Bulk Annuities Panel (March 2008) - Adding up the costs

The panel

Chairman: Clive Wellsteed, partner, Lane Clark & Peacock
Wellsteed is a partner on LCP’s buyout advisory team, advising on some of the defining buyouts of 2007. He is a regular conference speaker and commentator on the buyout market, with a decade of industry experience at LCP.

Mark Wood, chief executive officer, Paternoster
Wood held a number of senior positions in the financial services industry (including chief executive, Axa UK and chief executive, Prudential – UK and Europe), before setting up Paternoster, the insurance company that takes on the risks associated with defined benefit pension schemes, in December 2005.

David Evans, business development director, bulk annuities, Legal & General
Evans is a qualified actuary based at Legal & General’s office in Surrey. His focus is on product development, pricing and the marketing of the company’s bulk annuity products. Evans joined Legal & General in 1996 initially as a member of its financial reporting team and has now been working in the bulk annuities business for over eight years.

Tony Read, product development manager, AEGON Trustee Solutions
Read is responsible for the design and implementation of new products and services. AEGON Trustee Solutions is a leading provider of bundled defined benefit scheme solutions including and bulk buyout annuities.

Andy Reed, director, wholesale pensions solutions, Prudential
Reed is a qualified actuary with over 20 years’ experience in the UK insurance industry. Having implemented various significant bulk transactions, Reed is currently responsible for Prudential’s innovation within the DB market.

Joseph Collins, actuary, Lucida
Collins is a financial reporting actuary at Lucida


WELLSTEED: The Accounting Standard Board recently proposed using “risk-free” discount rates to measure pension liabilities in company accounts. For many companies this would recognise pension liabilities at close to the cost of buyout. Do you think the proposals a reasonable way to account for pension liabilities and would such a change push buyout higher up the corporate agenda?

WOOD: Arguably the risk-free rate is too cautious to discount the future obligations of a pension scheme.
The rationale is superficially attractive. A company takes commercial risk while the promise to pay pensions should be secured without exposure to risk. To the extent that the scheme is under-funded it carries the risk of the corporate sponsor being unable to meet funding obligations. That risk should not be compounded by investment in assets that add risk to the promise to pay pensions.
This philosophy however overlooks a fundamentally important point. Pension assets are held against liabilities for the payment of those liabilities over the long term. Risk-adjusted returns, which incorporate appropriate reserves for defaults, provide an optimal route to funding pension scheme liabilities. Insistence on a risk-free rate will escalate the costs of defined benefit schemes and place further pressure on corporate sponsors, with the rather inevitable result of additional scheme closures.
There will be cases where the imposition of this accounting standard will cause the cost of pension liabilities to rise above the level of buyout. Even where this is not the case the gap between the disclosed cost of the pension scheme and the buyout cost will narrow appreciably. As the gap narrows towards a reasonable risk premium, the demand for buyout must be expected to escalate.

EVANS: The question all interested parties should ask is “What is the true cost of the pension liabilities?”. These are currently calculated making reference to the returns available on high-quality corporate bonds. The yields on these bonds exceed the yields on government gilts to reflect the risk (default risk) that the corporate bonds may not deliver the required return. In the current credit crunch, yields on corporate bonds have increased further to reflect the increased perceived risk to the cashflows from those bonds.
However, current pension accounting conventions make no allowance for the risk of default within the yield used, meaning that the increased yields offered by corporates at present are simply translating into an improved level of funding for the pension scheme.
The plan to move from corporate bonds to “risk-free” discount rates for valuing pension liabilities will remove this anomaly in the current accounting convention. Within the industry this move is being viewed as just one more increment in the ever-increasing regulatory burden on defined benefit pension schemes. However, the implementation of this proposal would bring pension scheme accounting methods more in line with insurance companies, most of whom now use or are moving towards market consistent reporting.
If the discussion paper on this proposal becomes reality then defined benefit schemes will become even less attractive for companies to retain on their balance sheet. However, the proposal would seem to be an appropriate method of accounting for pension liabilities and will not create the subsequent issues but will purely highlight the previously hidden costs.

READ: There is something of a mixed bag in the ASB’s paper. Whilst moving to a risk-free rate such as gilts will certainly increase a scheme’s liabilities, not allowing for any future salary increases would, on the face of it, reduce a scheme’s liabilities. However an increasing number of defined benefit schemes are paid up with no active members and for them the question of future salary increases will not arise.
Overall therefore the proposals can be expected to increase liabilities but this will also go some way towards removing the differential between ongoing and buy out costs. This last point probably will push buyouts higher up the corporate agenda and yes may well lead to more taking place but links in with other aspects discussed below. It is also worth pointing out that so far we only have a discussion paper and which is open to comments until mid July after which the IASB and FASB will decide. However we know that the ASB has a fair degree of influence.

REED: These proposals present an accounting basis that will be closer to the true costs of funding a scheme, but will also make life tougher for many scheme sponsors to account for. However, our understanding is that any new accounting standard will not come into place until 2011 at the earliest. Pension scheme finances are already an increasingly prominent item on the corporate agenda and we expect this trend to continue following these proposals, with an increasing number of schemes looking to de-risk their liabilities, through buyouts and other solutions.

COLLINS: From an accounting perspective the proposals do not seem unreasonable since use of “risk-free” discount rates would enable direct comparison between different companies without adjustment and the accounting would be consistent with the way in which companies are required to value other assets and liabilities.
However there is a risk that the apparent deterioration in funding position (from, an accounting perspective) has unintended consequences such as forcing companies to increase contribution rates. We do not believe this is appropriate, since companies should be permitted to take account of the scheme’s investment strategy in determining future contribution rates.
Whether this balance sheet impact will force buyout higher up the corporate agenda is debatable, as we believe that buyout is already high on the agenda of many companies.

WELLSTEED: How has the credit crunch, and the resulting turbulence in financial markets, affected schemes going through the buyout process?

WOOD: In general not at all. The vast majority of schemes with which we are working are progressively de-risking or have already completed the transition from the long-term portfolio operated historically (which often includes a large proportion of risk assets including equities), to the post buyout target portfolio.
Typically, this portfolio more closely matches the duration of the pension scheme than the one run by the corporate sponsor through the pension trust. It also incorporates greater inflation protection and matches more closely the risk adjusted cash flows (including the provision for default) to those of the liabilities.

EVANS: Financial market turbulence can cause a great deal of uncertainty for trustees going through the buyout process. Buyout quotations are produced on certain financial conditions, and a shortfall or surplus will be determined, but in a turbulent market, by the time the assets are transferred the asset values and buyout prices may have changed significantly. To counter this uncertainty, Legal & General offers trustees the ability to lock into financial conditions once the buyout decision has been made. Alternatively, we can hedge the funding level volatility risk on behalf of clients.
The credit crunch and the resulting turbulence in financial markets has further demonstrated the risks of holding pension liabilities on a corporate balance sheet.
Throughout this recent period of volatility we have seen significant falls in equity values but little change to gilt and bond prices. Pension schemes are generally seeing falls in the value of their assets. However, the spreads on corporate bonds used by insurance companies have risen dramatically meaning that the buyout cost has fallen by more than the fall in an average schemes asset portfolio.
According to our figures, scheme funding levels compared with the buyout cost have risen to a multi-year high, suggesting that now is an excellent time to consider buyout.

READ: It is apparent that DB de-risking remains high on the corporate agenda and is likely to remain there for reasons discussed. Along with the uncertainty of the full impact of the credit crunch many trustees are facing falling a value of scheme assets plus falling bond yields all of which make immediate full buy out that much harder.
However we are also seeing this year, and especially at the larger end of the market, a realisation that immediate price is not the only driver. For example there is increasing interest in structured phased buy out solutions such as AEGON Trustee Solution’s joint venture with UBS called Affordable Risk Transfer Solution.

REED: Recent economic turbulence has highlighted one of the key reasons why more schemes are looking to de-risk, with many pension funds fluctuating between surplus and deficit. Any negative market outlook may lead to increased buyout activity – particularly for schemes funded close to the buyout cost. Ironically, the credit crunch fallout may have put off some schemes already considering buyout, due to affordability.
For those already going through the buyout process, there has been heightened focus on securing the best price, while schemes approaching buyout have felt an increased pressure to transfer from equities into bonds – and quickly! In some cases, pressure has even been applied to providers to accept equities as part of an in-specie transfer arrangement.

COLLINS: Most pension schemes have been adversely impacted by the credit crunch and resulting turbulence in financial markets:
• Credit spreads have widened leading to a fall in bond values;
• Deteriorating market sentiment has led to a fall in equity values;
• A reduction in liquidity has made it difficult for schemes to sell or even value certain assets, in particular property and some infrequently traded bonds; and, generally,
• Asset valuations remain very volatile.
The turbulence in the markets has again highlighted the risks that pension schemes are running by having a mismatch between assets and liabilities.
Schemes going through the buyout process are particularly exposed to changes in asset value between the point they decide to buyout and the time when liabilities are transferred. Not surprisingly, they are keen to identify mechanisms which allow them to lock in economic conditions to insulate them from sub-sequent turbulence. Lucida and other buyout companies are working to achieve this.


WELLSTEED: The buyout market in 2008 is expected to be the industry’s busiest year yet. How will you manage your resources to meet this demand? Will certain quotations be prioritised over others?

WOOD: We set up Paternoster with the expectation that the market for the transfer of pension liabilities by solvent companies to an insurer would grow rapidly. We anticipated that as companies became more aware of the financial cost of rapidly improving life expectancy and the need to more closely match assets with liabilities in order to comply with an ever more stringent accounting standard (the ASB have gone further than we anticipated), then they would see the merit of moving risk off balance sheet to the ‘safe haven’ on an insurance company. This is happening. The market in Q1 2008 looks like it could be larger than that of the whole of 2007. We might see something in excess of £10bn of buyouts in 2008.
Paternoster was set up to operate at these market volumes.

EVANS: 2008 has indeed been very busy so far and additional resource has been brought in to ensure Legal & General can continue to service the bulk annuity market to the high level that is expected of us.
While we realise that certain schemes are more time intensive than others, we committed 21 years ago to providing buyout solutions to all schemes. Accordingly our policy will remain consistent, even in the new highly competitive market. Rather than focusing exclusively on the larger-scale (and typically more lucrative) end of the buyout spectrum, we remain committed to servicing the full spectrum of this potentially substantial market.
Legal & General has highly efficient quotation, installation, and administration processes and a team of trained staff who have the skills and flexibility to focus on handling business aspects as and where they are most needed. Despite this, there is clearly a limit to the numbers of schemes that we can quote for or buyout at any one time.

READ: At Aegon Trustee Solutions we indeed expect 2008 to be a good year for bulk buyouts as we continue to develop existing, and launch new, propositions. To meet the expected demand we continue to invest heavily in experienced quality staff and also top end modern systems providing greatly enhanced capability in terms of scheme size and speed of production. We are planning still further systems developments to increase even more the degree of automation in the quotes process.

REED: As ever, Prudential will assess each case on its own merits. However, new proposals from FAS and the PPF mean that smaller pension funds are less likely to come to market, so, much of the anticipated activity is likely to be centred around schemes with larger liabilities. This may result in fewer transactions overall, but of a more significant size.
Prudential is well placed to manage such deals and our specialist in-house team has an excellent track record for successfully implementing numerous large transactions. This includes some of the largest pension scheme buyouts (totalling over £4bn), plus significant annuity ‘backbook’ arrangements with other insurers – such as the £1.7bn transfer from Equitable Life.
The pensions minister’s recent announcements also indicates the Pensions Regulator could be given additional powers in relation to the regulation of buyout activity to ensure the ongoing security of the plan. Therefore schemes will need to carefully consider the financial strength of any buyout provider and the likelihood of long-term stability.

COLLINS: When considering the strength of a scheme’s mortality assumptions, it is not sufficient to focus on future improvements alone. It is those improvements combined with the underlying base mortality table which drive life expectancy.
When setting our reserving assumptions we consider both the appropriate base table and future improvements. These are tailored to individual schemes based on a range of factors including: socio-economic profile of the membership; industry data; occupation of the members; and an analysis of the scheme’s own mortality experience. That said, in general our assumptions are consistent with The Regulator’s focus on the “long cohort” projection with an underpin.

WELLSTEED: The regulator has proposed that schemes with an inadequate allowance for future improvements in life expectancy in their funding valuation will face increased scrutiny. How does The regulator’s focus on the “long cohort” projection, with an underpin on the level future improvements, compare to your own reserving assumptions?

WOOD: The regulator’s basis almost exactly matches the approach we have adopted.

EVANS: Legal & General continuously monitors its mortality experience against benchmarks, and will update its assumptions as and where necessary.
The strength of an insurance companies reserves depends on the combination of many reserving assumptions. The main assumptions are investment returns, base mortality, mortality improvers, and proportions married. When considering the strength of individual insurance companies reserving bases, all these elements should be considered in conjunction.
Legal & General is more than comfortable with the strength of the reserves held to back our annuity liabilities.

READ: An interesting area which we are following with interest noting that the consultation runs to 12 May this year and that the proposals will apply to recovery plans for valuations with effective dates from March 2007.
Our view is that as a result employers and trustees should consider very carefully their current assumptions and the likely impact if a revision is needed. As with the possible changes outlined in the ASB paper, a reduction in the differential between ongoing and buy out costs is likely to see an increase in the volumes of schemes buying out.

REED: The Regulator’s position is a step in the right direction, and usefully forces this most critical of assumptions up the agenda of trustees, corporate sponsors and their advisers. We have long held the view that the allowance for future mortality improvements made by many pension schemes is inadequate.
That said, we caution against the blinkered use of the long cohort projection basis. A scheme’s mortality assumptions should reflect its own experience where appropriate and the regulator must recognise, as we do, that there are clear socio-demographic differences in both current mortality and the rate of mortality improvement. For certain schemes long cohort will be a perfectly appropriate basis, while for others it will not and a weaker or stronger basis may be more sensible. The selection of mortality improvement assumptions should be both considered and evidence-based.

COLLINS: We certainly expect the buyout market to grow in size in 2008 and have planned accordingly. From a human resources perspective, we have been building significant in-house capability to meet projected demand. In the event that we need to call on additional resources we have agreements in place with external providers.
In addition, before agreeing to provide quotations, we prioritise activity by considering the size of the potential transaction, the likelihood of the scheme transacting and the timescales proposed for the transaction.
From a capital perspective, Lucida’s financial backer – Cerberus Capital Management – has already committed £1bn of capital to the business. In addition, Cerberus has indicated it is prepared to provide further capital as the market expands.