While buy-ins can provide an immediate reduction to liability values, schemes run the risk of retaining key risks and storing up problems, says Jos Vermeulen
Today, many private defined benefit (DB) pension schemes are targeting a buyout with an insurer as their endgame. However, with many schemes unable to afford the cost of undertaking a full buyout in the near term, a popular stepping stone has been to undertake a partial buy-in for a portion of liabilities.
In a partial buy-in, a scheme transfers some assets to an insurer, which in return covers the cost of the pension payments for some of the scheme membership, usually the pensioners. There are many reasons schemes may look to do this but, far from being a silver bullet, a partial buy-in comes with its own inherent set of risks.
A major driver for buy-ins has been the seemingly competitive pricing from insurers. Typically, buy-in contracts are priced on a ‘gilts-plus' basis. This places a lower value on the liabilities than is accounted for in scheme valuations, which are based on government bonds. As a result, buy-ins appear attractive because they reduce the liabilities by more than the cost of purchasing the buy-in. But while cost should always be a factor, we urge schemes to look beyond price alone and consider other longer-term factors. A failure to do so could leave them open to potential pitfalls further down the line.
One such danger is that by using a partial buy-in as a stepping stone, schemes can inadvertently end up further from buyout than if they had focused instead on evolving their existing de-risking strategies. This danger is introduced by a number of contributing factors.
For example, one potential pitfall of a buy-in is that it is unlikely to cover non-pensioners. Therefore, while the value of retained liabilities may fall, the risks (for example, the sensitivity to interest rates and inflation) will fall by less. As such, schemes may transfer disproportionally more assets than risks to the insurer.
A buy-in offers security and cashflow matching for a portion of the liabilities, but schemes should consider the broader impact on the overall portfolio. In particular, how does a buy-in impact the expected return needed on the remaining assets and/or the scheme's ability to hedge its liabilities, and the expected time to reach the targeted buyout?
If a scheme is underfunded, the deficit will vary following the buy-in, potentially even falling. Crucially, however, a buy-in leaves fewer ‘free' assets to make up any funding level deficit. This increases the target return needed from the remaining assets, everything else being equal. Essentially you need your remaining assets to work that much harder.
In order to maintain a given hedge ratio, a proportion of the remaining assets must be allocated to collateral, further pushing up the required target return on the ‘free' assets. Not only would this incur additional costs but it could result in potentially selling assets at an inopportune time. Alternatively, schemes could decide to accept a lower hedge ratio.
Furthermore, we would argue that the pursuit of higher target returns following a buy-in increases the chance of defaults, negative returns and forced selling risk, especially during times of market stress. Ultimately, it potentially reduces the chance of the scheme being able to afford buyout at the target date. The alternative, maintaining a lower hedge ratio, could lead to an increase in liability-mismatch risk.
Finally, up to the point of a full buyout, regardless of the adopted de-risking method, there will always be risks affecting the assets or the liabilities that cannot be predicted or hedged. Examples could be poor short-term returns, transfer values forcing payments earlier than expected, or changes in legislation causing changes to benefits.
We suggest that schemes look beyond buy-in prices alone and assess the impact at the total-scheme level, considering a wider range of factors, such as value for money, impact on the total portfolio and flexibility to deal with unpredictable events. We believe that this will help them reach their endgame with more certainty.
A DIY or ‘self-managed' approach can replicate many of the characteristics of a buy-in- for example hedging longevity risks and generating cashflows to match outgoing payments - but directly and more broadly across the whole portfolio.
Jos Vermeulen is head of solutions design at Insight Investment
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The Carter & Parker Limited Staff Retirement Benefits Plan (1975) has agreed a £9.3m bulk annuity deal with Canada Life.
The Aegon UK Staff Retirement and Death Benefit Scheme has secured a £144m buy-in with Phoenix, covering around a quarter of pensioner liabilities.
Pension Insurance Corporation (PIC) has agreed a £750m bulk annuity transaction, converting a pensioner longevity swap held by the Scottish Hydro Electric Pension Scheme (SHEPS) into a buy-in.