In this blog, Charlie Finch discusses five key questions you should be asking to understand if you are further along your de-risking journey than you think.
In my previous blog, ‘Pension schemes could bag a bargain in 2018’, I outlined the findings from our latest de-risking report about the favourable conditions in the buy-in, buy-out and longevity swap market.
Indeed, at the end of 2017 around 1 in 5 of the UK defined benefit pension plans of FTSE100 companies were over 80% funded relative to the cost of buy-out, up from 1 in 8 last year. So, on the back of the improved funding and current attractive pricing we are anticipating a marked increase in demand from pension plans to de-risk. Anecdotal evidence is already supporting this with insurers reporting a large increase in pipelines this year.
Given the big stride forward schemes have made over 2017, I have set out below five key questions I think you should be asking yourself about your de-risking strategy.
1) Where would you like to get to?
The way we see it, there are three potential ultimate goals for every pension plan:
i) Firstly, you may wish to run the plan on, with the ultimate goal being self-sufficiency. Under this strategy, the ultimate objective is to be well funded on a low risk strategy, with limited risk of future contributions being required.
ii) Alternatively, the ultimate goal may be to buy-out the pension plan with an insurer, as soon as it is affordable to do so. This is often driven by a sponsor desire to remove the plan completely from the company balance sheet in the short term.
iii) Or perhaps you may take the view that, although the ultimate objective is to fully buy out the pension plan, this is best done by hedging longevity risk for pensioners (e.g. through buy-ins) as members retire, and to benefit from profits as non-pensioners exercise member options over time, and you are comfortable maintaining a reasonable level of risk on that journey.
Buy-ins and longevity swaps can be appropriate for all three strategies. The first longevity swaps have now been converted to buy-ins demonstrating their viability for schemes targeting full buy-out. Buy-ins are gaining increasingly widespread recognition as an attractive low risk asset class that can be held as part of a long-term self-sufficiency strategy.
2) How far away is your goal?
Given the improvements in buy-out funding for the FTSE100, we would be surprised if the funding position of your plan on buy-out is not markedly higher since the last actuarial valuation. Obtain an up-to-date estimate (through your online valuation platform, such as LCP Visualise, or by asking your advisers). Consider any deficit contributions already committed and what the additional cash cost would be to plug the buy-out shortfall.
3) How will you get there?
If the shortfall on buy-out remains unaffordable then consider how else it could be closed. For example, a phased buy-in strategy steadily insuring liabilities over time can achieve meaningful savings relative to the “standard” full buy-out cost – we estimate the ICI Pension Fund has saved over £100m. This approach has now become well established with nearly half of all buy-ins over £100m in the past two years being a repeat transaction for the pension plan. In addition, add in expected investment returns and expected gains from member options and you may find that the buy-out shortfall will close much faster than you think.
4) How do you keep on track?
There are of course other risks which are less easy to measure such as insurer pricing risk – the risk that insurer pricing deteriorates in the future pushing up the cost of buy-out. This is a risk that schemes and sponsors are becoming increasingly live to, with the dynamic currently shifting between pension scheme demand and insurer supply. After all, many schemes are targeting buy-out over a similar timeframe and if they all get there at around the same time then insurer capacity will quickly be exhausted with obvious implications for pricing.
There is a wide range of risks that can blow a pension plan off course such as investments underperforming, inflation or longevity. These risks can be monitored and managed by trustees and sponsors through tools such as LCP Visualise, and action taken to prioritise and tackle them.
5) What upfront work do you need to do?
This is all about having a realistic plan and prioritising the work required to achieve it. When approaching the market insurers will assess your commitment and likelihood of a transaction proceeding. So having a clear plan which you can explain to the insurers and realistic expectations can make a big difference to the insurer engagement and therefore the pricing achieved.
To get more detail around your de-risking options and these five key questions, watch our recent webinar or take a look at our recent case studies to see how others have tackled their de-risking journey:
- The largest buy-in of 2017 – The Pearson Pension Plan
- Reducing sponsor risk through buy-in - The Plumbing & Mechanical Services (UK) Industry Pension Scheme