In this blog, Yadu Dashora explains three red flags that could signal that a buy-in is not a good idea for your scheme (at least not right now).
An increasing number of pension schemes are using buy-ins as part of their long-term de-risking strategy, and recent market volumes are backing this up. We’re also seeing some of the most attractive buy-in pricing (compared to holding gilts) for years, so demand from pension schemes is only likely to increase.
Many trustees I talk to are asking if they should be looking at a buy-in given the current good pricing. But a key question they should first ask is “does a buy-in make sense for my scheme at the current time?”
To help you decide if a buy-in does make sense, here are three red flags that may signal that a buy-in may not be a good idea for your scheme, at the moment at least.
1. Longevity risk is relatively small compared to other risks
Longevity risk (the risk of members living longer than expected) will increasingly dominate as a scheme matures and takes steps to reduce interest rate, inflation and investment risks. Hedging longevity risk (eg through a buy-in) before it becomes dominant is sensible but if longevity risk remains small compared to other risks then a buy-in may not be the most efficient first step.
If this is you, consider other actions such as increasing interest rate hedging or reducing exposure to return-seeking assets. Longevity modelling tools, like LCP LifeAnalytics, can help by measuring longevity risk so you can easily get an idea of how dominant it is for your scheme compared to other risks.
2. The remaining assets after the buy-in are going to have to work too hard
Most schemes have a deficit and are relying on investment returns (and contributions) to make up this deficit. If the buy-in means selling return-seeking assets that you are relying upon to plug the deficit, then the remaining assets either have to target a higher return, or you have to accept a longer period to reach full funding.
If you are in this situation, you could consider insuring a smaller subset which can be accommodated more easily within your investment and funding strategy. This could still allow you to hedge some of your longevity risk and provides a platform for extending the buy-in over time as capacity to do so emerges.
3. The buy-in could limit your ability to hedge your interest rate and inflation risk in the future
Schemes typically use long-dated gilts and Liability-Driven Investments (LDI) to hedge interest rate and inflation risk. Exchanging these assets for a buy-in tends to offer the best value but can limit your overall hedging. You need to ensure you have enough assets after the buy-in to maintain your hedging (potentially through rebalancing), both now and for any future increases in hedging. This is particularly important for cashflow negative schemes where, if you run out of liquid assets, then you may be forced to sell return seeking assets to maintain hedging or meet benefit payments.
If your hedging arrangements are constraining the assets available for a buy-in, then a longevity swap might be a good way to hedge longevity risk instead. This would allow you to retain full flexibility to invest your assets as you wish, which you can use to hedge other risks or target a higher return. Indeed, a combination of a buy-in and longevity swap may be optimal for some large schemes.
My advice is that a buy-in is an excellent risk-reduction strategy, as long as you are in the right position to benefit from it. Trustees and sponsors should make sure they understand and check for these red flags before taking this route, because sometimes the best buy-in approach is to not buy-in at all (at least not right now).