Ren Lin and Callum Duffy challenge the common arguments used by those contemplating pension buy-ins
In recent years we have witnessed the rising popularity of bulk annuity buy-ins among UK defined benefit pension schemes – that is, where the scheme purchases the bulk annuity as an investment but retains legal responsibility for paying the members’ benefits.
Buy-ins have many appealing characteristics: they hedge longevity risk; closely match cashflows for pensioners’ liabilities; bear very low credit risk; and should be convertible into a buy-out with the same provider (which then takes on the legal responsibility for paying the members’ benefits). Given all these benefits, it is not surprising that buy-ins are considered part of the toolkit when a scheme becomes better funded.
However, it is important to take a holistic view when assessing the suitability of a buy-in. For example, it is clearly not enough to assess whether buy-ins currently offer a ‘good’ price relative to history, or whether they should be done sooner rather than later ‘while stocks last’. Pensions insurance consultants will focus on how to do a buy-in and the impact on longevity risk, while investment consultants will consider where to source the proceeds and how to restructure the residual portfolio, but an overall suitability test is essential.
While the attraction of buy-ins is clear in some instances, in other cases they can be detrimental to the trustees’ ability to achieve the scheme’s longer-term goals.
Three common arguments that may create misleading support for a buy-in are:
- Buy-ins sourced from government bonds (gilts) add value and reduce the required investment return
- Better buy-in pricing than implied by the scheme’s long-term target funding assumptions improves security and reduces reliance on the sponsor
- Doing a series of buy-ins is an advantageous way of achieving a buy-out.
While these arguments carry intuitive appeal, they are often misleading.
Impact on investment return
As both gilts and buy-ins are deemed low-risk investments, it may seem logical to switch out of gilts in exchange for a buy-in, given that a buy-in offers a higher return and longevity protection. However, this ignores the impact on a scheme’s residual assets and the implied level of risk.
Consider a scheme that is fully funded on a gilts +1.0% basis; by implication the scheme’s assets need to generate a consistent return of gilts +1.0% per annum in order to meet the scheme’s pension obligations. If the scheme conducts a buy-in at a price of gilts +0.4% per annum, meaning a proportion of its assets will only generate a return at that rate, it follows that the residual assets will need to deliver more than gilts +1.0% per annum, assuming an unchanged time horizon and no increase in deficit repair contributions.
This conclusion would hold regardless of whether the assets for the buy-in are ‘sourced from gilts’. This is why we could draw inappropriate conclusions by simply focusing on a comparison between the yield on the assets sold to fund the buy-in and the annuity pricing basis.
We show this in greater detail in Table 1, which shows a buy-in that results in a dramatic increase in required returns on residual assets. Furthermore, the trustee here will be adopting a ‘barbelled’ investment strategy, holding a very low risk buy-in asset alongside a now much higher risk residual portfolio. This often results in higher risk at the total portfolio level, as return and risk do not scale in a linear way.
Furthermore, buy-ins typically cover the shortest-dated liabilities, meaning any residual liabilities will have a longer duration. In this example, the liability value falls by 50% while the interest rate sensitivity falls by only 28%. This means the trustees will need to set aside a larger proportion of the residual assets to hedge liability risks through liability-driven investment (LDI), leaving even fewer assets to grow. This further increases the investment return requirements of those non-hedging assets, boosting uncertainty.
Buy-in pricing versus long-term funding target
Conducting a buy-in at a better price than a scheme’s target funding basis could allow the scheme to discount the relevant liabilities at a higher rate, reducing the funding ‘deficit’. It is therefore argued that, as the deficit has fallen, security is improved and reliance on the sponsor is reduced.
However, this argument ignores the impact on the remaining assets versus the liabilities not covered by the buy-in. Table 1 shows that, while conducting a buy-in reduces the remaining ‘deficit’ because the ratio of residual liabilities relative to residual assets increases, the return requirement – and, in turn, uncertainty – is actually higher. More uncertainty means a greater likelihood of needing to rely on the sponsor if risks materialise, with additional contributions potentially required.
Path to buy-out
It is often true that a big problem is more manageable if broken down into a series of smaller problems. While breaking up a buy-out into smaller buy-in transactions could help improve competitive pricing, doing buy-ins too early (ie when not sufficiently well-funded) will ultimately make the buy-out harder to achieve for the reasons outlined previously.
Furthermore, a buy-in will reduce a scheme’s flexibility to deal with future unpredictability. The illiquid nature of a buy-in asset leaves trustees with less resources to deal with any unexpected shocks that impact the economics of the scheme (eg residual longevity risks). This, in turn, increases the uncertainty of achieving a full buy-out within the targeted timeframe.
Time for a discussion
With a view to promoting greater debate on this topic, we believe that as a broad rule of thumb, after adjusting for the potential cost of longevity hedging, buy-ins typically serve to reduce overall risk only when the investment returns achievable on the buy-in are higher than the basis on which the scheme is currently funded.
The three arguments we have discussed could lead to buy-ins being considered suitable even though this condition is not met – resulting in greater uncertainty for pension investment strategies, greater reliance on sponsors, and potentially longer timeframes to reach the desired long-term funding target.
We hope this article will help stimulate discussion around the ‘right time’ to be using buy-ins within the profession and provide useful food for thought when assessing the suitability of a buy-in for pension schemes.
Ren Lin is head of client strategy at Insight Investment
Callum Duffy is solution designer at Insight Investment