Interest in buyout has surged among defined benefit schemes as the gilts crisis and favourable market moves have significantly improved funding positions over recent months. According to Barnett Waddingham’s DB End Gauge tracker, the average time for UK Pension schemes to be fully funded on a buyout basis is now only just over five years. AXA IM believes that over a quarter of schemes are now fully funded on a buyout basis, with anecdotal evidence suggesting it could be far higher, given the recent increase in gilt yields to levels not seen since the September 2022 mini-budget.
While good news for trustees with schemes in this position, Lionel Pernias, AXA IM’s Head of Fixed Income Investment Solutions, says widespread demand for full risk transfers has created a growing mismatch between supply and demand, with the market potentially more constrained than many realise.
He says, “Forecasts suggest that record numbers of risk transfers will be completed in the coming years as more schemes become fully funded on a buyout basis, but the market has limited capacity. Not only are there just eight insurers in the market and high barriers to entry, but there are other major hurdles to buyouts happening on the scale being assumed.
“Trustees have been told for a long time that a buyout is contingent on their funding status and little else, but the reality now is there is an unprecedented supply crunch, which means they could find themselves at the back of a queue that they didn’t know existed – and which is only getting longer.”
Pernias identifies a number of barriers both for trustees and insurers that could hinder schemes’ ability to buyout over the next three years. On the insurer side, he notes that two of the biggest potential issues are a lack of capital and difficulties sourcing suitable assets.
“One of the major hurdles is that insurers need capital to underwrite deals to meet their solvency ratios and they only have so much of it – the assets they will receive from pension schemes will not cover it,” he says.
“The other prominent issue is the lack of sourcing suitable assets. Insurers need to put their capital to work in high-quality public and private debt markets to ensure that cash flows match the liabilities under the matching adjustment framework. But there is a limited number of these assets and a shallow supply pipeline given the end of the unwind of the Bank of England’s corporate bond purchase programme. To make matters worse, there are fewer issuers coming to the GBP market with insurer-friendly new supply in 2023. If insurers cannot source those assets, they will not be able to underwrite the deal.”
Even if insurers are able to source the necessary capital and assets, schemes themselves must still contend with a number of challenges that could impair their ability to transfer as soon as currently intended. For example, they will still need to embark on the laborious task of cleaning member data, which Pernias says takes a significant amount of time, particularly if they have tens of thousands of members.
Moreover, insurers may become more aggressive on pricing given elevated demand, or leave a margin of risk for data uncertainty and start to take a highly selective approach amid closer regulatory scrutiny of deal volume.
“It should not be overlooked that many schemes, even if they are well funded, might still have long dated and illiquid assets that they can't easily sell, and insurers may not want those because they could be unsuitable for matching adjustment or the overall risk profile,” Pernias says. “That could add significant cost, but also be time consuming, as schemes are forced to sell those assets.”
With schemes potentially facing much longer waits to achieve a full risk transfer, he argues that trustees need to prepare for the possibility that they are held in a “holding patten” with no clear end point.
“Schemes need a Plan B if a buyout is not going to happen as quickly as they anticipated,” he says. “That means making sure the scheme becomes or remains buyout-friendly, while maintaining the desired funding ratio and putting any surplus to work.
“In our view, the most effective way they can achieve this is by allocating to credit through cashflow driven investment strategies, which can offer good liquidity, attractive return potential, stable and timely cashflows that could appeal to insurers in future, and ideally a climate-integrated approach that would help differentiate them in a competitive market where ESG risks and commitments are increasingly central. Credit is also a much better place to be if there is a more severe economic downturn than expected, as funding levels are not calculated on a corporate bond basis.
“It is clear that the buyout market has changed. Today, schemes simply cannot afford to sit on cash for unknown years while they wait to achieve a full risk transfer. Trustees must prepare themselves for a longer wait now.”
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