Innovative new solutions have finally put a full buyout within the grasp of many schemes, yet adverse market conditions may mean some are hesitant to transact immediately, says David Norgrove.
Faced with the rising cost of defined benefit provision, some sponsoring companies have turned towards benefit re-design, while an increasing number are closing their schemes completely.
Yet closing a scheme does not end a company’s obligation to pay previously accrued liabilities so the risk management burden remains.
Certainly, there are serious implications of unmanaged DB risk, which can affect the sponsoring company’s core business and financial performance, with significant knock-on effects for shareholders and scheme members.
While the threat posed by DB pension risk has driven the industry as a whole to seek more prudent investment strategies, extend recovery periods and attempt to make up for funding deficits by increasing contributions (BT recently announced its commitment to plough £2bn into its pension to halve its £4.1bn deficit, for instance), there is also an increasing acceptance that a more definitive solution is required.
Given the legacy nature of UK DB schemes, it is unsurprising that a move towards de-risking, and ultimately the end-game, is in principle attractive. In this respect, a full buyout offers the most complete solution.
What is more, in recent times, there have been opportunities where market conditions have combined favourably to boost funding levels and reduce the ultimate cost of such de-risking transactions.
Many schemes were in a favourable funding position back in 2008, for instance. And there are more recent examples – Long Acre Life research, for example, suggests the combined deficit of the DB schemes of the FTSE100 decreased from approximately £43bn on an IAS19 basis at the end of 2010 to about £27bn by the middle of last year.
Unfortunately, given the volatility of pension schemes’ investment strategies and their exposure to market-directional risk, these windows of opportunity are often short-lived – which means that, if schemes do not act quickly to lock in improvements in funding levels they risk a widening of their deficit the next time the FTSE takes a hit or bond prices rise. Indeed, that is exactly what happened in these examples.
The reasons for schemes’ inactivity in this respect can be attributed to an inability to measure their funding position on a continuous basis, an incomplete understanding about the exact nature of the risk they faced, a lack of board-level incentive to transact, and, of course, expensive buyout premiums. Yet, many of these barriers to buyout (and de-risking in general) are now diminishing.
Perhaps most importantly, the buyout premium has finally been addressed. Traditionally, buyouts have been priced at about 140% of the valuation of a scheme’s liabilities on an IAS19 basis – a price above and beyond what most have been willing to pay.
However, the development of innovative solutions that allow pension schemes to make an equity investment in a mutualised insurance company – in order to recapture some of the 40% premium which is traditionally accepted as insurance profit – may be a watershed for the industry. We believe they may ultimately reduce the price of buyouts by as much as 20%.
While such solutions as this may put the end-game firmly in the sights of many pension schemes, they should not simply sit back and wait for economic conditions to improve and funding levels to increase before hastily trying to seize the opportunity to transact.
Indeed, preparing for a major transaction itself takes many months – meaning any delay to the start of this journey could result in yet another addition to the list of missed opportunities.
Schemes must engage with buyout experts as soon as possible about potential routes to buyout: longevity swaps, synthetic buy-ins or deferred buy-in/buyouts are all legitimate precursors to a full buyout, for instance. The journey to buyout may be a long one for some schemes, which means now is the time to plan ahead.
David Norgrove is a former chairman of The Pensions Regulator and current chairman of Long Acre Life
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