 By Tiziana Perrella FIA, Principal, JLT Employee Benefits
The reports published regularly on the buyout market always stress how successful the market has been over the past few years. The various consultancies and insurers writing these reports are of course correct – against an extremely challenging economic and financial background the market has proved very resilient, with over £40bn worth of deals (buyouts, buy-ins and longevity swaps) being completed between 2008 and 2012.
However this is only a tiny proportion of the >£1trn defined benefit liabilities that exist in the UK. The majority of employers have continued to pay ever growing contributions that have mostly failed to impact scheme deficits in any meaningful way.
It seems to me that the most interesting aspect is not how many schemes have completed deals, rather, why so few have. While affordability is the key factor, I would argue that a lack of appreciation of the value of a bulk annuity is also responsible. I have set out below some scheme profiles which would most likely benefit from engaging with the market at an early stage.
Schemes with large gilt holdings
Falling gilt yields have brought healthy gains to schemes with significant gilt holdings. For these schemes, the buyout funding position has most likely improved over the past year and some have been able to do a straight exchange of their gilt portfolios for a bulk annuity policy, effectively de-risking their longevity for free. While it is hard to estimate a timescale for gilt yields to normalise, there is an expectation that they will do at some point. Pension schemes could cash in their gains and re-risk, however this sounds less than desirable if, as is likely, the gilt portfolio was not held on a speculative basis but as a relatively close match to pensioner liabilities. In these circumstances there does not seem to be any clear advantage in holding a gilt portfolio for the longer term. Affordability has in fact decreased over the last few months due to increases in the expected rate of inflation; engaging with the market and agreeing a contract structure / trigger point in advance will ensure that a transaction can be undertaken when circumstances allow.
Schemes with risky mortality profiles
While the attention of the specialised press tends to be focused on larger schemes, there are around 5,000 schemes in the UK with assets of £20m or less, usually sponsored by very small employers. These schemes are likely to have a significant proportion of the liabilities shared among a small number of members, normally the owners of the business or the senior management. The life expectancy of these individuals will have a fundamental impact on the financial health of the overall scheme, however this additional risk is rarely taken into account in selecting the mortality assumptions for the funding basis. This skews the risk attaching to the scheme for both the trustees and the sponsor. A solution which may best fit these schemes is an “underwritten” bulk annuity, i.e. a contract for which the pricing takes into account summary medical information collected from the members, and from the key lives in particular. This market is new but growing rapidly and we anticipate more entrants and a streamlined process to develop over the next few months.
Schemes undergoing an actuarial valuation
Trustees of schemes which are undergoing an actuarial valuation know that they will have the employer’s ear while the schedule of contributions and recovery plan are finalised. This could be a great opportunity to check whether some of the scheme liabilities can be passed to the market at a price close to Technical Provisions. If this is the case, a deal could be struck without the need for any additional funding negotiations. While insurers are reluctant to get involved in purely speculative cases, they are usually happy to assist with a preliminary assessment of what could be affordable. An efficient discussion could involve the disclosure of the full scheme data and proposed funding basis, so that an acceptable size and shape for a transaction can be identified in advance.
Schemes with a weaker employer covenant
Trustees of schemes with a weaker covenant would be expected to want a reasonably accurate understanding of their buyout position, as the likelihood of these schemes being run off is smaller. “Weaker” schemes are probably on average more poorly funded; however the pressure to secure segments of the liabilities as and when they are assessed to be affordable may well be higher.
The above list is of course far from exhaustive. While a bulk annuity purchase may not be available to all schemes, there is no doubt that many more schemes wishing to de-risk could afford some kind of deal to fit their circumstances if they investigated the market properly. Securing the right policy is a process which can take a considerable amount of time to complete, as it requires the input of all stakeholders in the scheme, with their different objectives and priorities. The difficulties are exacerbated in a volatile financial environment and adverse economic conditions. A clear understanding of the market and the position of the scheme within it is crucial for a transaction to proceed.
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