To say that 2022 has been a turbulent year in the financial markets would be an understatement. One consequence is that many defined benefit pension schemes have seen a significant increase in funding levels, with gilt yield rises and widening credit spreads bringing them closer to their endgame objective more quickly than expected.
However, for those pension schemes that are at an earlier stage in their de-risking journey - and for which buyout remains out of reach despite funding level gains - further market volatility can be more foe than friend.
One of the ways in which these pension schemes can quickly lock into their improved funding position and insulate themselves against a reversal in fortunes is to protect against investment risk. In 2019 Legal & General introduced a new solution, the Assured Payment Policy (APP), which allows pension schemes to do just that.
Allowing pension schemes to lock into improved funding levels
APPs provide pension schemes with a pre-agreed series of future cashflows (either fixed or inflation-linked), in exchange for an upfront premium. They have many similarities to a buy-in, but are typically around 10-15% per cent more affordable when used to insure liabilities associated with deferred members. This is principally because the policy's cashflows provided under an APP will not vary with longevity or other demographic experience (as they would with a buy-in or buyout). Instead, the APP protects against asset yields, interest rates and inflation - indeed, all market and reinvestment risk is passed to Legal & General, at a rate of return in excess of gilts. Alongside this, the APP gives pension schemes the right to add the longevity risk protection to the APP (i.e. to convert the APP into a full buy-in or buyout) when they are ready to do so.
APPs have additional bespoke features designed to benefit trustees. For example, APPs can support short-term liquidity needs, and trustees can periodically adjust the APP cashflows to match their latest projected member benefit payments.
Additional key benefits for sub-£100 million pension schemes
APPs can be used in a range of different circumstances to meet a pension scheme's specific needs. Legal & General has written six APPs ranging from circa £10 million to circa £900 million. APPs can work for pension schemes of any size and for a variety of purposes. For example, they can allow a pension scheme to "build its own bond", given that the cashflows can be tailored to meet the pension scheme's requirements. More commonly, they are viewed as a buy-in with flexibility as to when the longevity protection element is added.
An excellent example of an APP in action is the recent circa £10 million APP that we transacted with the Flour Milling and Baking Research Association Pension and Assurance Scheme, which has partnered with our investment management business, LGIM, for nearly twenty-five years. The transaction demonstrated benefits of APPs to sub-£100 million pension schemes:
- The pension scheme will now benefit from access to the scale and asset sourcing capabilities of Legal & General's annuity portfolio of tens of billions of pounds, a benefit which is particularly pronounced given the pension scheme's standalone asset holdings;
- Accessing our investment portfolio in this way provides an opportunity to minimise the variation between the cost of a bulk annuity and the pension scheme's assets. We invest in the same assets to back APPs as for buy-ins (the premiums are invested in the same portfolio), meaning that an APP offers a good hedge against movements in bulk annuity pricing;
- The trustees and sponsor should now benefit from the reduced time and costs involved in the running of the pension scheme; and
- The trustees have a right to a future quote from Legal & General to convert the APP into a buy-in, which will likely be valuable in an increasingly busy market.
The cost of adding protection against longevity risk to the APP should, all else equal, decrease over time as the members get older.
Conclusion: an opportunity to de-risk for pension schemes closing in on buyout
For those pension schemes that now find themselves much closer to buyout but still with a funding shortfall, an APP represents a compelling opportunity to lock into recent funding gains. The APP then delivers a safer and more certain path to buyout for trustees and their corporate sponsor.
This post is funded by Legal and General