurer.
Other deals completed included Aviva Staff Pension Scheme’s £5bn longevity swap with re-insurers Munich Re, Scor and Swiss Re; the transfer of £3.6bn worth of liabilities from the ICI Pension Fund to L&G and the Prudential; Pension Corporation’s (PIC) buy-in deal with French oil company Total, where the PIC reinsured £1.6bn worth of liabilities.
These deals are rare in terms of size and structure and the market is unlikely to see such deals on a regular basis. However, all the evidence suggests that the de-risking market is poised for growth.
Amy Kessler, head of Prudential Retirement’s longevity risk reinsurance business, expects the UK de-risking market to continue to grow and thrive and says the de-risking trend has taken hold. “From a corporate perspective, de-risking is a focal point for management,” she says. “This year has been fascinating, as we’ve seen the record for the largest UK transaction tumble. There are new record transactions every year, and there’s plenty of reinsurance capacity aimed at the UK market right now.”
With such large longevity risk transactions being underwritten, some have suggested that longevity swaps could also be utilised by smaller schemes.
“Some providers are actively offering longevity swaps to smaller schemes,” says Sadie Hayes, senior consultant at Towers Watson. “But there is a lot of complexity, including more government requirements, in longevity swaps, both in these contracts themselves in terms of the assets that are used alongside those contracts to hedge other risks. Doing a longevity swap generally means having a long-term plan in place. Therefore, smaller schemes are focusing more on getting to a point where they can do a bulk annuity.”
However, most disregard this possibility. “We’re cautious about the possibility for smaller schemes to buy longevity insurance and reinsurance,” says Kessler. “In order to effectively isolate longevity risk, you need to have complex and sophisticated LDI strategies that protect you from inflation risk and interest rates risk. The small to mid-sized pension schemes are unlikely to have the scale for those sophisticated asset strategies that insurers have.”
Jay Shah, head of business origination at Pension Insurance Corporation, agrees: “I don’t think longevity insurance works for smaller schemes,” he says. “Smaller schemes have to deal with other risks that are more significant, chiefly inflation and interest rates.”
The changes announced in the 2014 Budget also play an important part in the de-risking market. Since buying an annuity from an insurance company at retirement is no longer required, and appetite for annuities by future DC pensioners may be significantly lower, insurers will build spare capacity that will naturally be directed towards buyout or buy-in deals.
Earlier this year, L&G said it expected the UK individual annuity market, currently worth £12bn, to fall by 75% by the end of 2015, although it is difficult to estimate how much capacity will be shifted from individual annuities to buy-ins and buyouts.
• Liability-driven investment (LDI) – An investment strategy that consists of building a portfolio of assets that ‘match’ the scheme’s liabilities. An LDI portfolio will contain assets that generate cashflows similar to the obligations of the scheme in terms of pension payouts. Assets in the LDI portfolio will reflect the liability curve and the level of risk borne by those liabilities.
• Bulk annuities/buy-in – A buy-in consists of an insurance company acquiring a portion of a pension scheme’s liabilities through what is effectively an insurance policy. Through its trustees, a pension scheme enters into an agreement with an insurance company, under which the scheme pays a premium to the insurance company and the scheme subsequently receives payments equivalent to a portion of its liabilities. This kind of agreement covers, for a portion of the liabilities, all risks including inflation, interest rates and longevity.
• Buyout – In a buyout, the scheme will transfer all its liabilities to an insurance company and ‘wind up’, because it no longer has any contributing members. The insurance company then pays the pension benefit to all the existing or deferred pensioners. A full buyout requires a pension scheme to be fully funded for insurance purposes.
• Longevity swap – An insurance policy through which a scheme insures the risk that its members will require payments for longer than previously expected. A scheme buying a longevity swap will tend to have all other risks (inflation, interest rates) covered through other instruments or strategies.
Bearing this in mind, is there sufficient supply of high quality fixed income assets for insurers to buy in order to match the liabilities they are taking on? There is no doubt that some capacity will be come from the retail annuity market, but what if there is a spike in demand for buy-ins and buyouts as well as LDI strategies?
Spurred by the shrinking gap between yields from corporate bonds and Gilts, insurers and pension funds have developed expertise in alternative asset classes with bond-like characteristics and Shah says insurers are making more use of illiquid assets. “They need safe, secure, long-term income that is inflation linked, but they don’t need to trade those assets all the time, so they don’t have to be hugely liquid,” he says. “We have been investing increasingly in infrastructure. It takes a lot of due diligence, and you can’t do it in large chunks. They are relatively small deals individually and quite resource intense.”
However, some point out that pension schemes wanting to de-risk may face pricing pressure, at least in the short term. This could happen if demand for de-risking solutions increases suddenly and insurers face a squeeze in the liability-matching assets they can buy.
“Up until now, the supply from insurance companies has outweighed demand from pension schemes,” notes James Mullins, partner at Hymans Robertson. “There have been no issues for schemes as they can get a good price from a good number of insurers. But if demand grows quickly following rises in interest rates and improving funding levels, lots of schemes may want to transact at once and to provide all that capacity may be difficult. I’m sure there is the capital, but it could be a challenge in terms of other resources. The fact that they are no longer doing as much individual annunity business will help them in the short term, but they will have to work hard to find the right assets.”
However, Emma Watkins, partner at LCP, believes that pricing of buy-in transactions will not be affected by an imbalance between supply and demand. She says: “The most significant driver of bulk annunity pricing is the assets that insurers can purchase to back the liabilities being secured. To the extent that they can purchase risk-adjusted, higher yielding assets, this will be reflected in a better price. Despite decreasing credit spreads, buy-in pricing is still at a favourable level; you can exchange a portfolio of Gilts for an insurance policy with little to no funding strain.”
Watkins thinks it is likely that demand will raise prices but says favourable pricing will continue if there are sufficient assets to back bulk annuities.
Freeman adds: “With the focus moving to full buy-out, the key demand-supply issue is not one of capital or assets, but more one of having enough people with the experience to negotiate and agree full buyout transactions, both on the trustee advisory side and at the bulk annuity providers.”
First things first
Smaller schemes have a range of choices to ease liability risks, and many of them are far from a fully funded position, which means they will look at de-risking from a different perspective. “De-risking can have a totally different meaning to different people,” says Paul McGlone, partner at Aon Hewitt. “It might mean anything from selling growth assets to increasing your leverage or doing a bulk annuity or a liability management exercise. We’re seeing a lot of schemes who haven’t done LDI starting to put it in place for the first time. There is a lot more activity in LDI than there is in annunities, so we get a very skewed perception of what is going on out there.”
As liabilities mature and funding improves, all schemes will have to consider the best opportunity. McGlone says buying a bulk annuity is an investment decision that may make sense if the assets needed to buy it are sitting in low-yielding Gilts, but not if they are invested in higher-yielding corporate bonds or in an LDI portfolio that offers interest rate and inflation protection.
“You have to afford to buy a bulk annuity,” he says. “It’s not just about the price of the annuity, it’s about what else you should be doing with those assets. De-risking is a bit of a nonsense word. It means totally different things to different people. There’s also an incorrect perception that it should go on forever. If a scheme is not looking to wind up, then there is a point when de-risking should stop.”
However, the drive towards de-risking means DB funds are becoming similar to insurance companies as they continue their journey towards de-risking, says Mike Rogers, senior investment and risk management actuary at Towers Watson, with an eventual plan to transact a buyout and wind up the scheme.
“This drives change in the dynamic of the market,” he says. “Interest rate and inflation hedging have become absolutely crucial for pension schemes, but hedging longevity risk has also become very important, whether directly using longevity swaps or indirectly through a buy-in policy.”
Here, high quality illiquid assets like infrastructure, social housing or ground rents come into play, assuming the fund has a long enough time horizon. “It’s quite similar to what insurers do, except that pension schemes have more regulatory flexibility,” Rogers adds.
Laura Brown, head of LDI distribution at Legal & General Investment Management (LGIM), agrees: “There was a perception that pension schemes shouldn’t be managed like insurers, because they needed to be able to take advantage of their flexibility. Nevertheless, we will see the insurance industry become increasingly more involved in pension de-risking strategies.”