Following Rolls-Royce's record buyout earlier this month, James Phillips speaks to some of the key players about the process.
The bulk annuity market has landed its first mega-deal of 2019 with a record-breaking partial scheme buyout between the Rolls-Royce UK Pension Fund (RRPF) and Legal & General (L&G).
Valued at £4.6bn, the deal is almost twice as big as the £2.5bn transaction conducted between automotive firm TRW and L&G in November 2014 - and the deal signals the start of a busy year for the buyout market.
Insurers are expecting volumes of bulk annuities to surpass last year, which saw records broken with a total of £24.2bn of buy-ins and buyouts transacted - but 2019 is heading toward £30bn or more.
The RRPF's decision was part of a broader "journey to simply, de-risk and strengthen" the sponsor, its chief financial officer, Stephen Daintith, said when announcing the transaction, with both the trustees and the company having "worked intensely" to get to this stage.
Around 33,000 pensioners have had their benefits insured as a result of the deal, while significant longevity risk has been removed, benefitting the remaining 43,000 members. As the company said: "The residual obligations, which remain well-funded, will be smaller with less risk for the trustee and Rolls-Royce to manage in the future".
But aside from strengthening benefit security and providing longer-term reassurance to the sponsor, the transaction says a lot about the state of the pension risk transfer market.
While the overall market is buoyant, the RRPF deal shows insurers' increasing capacity and willingness to take on high volumes of pension liabilities. For L&G, this also comes hot on the heels of the £4.4bn pensioner buy-in with the Airways Pension Scheme last September, also a record-breaking transaction.
Aon risk settlement senior partner Martin Bird - whose firm provided actuarial, insurance and longevity advice to the trustees - argues the market is going into overdrive.
"The momentum has just gone straight through from December," Bird says. "Looking back at the market over the past few years, it's generally been dominated by large pensioner buy-ins but, actually, that has changed quite quickly and it's now full-scheme buyouts."
The main drivers of this are improvements in funding positions, de-risking of investments, and mortality data updates.
Mercer investment consultant James Maggs - whose firm advised the trustees on investment - notes the scheme had "an extremely well risk-managed investment strategy" over a long period.
"That put them in good stead," he says. "It required collaboration between the trustees and the corporate over a very long period. They were already in a very good position before this transaction, and highly-hedged in terms of their interest rate and inflation exposure."
The improvements seen in the RRPF are representative of a more general trend. The last year has seen significant improvements in funding levels - although against a volatile backdrop - while over £1trn of pension liabilities are now hedged, according to recent XPS Pensions research.
"Schemes have been pleasantly surprised over the past 21 months or so, and perhaps full-scheme buyout is closer than they might have realised," Bird continues.
"A lot of schemes have medium- to long-term plans to get to full buyout, but once you get within spitting distance it crystallises activity and a sponsor might raid a war chest and find some additional cash to get the scheme over the finish line."
Crucial to the RRPF deal was Rolls-Royce providing an exceptional cash contribution of £30m.
As with most bulk annuity transactions, a price-lock mechanism was used, with the value of assets that needed to be transferred to the insurer agreed at an early stage.
"Price locks create a bit of breathing room to then actually have the time to work through all the documentation and complete the deal without either party running the risk that the price moves," Bird says.
This is particularly important as, although the scheme was unable to confirm the timeframe for this deal, multi-billion pound liability transfers can take over a year.
In deciding which assets to transfer, the RRPF used an existing hedging portfolio and longevity swap to its advantage. The hedging portfolio is particularly attractive to insurers, as the low-risk assets are in tune with their preferences, Bird says.
"What a lot of schemes are figuring out is that, rather than disinvest all the assets that they are invested in, they are saying, ‘Well, if we're already invested in low-risk assets that the insurer is likely to purchase anyway, isn't it better to just novate existing assets?'"
In a Solvency II world, Bird argues, insurers are increasingly having to be "very particular about the sorts of assets that they want to invest in" so passing over LDI portfolios makes more sense.
"A big part of the transaction was how that hedging portfolio was taken account of but, more generally, this stuff really drives value and it's a really important part of the economics of the deal."
L&G head of origination and execution John Towner agrees hedging portfolios are useful, but not necessary.
"It's not that those assets were necessarily more attractive to us, it was more that it helps the pension scheme achieve the objectives it wants to achieve from the transaction."
He adds: "By including that portfolio, what they were able to do is move assets as part of the transaction and it's almost like we're getting our hedges.
"That's something you see in bulk annuities quite often - pension schemes will think about the types of assets that they hold, that the insurer may want to keep for the long-run, and they will include them in their premium payment. It's a tried and tested approach within bulk annuities.
Similarly, in a partial buyout situation, it is important for the scheme to continue managing its risk once the deal is done. Maggs explains: "You wouldn't want to transfer assets across which left you, for example, 50% hedged if your target is 100% hedged, because then you'd have to scramble around to rework the investment strategy afterwards.
"That's really important for any size of deal but it's especially important the larger the deal gets because it will take longer to readjust your investment strategy afterwards. Ensuring appropriate continuity of investments while doing a bulk annuity transaction is absolutely key."
Regardless, for the insurer, transitioning that portfolio is cheaper, Towner adds: "Having an existing LDI portfolio does reduce frictional costs when we receive those assets. It makes for a more efficient deal completion."
Similarly, the scheme restructured a £3bn longevity swap agreed with Deutsche Bank in 2011, insuring the longevity risk of 37,000 pensioners.
Many schemes have taken advantage of longevity swaps to reduce the associated risk while also enabling further de-risking on the investment side, in turn often improving funding levels.
As with the hedging portfolio, the ability to use this existing longevity swap facilitated the deal, Bird explains, as hedging longevity risk is more "capital friendly" to comply with Solvency II.
"If you're doing an annuity deal with a pension scheme that's already got longevity reinsurance, it is more economically advantageous for all parties to just simply move that onto the insurer's balance sheet."
The mammoth buyout has some key lessons for other schemes approaching a similar point in their long-term journey - and as this endgame becomes more achievable, it is likely the market will see a large number of buyouts this year and in years to come.
Without specialist help, smaller DB schemes are being left behind in a bulk annuity market increasingly focused on mega-deals, says Rob Dales.
Interest around DB consolidators is high but there remains regulatory uncertainty around their future. Lesley Carline looks at what the future might hold for this section of the market.
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