The pensions buyout market

The pensions buyout market is starting to recover after a sharp decline, but employers are keen to find the right de-risking options, says Nicola Sullivan

The pensions buyout market is in a state of flux. It reached its peak as the economy headed towards recession, gobbling up the risk associated with deficit-burdened defined benefit (DB) schemes in multi-million-pound buyout and buyin deals, which often hit the headlines. This lucrative period spanned all of 2008 when the market was valued at £8bn, compared with £3bn in 2007, according to figures from Punter Southall.

But as the recession deepened, cash dried up, employers lost faith in the insurance market, and insurance giants such as AIG suffered dramatic losses. As a result, the buyout market has shrunk substantially to £1.5bn in 2009.

Laith Khalaf, pensions analyst at Hargreaves Lansdown, says: “I think we had a boom in the industry last year. This year has seen a tail-off for a number of reasons. One of those is simply economic circumstances and the fact there are, or have been, such widening deficits employers are having to [accept] that it would simply be more expensive for them to buy out their scheme at a time when cash is pretty thin on the ground.”

Serious intent

But Jay Shah, partner at buyout firm the Pension Corporation, paints a more positive picture of the market. “Over the last 12 months, we have seen huge market dislocations,” he says. “Some decisions to buyout or not were put off, yet transactions continued to happen. As markets start to settle, trustees and employers are opening up discussions again. The intent to buyout has become much more serious.”

But there is some scepticism about how quickly the market will recover. “The industry seems to be largely on hold,” says Khalaf. “But in terms of demand, there are potentially new clients coming along in terms of plans that are closing to future accrual.”

One factor that has made conditions more difficult for the buyout market is legislation from the European Union, which, as it stands, will require insurance companies to hold more capital against the liabilities they take on. This could make bulk annuity deals (which cover buyins and buyouts) more expensive, says Khalaf.

Another blow for the market is that the recession seems to have prompted employers to be more creative when managing the risk associated with their DB plans, shifting the focus, for the moment at least, further away from traditional bulk annuity deals.

According to analysis released by Watson Wyatt in July, pension funds are now more likely to design their own ways of hedging risk than buy a bulk annuity solution. This is partly because of the increased focus on longevity swaps, where organisations enter into a transaction to hedge their pensioner liabilities against improvements in longevity.

Hedging longevity†

The main attraction of hedging longevity risk in this way is there is no requirement for an employer to make immediate contributions. They are also not required to sell assets at current depressed prices. James Mullins, liability management specialist at Hymans Robertson, says: “What [employers] are doing is buying into an agreement with a provider, whereby over time they will either pay [the provider] money if people are dying off more quickly than they thought, or the provider will pay the employer if members are living longer than anticipated. The money changes hands over time rather than an upfront need for capital injection, so that is obviously pretty attractive at the moment.”

One of the first organisations to set up such an arrangement was engineering firm Babcock International, which signed a deal with Credit Suisse to remove the risk of retirees living longer than expected from its DB plan. If staff do live longer, the bank pays the difference, but if they die earlier, it will benefit. Babcock arranged the deal, which will run for 20 years, solely for the pensioners in its scheme.

Paul Trickett, European head of investment consulting at Watson Wyatt, says: “Now a few large funds have completed such transactions, we expect more to follow quickly.”

Longevity swaps

But Martin Hunter, a consultant at PunterSouthall Transaction Services, sounds a note of caution as consultants enthuse about longevity swaps. “The deals to date, and for the next year or two, will concentrate on just current pensioners, so it will not remove all longevity risk from a pension scheme,” he says. “It will leave behind the more risky deferred pensioners and there is more uncertainty about how long they are going to live.

“Over the next two years, we expect the longevity swaps market will grow but it needs to overcome a number of obstacles.”

So it is important for employers to ensure pension scheme trustees are fully aware, not only of the options available to manage risk, but also of how they work in practice. David McCourt, senior policy adviser, investment and governance at the National Association of Pension Funds, says: “There is a need for people to understand the complexities [of longevity swaps] because they do not want to be held to account in the future for doing something that turns out not to be a de-risker, but causes problems later on.”

Enhanced transfer value

Enhanced transfer value (ETV) exercises are also likely to make a comeback after slipping into relative obscurity last year. An ETV is used as an incentive for members to leave the scheme. This is particularly suitable for employers that believe the cost of the transfer value in addition to any enhancement is less than the liability or the cost of managing this.

For example, it may cost an employer £200,000 to fund the cost of an individual’s pension, compared with a transfer value of £150,000. If it can persuade the member to take an ETV of £180,000, it will have reduced the cost of the liability by £20,000.

The reason for ETVs’ popularity is a fall in corporate bond yields, which means some employers might be able to make a profit by using them to manage their liabilities.

“Bond yields have fallen in a big way in the last few months,” says Mullins. “Effectively, that means what was £70,000 in the company’s accounts is probably now £95,000, whereas previously, £100,000 like for like probably would not have moved much. If the trend continues and bond yields carry on falling, it could even get to the stage where if [employers] do an ETV exercise, they could profit.”

The pace at which the buyout market recovers remains unclear, but one thing is certain: while cash is tight, employers are more likely to spend time investigating which de-risking option is best for them.

Key definitions: buyouts, buyins, longevity swaps

  • In buyouts, pension scheme assets and liabilities are transferred to an insurance company, relieving sponsoring employers and trustees of liabilities. Buyouts are traditionally used to secure members’ benefits during a scheme wind-up.
  • Buyins effectively insure benefits for a selection of pensioners, allowing trustees and employers to continue to manage the scheme and effectively retain its assets.
  • In longevity swaps, an employer buys into an agreement with a provider and either pays them if pensioners die off sooner than expected, or receives money back if members live longer than anticipated.

Case Study: RSA ensures risk reduction

In July, RSA Insurance Group and its UK pension schemes’ trustees unveiled a de-risking strategy to reduce the plans’ exposure to longevity and market risk.

RSA insured £1.9bn of the schemes’ liabilities with Goldman Sachs International and Rothesay Life, which covers about one-third of RSA’s UK pension liabilities.

This allows RSA to take advantage of market conditions to enhance returns and eliminate inflation, interest rate and longevity risk on about one-third of the schemes’ liabilities. This has been secured with no change in the risk profile of the schemes’ assets.

The schemes retain legal ownership of the assets, which remain invested in a high-quality, low-risk portfolio of UK gilts and other UK government-guaranteed bonds. This is similar to a bulk purchase buyin annuity contract, but with enhanced security.

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Andy Haste, RSA group chief executive, says: “We are pleased to have worked with the trustees to deliver a strong solution which takes advantage of market conditions. Following action taken in previous years, the schemes were strongly positioned to achieve this next step.”

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