Still a realistic option
Charlie Finch and Ken Hardman consider the future direction of the pension buyout market in the UK
Over the last two years it has become common practice in the UK to use insurance products to de-risk final salary pension plan liabilities. This reached a peak in 2008 when insured pension buyout volumes hit £7.9bn - more than four times 2006 levels.
However, the brakes have been applied in the wake of the global financial crisis. Paternoster, the most well known of the new breed of companies offering pension buyouts, has closed to new business. Traditional buyout volumes have fallen to around £1.5bn (€1.75bn) for the first half of 2009. Looking further ahead, Solvency II will introduce new challenges from 2012.
So where next for the UK pension buyout market? One of the defining features of the market has been the ability to innovate and to adapt to changing regulatory and economic circumstances. It is also clear that there is no let-up in demand; UK companies still want to contain and ultimately reduce their pension liabilities as demonstrated by the recent wave of pension plans being closed to existing members. Once closed, the natural next step is to target ultimate wind-up and transfer to an insurance company.
Pension buyout providers have responded by developing new products and structures. In May there was the announcement of the first longevity-only hedge by a UK pension plan. Babcock International capped its exposure to pensioners living longer than expected through a longevity swap with Credit Suisse. Critically, it was able to eliminate longevity risk without passing across assets up front. This avoided the key obstacles to a traditional pension buyout posed by the economic crisis in early 2009 (see panel). But it is only a partial solution. Babcock International has some remaining exposure to investment markets and is now reviewing its inflation and interest rate hedging to further reduce its pension risk.
Breaking new ground
RSA Insurance broke new ground in July with the announcement of a £1.9bn buyout deal with Goldman Sachs to insure 55% of its pensions in payment. Not only was this the largest insured deal by a UK pension plan to date - surpassing the £1bn-plus deals in 2008 by Cable & Wireless and Thorn - but the design and structure of the transaction was particularly innovative.
RSA Insurance's transaction was effectively a ‘DIY buyout'. It combined a longevity swap with an interest rate and inflation swap to achieve the same result as a pensioner buy-in. The longevity risk transferred to Goldman Sach's UK insurance subsidiary, Rothesay Life, and the investment risk to Goldman Sach's banking arm with each contract fully collateralised. Through this solution RSA Insurance eliminated the key risks for over half of its pensions in payment while minimising any counterparty exposure.
One of the key features of the deal was that it was struck on terms that did not require immediate additional cash funding for the pension plans from the sponsoring employer. In part this was achieved by restructuring the underlying bond portfolio to lock in to higher investment returns arising from pricing dislocations in UK government bond markets - partly driven by the UK government's quantitative easing programme.
A DIY buyout is effectively an extension of liability driven investment strategies that are pursued by many pension plans. The key change is the advent of longevity swaps allowing longevity risk to be added to the equation and so achieving a much closer match for the pension plan's cashflows.
DIY buyouts have become more cost effective in recent months when compared with a traditional buyout with an insurance company. This can be measured by the ‘break-even' investment return that needs to be achieved on the underlying asset portfolio to put it on a par with a traditional buyout. This break-even investment return fell dramatically in early 2009.
The improved cost effectiveness of a DIY buyout has been driven by a combination of changing investment market conditions, more cautious buyout pricing and improved longevity pricing. Last autumn the asset portfolio underlying a DIY buyout would have needed to be invested heavily in corporate bonds or other performance-seeking assets. In spring the assets could be invested mostly in government bonds and still be cost-effective. Indeed, in the case of the RSA Insurance deal it chose to invest its portfolio entirely in government-backed securities.
Outlook for pension buyout
The current attraction of longevity swaps and DIY buyouts is partly a result of the unusual investment conditions we are seeing in the wake of the financial crisis. As conditions change, their relative attractiveness may change.
As the economic crisis recedes we expect to see a rising level of insured pension buyouts. There are already signs of improving con ditions: pension plan asset levels are beginning to rise; the recent interim results from the insurance firms show robust solvency positions; and liquidity is returning to key investment markets.
There are still further obstacles on the horizon. Solvency II is due to come into effect from 2012 and in its current form this is widely expected to increase reserving requirements pushing up pension buyout prices by as much as 10-20%. The insurance industry continues to lobby for Solvency II to be amended but if it begins to believe that it will remain in its current form then we expect it will start factoring it into its pricing sooner rather than later.
Pension buyouts are a proven effective de-risking solution in the UK and, ultimately, for companies looking to fully exit their pension liabilities, they remain the only realistic option.
Here is a list of what trustees and sponsoring companies should do to take advantage of de-risking opportunities:
• Understand the insurance companies and the products available - getting to grips with sophisticated insurance products is important if you wish to take advantage of opportunities. In a transaction situation time is often limited, so advance preparation will pay dividends.
• Review your data - a clean set of data will enable a transaction to move more swiftly and lead to both lower prices and pricing certainty. Most pension plans have at least some unresolved data issues and a data review can provide significant benefits. For larger plans, the importance of a detailed record of mortality experience should also not be underestimated.
• Optimise your investments - as well as looking for investment opportunities presented by the current investment turmoil, consider the longer-term objective of eventual asset transfer to an insurance company. Pension plans should focus on marketability and liquidity so that asset transitions can be executed quickly and efficiently as opportunities arise.
Pension plans that are well prepared will be able to move swiftly as de-risking opportunities arise.
Charlie Finch is a partner and Ken Hardman is a consultant at Lane Clark & Peacock