As schemes move towards cashflow negative status, many are looking to insure their members' liabilities. James Phillips explores creative ways to approach buy-ins
De-risking is an important part of any defined benefit (DB) scheme's journey to self-sufficiency and end of life, leading to billions of pounds of deals with insurers over the past few years.
In the first half of 2017, more than £5bn of buy-ins were completed, almost double the amount agreed in the same period in 2016.
However, there is concern that schemes may be de-risking the wrong tranche of members - those aged over 70 who may die before the scheme reaches a point where it is able to afford a buyout. According to Punter Southall, this can mean the schemes end up not as far down their de-risking journey than they had hoped.
In addition, de-risking this tranche of members can swallow the 'safer' assets - gilts and corporate bonds - leaving the remaining members in perhaps a more precarious position, relying on the riskier assets such as equities.
Yet the industry has seen some creative deals, particularly over the last year, so are schemes moving away from this age-based approach?
Punter Southall head of de-risking solutions Colette Christiansen previously told PP that schemes may not be extracting as much value as possible from their buy-ins, pointing to historical de-risking deals.
This is particularly important, she said, where trustees have a long time horizon in which to move themselves to a position where they can afford a buyout and, by de-risking the older members alone, it may be the case that not as much risk is removed from the scheme as hoped.
"Over the next five to 10 years, the supply/demand balance is going to move in favour of the insurers, and therefore buying a tranche of bulk annuities now does make sense," she said.
"We have seen a lot of schemes doing that, but what we haven't seen as much as we should have is people maximising the value from that transaction and really putting it into their journey plan.
"The key question people don't necessarily ask is 'when am I likely to be able to buy out?' We've seen schemes who did a pensioner buy-in in 2008 - after nearly 10 years a substantial number of those people are now dead. They've insured people who are no longer alive, which doesn't really get them further towards their goal."
The younger cohort of pensioners carries more risk to a DB scheme than the older cohort, namely due to continuing improvements in longevity driven by medical enhancements. Therefore, it makes sense to focus insurance policies on this group.
However, the cheaper policies associated with the older members may be a driving factor in seeking these deals solely for them. BlackRock director of client solutions Vivek Paul explains the reduced longevity risk allows insurers to offer better pricing.
"What you need to consider here is what the insurers are considering when they're pricing liabilities," he states. "One of the functions is the likely longevity risk of these guys and therefore you might expect to see - all else being equal - keener or more competitive pricing for people who are very old because they are going to have shorter mortality."
Yet Pension Insurance Corporation (PIC) head of origination Jay Shah argues schemes are moving away from this mind-set and seeking more "creative" solutions that split scheme members by characteristics other than age.
"We're seeing far less of the crude approach of insuring all the over-70s and not insuring the under-70s," he states. "We're finding that is more of a rarity and trustees are asking for pricing across a range of different slices; there is more sophistication."
He explains that trustees are not simply dividing members into tranches by age, but are seeking more creative solutions based on socioeconomic factors such as pension pot size and location, or insuring base benefits without future increases or spousal entitlements.
"What you sometimes see is that trustees are keen to insure members with the highest pensions - not necessarily because they will be more expensive because they're expected to live longer, but because they represent concentration risk.
"As a rule of thumb, you find that the top 10% of scheme members by amount of pension represent something like 50% of the total liabilities of the scheme."
However, the question is not simply about the members who are insured, but the timing of the deals.
Lane Clark & Peacock (LCP) partner Charlie Finch agrees, pointing to the Philips Pension Fund, which insured all members over four deals, before completing a £2.4bn buyout in November 2015.
"By splitting it up in that way, it was able to access better pricing than if they had done it all in one go, partly because different insurers have different sweet spots," he states. "For example, in its very first buy-in, it chose to do a £500m subset of the highest paid pensioners.
"That went to Rothesay Life, which was able to offer particularly attractive terms at the time because of a longevity reinsurance deal in the background. It was keen to take on white collar higher paid lives to offset a lot of blue collar lives they'd taken on elsewhere.
"Then in June 2014 they did the younger pensioners because that was when the pricing was better."
What is perhaps most important in assessing the value for money a buy-in might provide is the various forms of risk that can be removed during the process, rather than the immediate value of liabilities it could remove.
On top of this, it is also important for schemes to consider their asset allocation when looking to do such a buy-in. The older the members in a scheme, the more likely that it is invested in safer assets such as gilts or corporate bonds.
BlackRock's Paul adds that the residual asset mix is an important part of the decision-making process.
"Let's imagine your pension fund is 50% pensioners and 50% non-pensioners, and you are holding 50% of matching assets and 50% of equities," he explains. "If you were to buy-in those pensioners, and you passed over all your matching assets, then what are you left with? Equity to match all your non-pensioners and maybe that's not right.
"The broader question for pension funds is, when they're thinking about these strategies, is the residual mix appropriate for those members?"
Buy-ins are concentrated on pensioner members, yet there is perhaps an argument that deferred members may also be a good section to insure.
These members hold a significant amount of longevity risk, and so removing that risk would go some way to halting a scheme's increases in liabilities.
However, pricing for deferred members is much higher than for pensioner members, particularly since the introduction of Solvency II regulations, which requires insurers to hold more capital depending on the longevity risk they are exposed to.
PIC's Shah says: "Our experience is that pricing has gone up but not by as much as we'd anticipated at the start of 2016 when Solvency II came in," he says. "Insurers have had to hold more capital for the deferred members, and that effects pricing.
"What we find is the focus tends to be on pensioners and, ultimately, deferred members get insured as part of a full scheme buyout, rather than individual tranches."
Purchasing a buy-in for deferred members will clearly depend on each scheme's financial circumstances, BlackRock's Paul argues, adding they therefore need to consider the pros and cons of such a deal.
"Prices have clearly gone up for deferred members," he argues. "It's worth schemes questioning whether or not it is the right call for them to go down this route. There are arguments for and against the passing of benefits over to an insurer, and clearly one potential con here is there is a material cost.
"It's worth questioning, given where non-pensioner pricing has moved to, whether or not it is the right move for all pension funds."
What is the takeaway message for trustees looking to insure some of their members? For LCP's Finch, they need to undertake a cost benefit analysis.
"For smaller schemes you clearly have more limited room to manoeuvre," he states. "It's the very largest ones where it applies the most, and they should be thinking about, a) what impact it will have on their asset strategy and, b) which subset will offer the best value."
Aviva Life & Pensions has concluded an £875m buy-in with its own staff pension scheme, following on from a similar transaction last year.
Just Group has completed a £74m pensioner buy-in with the UK pension scheme of a US-listed engineering business.
The Smiths Industries Pension Scheme has secured a £146m buy-in with Canada Life in its fourth bulk annuity and its sponsor’s tenth overall.
The Prudential Staff Pension Scheme has entered into a £3.7bn longevity swap with Pacific Life Re, insuring the longevity risk of over 20,000 pensioners.
The Baker Hughes (UK) Pension Plan has secured approximately £100m of liabilities through a buy-in with Just Group.