3 August 2020
For many schemes there has been a move towards pensioner buy-in transactions as a de-risking step as schemes progress on their de-risking journeys and seek to reduce the risk to member benefits.
Is this, as many schemes believe (and as has been the case for 7 of the 20 largest full buy-ins/buyouts), a sensible step along a path to full buy-out? Or does it make securing benefits in full at the point of final buy-out harder, not easier?
It is first worth a reminder of the reason why pensioner buy-ins have been so popular. Pensioner buy-in pricing has been attractive for a number of years, with pensioner buy-ins funded from gilt holdings typically leading to an improvement in scheme’s funding positions with no company cash required.
A series of buy-ins over time can also be an efficient risk management. Let’s look briefly at a couple of key points.
As schemes move towards lower risk investment strategies, longevity risk becomes increasingly dominant. A pensioner buy-in offers a way to hedge longevity in incremental steps; in the same way that schemes have slowly increased interest rate and inflation hedging over time. Reducing longevity risk in this way can be more efficient as it avoids any single risk becoming dominant.
Another risk addressed by buy-ins is insurer pricing risk. A worsening in pricing could happen for a range of reasons, for instance due to changes in regulation. Arguably the biggest risk for many schemes’ journey plans is that insurer pricing increases in the future by, say, 5% making full buy-out unaffordable. A series of buy-ins provides protection against a worsening in future pricing, helping schemes lock into the average pricing over time. This approach is no different from any large investment, spreading the investment helps smooth out pricing volatility.
For larger schemes a series of smaller buy-ins can be more cost effective than a single “mega” transaction. Insurers only have a limited pipeline of attractive assets to support their best pricing. So, by being flexible, a well organised scheme can seize those pricing opportunities as they arise. In contrast, a single mega transaction will be very reliant on the assets insurers have available at the time.
Lastly, pensioner buy-ins also have softer benefits. A full buy-out is a complex transaction, so undertaking a more straightforward initial pensioner buy-in is a valuable learning experience. It is also a clear demonstration to the market that the scheme is well prepared and willing to transact.
Despite the benefits of buy-ins, there are pitfalls to avoid which, if not properly navigated, can ultimately make it harder for the scheme to move to buy-out. For instance:
- Reduced level of engagement from the wider insurance market; or
- Allocating more assets to the pensioner buy-in that the scheme can afford; or
- Costly/difficult to insure residual liabilities; or
- Restricting options for residual risk cover on buy-out.
Firstly, obtaining strong insurer engagement is central to achieving the best pricing. Approaching the market for subsequent transaction(s) needs to be done carefully. Other insurers may view the incumbent insurer(s) as having an advantage in any transaction and so be less likely to agree to quote, or to allocate their best assets to the pricing. It’s therefore important to consider this upfront.
But having an existing buy-in can also be very positive. Building strong relationships with insurers through an initial buy-in can have powerful benefits. For larger schemes appointing a panel of insurers with umbrella contracts as part of a phased buy-in strategy can provide better engagement from key insurers. This approach has been adopted by, for instance, ICI and Pearson. Even for smaller schemes, it is possible to ensure the wider market is interested in participating; LCP has plenty of recent experience of helping trustees with existing buy-ins get engagement in the market and secure buy-out with a different insurer.
Secondly, it is vitally important for any pensioner buy-in to be sized appropriately. This is to ensure the remaining invested assets can generate sufficient return to close the gap to buy-out over the desired time-frame, whilst providing sufficient collateral for the wider hedging strategy.
The other risk arising from undertaking a pensioner buy-in is that you are left with an expensive, difficult to insure, set of residual liabilities. Insurer appetite for non-pensioner liabilities has improved in recent years but they remain more expensive and are best insured alongside pensioner liabilities to provide balance.
Before entering into an initial buy-in, consider how the scheme’s membership profile and asset strategy will evolve over time as that is key to sizing the initial buy-in and when to extend it in future. But be reassured that even if you do reach full buy-out quicker than expected, we have achieved attractive pricing recently for several deferred heavy schemes (for instance the Post Office scheme was almost entirely non-pensioners).
The final potential issue is the availability of residual risks cover (which covers the cost of correcting any inaccuracies in data / benefits found in the future) from the chosen insurer at the point of buy-out. This cover is purchased in a majority of full buy-ins/outs over £250m and typically comes into effect at the point of the final buy-out. This cover involves intensive due diligence on the data and benefits to agree the price and terms and if this is not completed as part of the initial buy-in when there is competitive tension then it may result in less favourable terms, or even no cover at all, from the incumbent insurer at the point of buy-out. There have been innovative solutions in specific cases (e.g. the insurer for the final transaction providing “wrap-around” cover across all existing buy-ins). However, where residual risk cover will be important, it is worth considering this is as part of the initial buy-in noting the additional work involved, particularly on data/benefit due diligence.
So in conclusion, is a pensioner buy-in a hindrance to full buy-out? Not if done properly; a phased buy-in strategy can help schemes reach full buy-out with greater certainty and at a lower overall price.