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The Actuary The magazine of the Institute & Faculty of Actuaries

Pensions buyouts: Jostling for position

There was quite a bit of hustle in the UK defined-benefit (DB) pensions market in 2006 with the advent of new players into the bulk buyout arena. This segment of the market had only two players up until that point — Legal & General and Prudential — and so this development gained significant interest from many.

Players who have since joined the bandwagon include Lucida, Paternoster, Goldman Sachs, Pensions Insurance Corporation, Synesis, UBS and Aegon, among others. While most of these specialist pension providers have the financial backing of global investment giants such as Deutsche Bank, Royal Bank of Scotland, HBOS, Sampo Life and Swiss Re, players such as Goldman Sachs are on their own.

The main factor that drew these providers into the bulk buyout segment was the business potential worth approximately £800bn available for grabs. In fact, the FRS 17 pension liabilities for the FTSE 100 companies alone are estimated to be more than £300bn. History reveals that this was a business opportunity created out of the failure of company-maintained DB pension schemes in the UK to meet their employees’ pension liabilities.

A range of factors have contributed to this failure, including:

>> Increased longevity (mortality risk) above that assumed by the pension schemes in valuing future pension payments
>> A reduction in investment returns beyond that assumed due to reduction in interest rates on debt instruments (such as bonds and gilts) and falling equity markets
>> A higher rate of inflation than assumed leading to higher salary increases — and, in turn, DB pension increases — than provided for
>> An increasing proportion of pensioners to active members in employment due to the retirement of the ‘baby boomers’ post-World War II.

Bulk buyout is no longer an option exercised only by firms on the brink of insolvency. Now employers that are financially sound and are maintaining a DB pension scheme in-house are exploring the bulk buyout option for the reasons detailed in Chart 1.

The push factors are created by a combination of industry, regulatory and economic changes over which the providers have almost no control, although business opportunities can arise from this.

For example, the Pension Protection Fund (PPF) levy terms have been revised recently — instead of the earlier 125%, firms now need to have pension assets worth 140% of their liabilities to avoid paying the risk-based levy — amid widespread criticism from the industry. Since the primary subscribers to PPF are firms that do not have sufficient assets to meet their liabilities, an increase to the levy could both potentially act as a disincentive to these companies to continue in PPF, as well as deter those who might be contemplating joining. In fact, at the end of 2006, industry reports indicated that there were more than 65,000 such PPF customers who are now possible potential targets for bulk buyout providers.

Market advantage
Providers also currently possess a distinct advantage with increased bond yields. This has translated in terms of reduced cost for buying out pension benefits, which the providers can use as a unique selling point. Interestingly, industry reports point out that the buyout cost of pensions in payment has reduced by approximately 6.5%, and deferred pensions by more than 11%.

The time could not be riper for the providers to look at various other options, including:

>> Devising a buyout premium that is more competitively priced and is commensurate with the extent of the shortfall of pension assets against liabilities. A buyout premium that is priced at around 30% to 50% of the FRS- 17-valued liabilities is deemed high by pension schemes. However, this has reduced with the recent increase in bond yields. Providers need to revisit this and devise a more robust way of pricing the buyout premium, taking into account the specific factors that may apply to a particular pension scheme, instead of adopting a ‘one size fits all’ approach.
>> Developing more attractive products or schemes that would enable pension scheme sponsors to offload a proportion of their overall pension liability. For example, a tranched buyout may enable a sponsor to disaggregate its pension portfolio by offloading only the assets and liabilities pertaining to pensions in payment, while keeping the deferred and active members’ pension liabilities to themselves.

A phased buyout is another example whereby a sponsor that is not in a position to get rid of all its pension liabilities in one transaction, might agree a phased buyout over a period of five to 10 years.

Another innovative idea is to use a profit-sharing contract where the pension scheme shares a proportion of the provider’s profits.

>> Focusing more on designing innovative buyout solutions for companies outside of the FTSE 100. One of the major criticisms of the Pensions Regulator against buyout providers is that they are targeting only pension schemes that have sponsors listed in the FTSE 100. Providers need to recognise this and focus on designing appropriate buyout solutions for smaller companies that allow for their risk appetite. This would also serve to expand a market with tremendous potential.

Challenges and issues
Unsurprisingly, success in a competitive bulk buyout market does not come without its own challenges and issues, including:

>> Competitive product pricing — although bulk buyout prices are still high compared to company pension funding levels under FRS 17, price reduction cannot be resorted to beyond a certain threshold as it comes with a higher share of asset risk to be absorbed by providers. While it may be tempting to offer a price reduction and secure high business in a competitive market — especially when bond yields are high and the stock market is booming — providers also need to provide for the flip side, such as whether the same is sustainable if the investment market turns hostile in the future.

>> Financial Services Authority (FSA) capital requirements — in the UK, the FSA has put in place stringent reserving requirements that require a bulk buyout provider to have 30% to 50% more capital than that required under the FRS 17 pension standards. Pension schemes that have a 100% funding level wishing to buyout the liabilities would still need to pay an additional premium of 30% (of the funded value). The premium might be higher still for schemes that do not have sufficient assets backing their pension liabilities. This may act as a deterrent for schemes wishing to opt for the bulk buyout option.

>> Volatility in investment markets — a healthy bond and equity market is a prerequisite for a healthy buyout market. Too much volatility in investment markets would not only upset the pricing of providers’ products, but also create uncertainty in the minds of the pension schemes in going for the buyout option.

>> Postponement of buyout decisions — a continuously improving investment market may be a positive trigger for pension schemes to go for buyout, but it may also sometimes work against it. Backed by a buoyant investment market, pension scheme trustees may tend to postpone the buyout decision hoping that higher investment returns may fetch higher benefits for their members if the option is exercised at a later date.

>> Pensions data accuracy — the accuracy of data relating to pension schemes is another major challenge that providers may face. Providers should ensure that the data available in respect of the assets and liabilities for all sections of the pension scheme is up to date and accurate before generating a buyout quote.

A look at the past will reveal that there were several market players apart from Legal & General and Prudential before 2005 but they all withdrew from the market, primarily due to the stringent capital requirements imposed by FSA on bulk buyout providers (much higher than that required for company-maintained DB pension schemes). This, in turn, translated into a high bulk buyout premium, rendering buyout unattractive.

Although it is not too different now, the industry is of the belief that bringing in more competition will provide more innovation in product design and service, in addition to a better deal with pension schemes in terms of price. It is possible that many pension scheme sponsors will opt to leave the major headache of DB pensions management to a specialist third-party provider so they can focus on their core activities.

The day is not far off when there will be plenty of action in the bulk buyout sector, not only in the UK but across the European Union as a whole.

>> Bulk buyout is the buyout of the assets and liabilities of an employer/ trustee-maintained defined-benefit pension scheme by an insurance company for a buyout premium. The buyout premium is estimated to be around 30% to 50% of the value of the liabilities based on FRS 17 pension standards.

>> FRS 17 is the UK accounting standard for measuring pension scheme assets, liabilities and surplus/deficit.

>> The Pension Protection Fund was established to secure the employee pensions of firms that do not have sufficient assets in hand to meet their pension liabilities and are on the brink of insolvency. It primarily takes over the assets and liabilities of the firms that subscribe to it, and collects a levy — risk-based plus investment-based — depending on the extent of shortfall of assets to liabilities.