The return of the buyout

In November 2015, the trustees of the Philips UK Pension Fund announced they had completed a £2.4bn buyout with Pension Insurance Corporation - a deal which covered the benefits of around 26,000 UK pension scheme members and settled the multinational firm's entire UK pension plan obligations.

Yet, since this transaction there hasn't been a buyout of over £1bn¹ - a fact that has been attributed to both affordability among schemes and the introduction of Solvency II in 2016, a directive which sets out how much capital insurers have to hold to back their liabilities.

Under these rules, insurers are required to closely match liability and asset cashflows in line with strict rules on ‘matching adjustment' eligibility - something that made the underwriting of nonpensioner liabilities much more challenging.

Yet, insurers are now getting to grips with what pricing looks like for deferred members - meaning they are now able to offer better terms on buyout pricing.

Pension Insurance Corporation head of business development Mitul Magudia explains: "Insurers now understand how Solvency II works and what can and can't work in terms of assets and have they have found a number of assets that work very well for pension schemes that have deferred members."

Indeed, most insurers have now set up teams to source such long-dated direct investments and have been investing heavily in areas such as social housing, student accommodation, lifetime mortgages and infrastructure - often illiquid assets that are long in duration and have cashflows that match insurer liabilities.

Magudia says: "This means insurance companies are now able to offer competitive pricing on full buyout in a way that they perhaps weren't able to immediately after Solvency II and that is one big factor that is driving down pricing on full buyouts and making them much more appealing than they had been historically."

How the Philips UK Pension Fund executed its buyout

The Philips UK Pension Fund's £2.4bn buyout - concluded with Pension Insurance Corporation in November 2015 - was the largest of its kind ever completed in the UK market.

The transaction - which covered the pension benefits of around 26,000 UK pension scheme members - came about because of a significant corporate restructuring at the sponsor, a demerger to separate Philips' lighting division from its healthcare and consumer lifestyle division.

The scheme had previously conducted three buy-ins - insuring around a third of its membership in three transactions covering around £1.1bn of liabilities, between August 2013 and September 2014.

A key feature of the buyout transaction was the simultaneous reinsurance of the longevity risk by PIC with Hannover Re.

Funding level improvements

But it isn't just insurer pricing that has been improving and Magudia says pension scheme funding levels are also picking up due to a number of key factors.

He says contributions into pension funds and the performance of assets have helped improve funding at the same time as changes to longevity assumptions have reduced scheme liabilities.

But he says there has also been a significant uptake in liability management through transfer values, something that has had a huge impact on the buyout cost of schemes as a larger and larger number of deferred members opt to transfer out of defined benefit schemes.

Magudia says: "When you put mortality, contributions and liability management all together, most pension schemes have seen significant improvement in funding levels over the last 12 to 24 months."

He adds that there are a number of schemes that have seen a five to 10 point improvement in funding levels on a buyout basis over the past year to 18 months - noting that there are now an increasing number of schemes that are over 90% funded on such a basis.

Magudia adds: "A lot of schemes that have historically been working their way to buyout, but had not expected to get there for another 10 to 15 years, are suddenly finding if they conduct a liability management exercise or get particularly competitive pricing from insurers, they are now in scope."

Willis Towers Watson head of transactions Ian Aley agrees. He says: "If we look back a few years when most schemes set their journey plans, their funding was relatively weak, the buyout price was considered expensive and, consequently, it was a distant aspiration rather than a real possibility in the short term.

"As funding has improved and those schemes have got closer to their buyout aspiration, they have found they were actually being quite cautious in terms of their estimation of buyout price, while the insurers have perhaps improved their pricing somewhat. A lot of schemes that are reasonably well funded are finding that it is a bit better than they thought and are now within touching distance of pursuing buyout."

Hymans Robertson partner and head of risk transfer buyout solutions team James Mullins also says that buyouts are becoming more affordable.

He says: "Improvements in funding levels mean that, not only are schemes better able to afford buy-ins, they are actually also that much closer to buyout as well.

"In addition, because pension schemes do so much more risk management now than they used to, funding levels are much more resilient - so if market conditions get worse, the drop in funding levels will be much less than it has been in the past because pension schemes are better hedged."

Closing the gap

While schemes are getting closer to being able to afford a full buyout, there are a number of things they can do to help close the gap - and well-timed actions across both assets and liabilities could shave years off the time it takes to reach buyout (see box).

PIC's Magudia says one of the most interesting areas here is on liability management - and he says his firm is seeing an increasing number of schemes that are looking to run liability management exercises such as pension increase exchanges (PIEs) and transfer exercises at the same time as a buyout.

He says schemes may be also be able to improve their funding level by working on their data and by reviewing benefit specifications. And he says the competitive process between insurers bidding for buyout business could reduce prices further still.

Magudia explains: "Cleaning your data - getting some marital data and postcodes and so-on - that might get you down a couple of percent; sorting out your benefit specification might be worth another couple of percent; and then the insurers' competitive process itself will reduce prices by a few percent and then you are within a few percent of a buyout and in a position to write a cheque.

"These are the kinds of discussions that are going on at the moment and we are seeing more and more schemes that are in cheque-writing distance."

Willis Towers Watson's Aley agrees that there are big opportunities for schemes to reduce buyout cost, particularly in managing the deferred member population.

He explains: "The big saving for schemes approaching buyout is around their deferred membership, which is less attractive in price compared to the reserves they hold.

"This is logical because the scheme is allowing for commutations and potential transfers in the period before a member draws their pension, whereas the insurer has to reserve on the basis that the pension has to be paid in full - so the insurer pricing is more cautious and, to the extent that individuals take the choice either to retire or to transfer ahead of the buyout, then that improves pricing or reduces the deficit. He adds: "There is a big potential saving here."

He says such transfer exercises can be a win-win for both the scheme and the member, especially if the individual doesn't value the format in which the pension is provided under the scheme - for example, people who are not married."

Aley also thinks that PIEs and other means of addressing caps and floors on benefit increase can be a win-win - offering members a better deal and reducing the cost of a risk reduction deal.

He says: "Certain caps and floors on benefit increase can be inefficient from an insurer capital perspective and, to the extent you can offer members a better deal, you can also bring the price of a buy-in or buyout down."

Added to this, consultants also point out that insurer pricing for deferred members has come down a lot in the past year - something that isn't always appreciated by trustees and sponsoring employers who may be relying on out-of-date buyout estimates.

Hymans Robertson's Mullins explains: "Deferred member pricing looks much less expensive than it did 12 months ago but I'm not sure if every trustee or sponsoring employer is aware of that - this pricing dynamic is perhaps not widely known."

Mercer partner and head of risk transfer Andrew Ward agrees. He says: "I think there are a number of schemes out there that have solvency estimates as part of their actuarial valuations that don't fully reflect the realities of current market pricing.

"Longevity changes that have either happened in the scheme or are being reflected in insurer pricing - along with the impact of some transfers out of the plan of deferred members - means that an awful lot of schemes are realising they are a lot closer to full buyout than expected."

Insurer innovation

Insurers are also offering flexibilities in order to help schemes that are close to buyout afford to complete such a deal - and there are a number of things that can be done on the asset side.

"Most insurers can be quite flexible around the assets they can accept from a scheme," PIC's

Magudia explains. "If the sponsoring employer is able to issue debt, and this is something that can be used by the scheme to increase assets, this is something that may be attractive to an insurance company if it can be shaped to match the cashflows and the liabilities of the scheme."

In addition, some insurers are willing to transact on the basis of a deferred premium, where the scheme does not pay the full cost of the buyout until sometime after the date of purchase.

Hymans Robertson's Mullins explains: "If you are a scheme that can't quite afford to go to buyout, but the company is willing to pay in some money over the next five years to help get there, some insurers are able to offer products where you can lock down all the risk today but the company pays that money in gradually over the next five years to fund the gap. I think that kind of product will become more and more common."

Is a buyout more affordable than you think?

Some schemes are now finding themselves well-funded against their buyout or solvency measure.

While, on first glance, they may appear to be years away from being able to buyout, Willis Towers Watson specialist bulk annuity adviser Matt Wiberg says well-timed actions across both assets and liabilities could shave years off the time it takes in practice.

Wiberg says there are two key things schemes should think about. Firstly, he says schemes need to understand how far they may be from the true buyout cost - noting that, while schemes are required to measure their funding level at each statutory valuation, it is important to understand how reflective this is of the actual cost of settling benefits and also to bear in mind that terms available in the market can vary significantly over time.

Secondly, he says schemes should consider how to close the remaining gap - explaining that, while schemes may expect a combination of asset outperformance and contributions to do much of the heavy lifting, being able to shave a number of years' worth of costs off a journey plan can amount to a significant value which can be offset against the deficit.

As such, Wiberg says there are three actions schemes should be considering in the run up to a buyout:

1. Having a data audit: Although scheme data may be adequate for the administration of the scheme on a day-to-day basis, Wiberg says enhancements could be required for buyout - work he says can reduce the cost of the bulk annuity policy and also the costs of any indemnity/run-off insurance secured by the trustees following the buyout. Key data actions include tracing any members a scheme has lost contact with; reviewing any long-term suspended members and deferred members well over normal retirement age to determine if these members have actually died; and, finally, gather data on marital status and spouses.

2. Providing members with more details about their options: Wiberg says transfer values will be lower than the cost of buying the same benefits with an insurer as part of a buyout and wind up of the scheme. But he says what isn't always appreciated is that the transfer value paid to a member in a well-funded pension scheme is likely to be up to 40% higher than the surrender value of a deferred annuity policy - that is, the payout the member would get if they left the scheme following a buyout. As such, he says schemes approaching the goal of buyout should consider a bulk exercise to inform deferred members of their retirement options sooner so they can understand the choices available to them and make the right decisions. He says pension levelling options, the payment of winding-up lump sums and pension increase exchange exercises should also be considered.

3. Thinking about how and when to engage with insurers: Finally, Wiberg says building relationships with the insurers will be key to getting maximum engagement and the best pricing when the time is right for a scheme to transact.

Wiberg says that having such a proactive approach; taking actions such as data audits, transfer exercises, winding up lump sums; and the impact of competition on buyout pricing could mean a scheme that is 85% funded on a buyout basis could become 100% funded in a very short period of time.

Source: Willis Towers Watson's De-risking Report 2018

Being prepared

However, while buyouts are becoming more affordable - and insurance pricing is keen - the rise in the number of schemes coming to market to investigate such options means the insurance market is becoming increasingly more selective around which schemes it chooses to quote for.

PIC's Magudia says: "There is certainly a piece of advice to schemes around being the most attractive they can be to providers and being ready - and it is really those schemes that will fair best.

"I think there is a risk that those schemes that aren't quite as prepared may not get quite the same traction as others."

Looking out over the coming months, Magudia says there are likely to be a number of £1bn-plus buyout transactions conducted - and he believes this could be the start of a trend.

He says: "I expect this is the start of a long-term trend and if scheme funding and insurance pricing continues to improve, we will start to see a huge volume of schemes going through the buyout route."

Hymans Robertson's Mullins agrees: "Where in the past, buyouts have been fairly rare, they are going to get more and more common, there is no question about that. And I think we are going to see larger and larger pension schemes being able to afford full buyout."

He adds: "When the funding level has improved to the point where that pounds amount gap is less than it was, then you start to think about dealing with this once and for all. As such, you will see more and more companies deciding to pay that final lump sum to get this over the line."

A version of this article was originally published in Professional Pensions risk reduction supplement published in June.

¹ Since this article was originally published, the Nortel Networks UK Pension Plan announced it has secured a £2.4bn PPF-plus buyout deal with Legal & General