DB pension schemes contemplating insurer buy-ins should evaluate them against other strategies, says Jos Vermeulen of Insight Investment
As an interim step towards their endgame, some DB pension schemes are tempted by insurance company ‘buy-ins'. In these, the pension scheme transfers some of its assets to an insurer, which then covers the cost of a portion of the scheme's pension payments.
Insight recommends the following analytical framework to evaluate buy-ins against other strategies:
Value for money: Buy-in contracts are typically priced on a ‘gilts-plus' basis making them look attractive compared to the cost of matching liabilities with government bonds.
But buy-in costs need to be compared to self-managed approaches that can replicate many buy-in characteristics at a lower cost. Insurers, after all, must price in their capital costs and profit margins and are subject to greater investment restrictions.
Impact on overall portfolio: Will the buy-in drive up the return needed from the remaining assets in the portfolio - obliging the scheme to invest in riskier assets - or limit the scheme's ability to hedge its liabilities? What will be the impact on the expected time to reach the targeted buy-out?
Flexibility to deal with the unpredictable: If things don't go to plan, perhaps because of changes in legislation or problems in investment markets, the pension scheme may be cornered into investing its remaining assets in relatively risky assets in order to bridge any gap - or forced to sell assets at an inopportune time.
"Buy-ins tie up a lot of high-quality assets, often to deal with the lowest risk members - the pensioners", says Vermeulen. "That can widen the range of outcomes for the scheme as a whole, increasing overall uncertainty," he says. That's why the analytical framework often shows that "buy-ins can make it more difficult to get to your endgame".
Insight describes the choice between a buy-in and a self-managed approach as being like competing teams deciding how to cross difficult terrain. Team A grabs a head start by moving rapidly along an easy-looking route, only to find they are later committed to climbing a steep ridge with ravines on either side.
Team B evaluates the terrain before taking a steadier track that offers a choice of surer ways to the destination. "Compared to buy-ins, many pension schemes can reach their goal with much higher certainty by extending their hedging strategies to include longevity hedges, transitioning assets to be more cashflow aware and increasing the focus on a more diverse range of high-quality credit assets," says Vermeulen.
As schemes begin planning for the endgame, this self-managed approach often offers the optimum mix of strategic control, flexibility and cost-efficiency.
Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
ASSOCIATED INVESTMENT RISKS
Where the portfolio holds over 35% of its net asset value in securities of one governmental issuer, the value of the portfolio may be profoundly affected if one or more of these issuers fails to meet its obligations or suffers a ratings downgrade.
A credit default swap (CDS) provides a measure of protection against defaults of debt issuers but there is no assurance their use will be effective or will have the desired result.
The issuer of a debt security may not pay income or repay capital to the bondholder when due.
Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
Investments in emerging markets can be less liquid and riskier than more developed markets and difficulties in accounting, dealing, settlement and custody may arise.
Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.
Where high yield instruments are held, their low credit rating indicates a greater risk of default, which would affect the value of the portfolio.
The investment manager may invest in instruments which can be difficult to sell when markets are stressed.
Where leverage is used as part of the management of the portfolio through the use of swaps and other derivative instruments, this can increase the overall volatility. While leverage presents opportunities for increasing total returns, it has the effect of potentially increasing losses as well. Any event that adversely affects the value of an investment would be magnified to the extent that leverage is employed by the portfolio. Any losses would therefore be greater than if leverage were not employed.
This document is a financial promotion and is not investment advice. Unless otherwise attributed the views and opinions expressed are those of Insight Investment at the time of publication and are subject to change. This document may not be used for the purposes of an offer or solicitation to anyone in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it is unlawful to make such offer or solicitation. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment.
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