The AIB Group UK Pension Scheme has entered into a £250m insurance contract to hedge the investment risk associated with a portion of its liabilities, becoming the first defined benefit plan to undertake an alternative derisking solution.
Announced on Thursday, experts predicted the transaction with Legal & General could spark further innovation, given the appetite for employers to settle their liabilities in a predictable way.
The deal was concluded at the end of 2019 and covers 1,300 members. It is split between a £850m pensioner buy-in and a £250m assured payment policy.
An APP is similar to a buy-in, but does not cover longevity risk. In exchange for a premium paid to the insurer the scheme will receive a stream of cashflows that match its liability profile and vary with changes, such as in interest rates or inflation. With insurer capital backing the contract, this therefore removes investment risk to a fuller extent than schemes can achieve by managing assets themselves in a liability-driven investment solution.
For a pension scheme with a 50:50 split between pensioners and deferred members, it could be around 10 per cent more affordable than typical bulk annuity pricing, L&G has claimed.
There is a growing market here for solutions for the schemes who are not quite there yet
Adam Davis, K3 Advisory
Under the terms of the contract, AIB will have the option to make further payments to convert the contract to a buy-in, in a phased way, over the next five years. Andrew Ward, head of risk transfer at Mercer and adviser to the AIB trustees, explained that this "gives time to clean and rectify data, and allows the scheme to benefit from member choice and exercises".
"The process for this conversion is set out under the policy. There are some defined additional contributions due over the period to facilitate the conversion, and the move to full buy-in could potentially be accelerated if there are deferred member transfers out," he added.
Bulk annuities are not for everyone
The AIB fund has been on a derisking journey for a number of years, including a longevity swap concluded in 2016. Despite the scheme’s funding position continuing to improve, it “wasn't quite in a position to do a full buy-in at the current time”, Mr Ward explained.
Despite rising funding levels and increased maturity leading to a boom in the market for buyouts and buy-ins, last year's record-breaking £40bn in transactions pales in comparison to the scale of the UK's entire DB liability, with many schemes well short of the funding level required to buy out benefits.
Chris DeMarco, managing director, UK pension risk transfer, at L&G, said this leaves the door open for innovative solutions aimed at the less well-off end of the market.
“Alternatives to conventional buy-ins and buyouts make sense for schemes that can't do it,” he said, arguing that the AIB deal provides a proof of concept.
He said an APP will not be the right solution for every scheme but could work for those that have “some deferred contributions coming in over the next few years, but they want to lock in a lot of the elements today”.
Independent experts welcomed the addition of a new solution to the range of options for employers and schemes, but said much will depend on the precise features of such contracts.
Adam Davis, managing director of small-scheme specialist bulk annuity consultant K3 Advisory, said: "There is a growing market here for solutions for the schemes who are not quite there yet."
A key determinant of the APP's success will be the manner in which it can be unwound, or converted into a derisking solution that insures against longevity movements.
L&G claimed that the APP can be combined with a longevity swap to create a synthetic buy-in, but Mr Davis said he is sceptical of these structures.
"They seem to be a neat way to just extend the life of pension schemes further," he said, noting that this was in "in the interest of advisers" rather than employers.
A further problem would arise if APP contracts cover a portion of liabilities indefinitely and cannot be unwound. With other insurers unlikely to accept the contract as part of a premium payment, Mr Davis noted that the solution could see schemes committed to transacting with a single insurer, regardless of price.
"I'd want to make sure that [trustees] were really sure of how they can then deal with the risk that they're left with," he said, but added that if APPs are structured as a time-limited bridge to buyout they could attract significant demand.
Solution similar to consolidators
The launch of APP as a solution for schemes that cannot currently afford buyout brings L&G, a traditional bulk annuity insurer, into competition with the upstart defined benefit commercial consolidators.
Clara Pensions and the Pension SuperFund are yet to separate their first scheme from employer, but both report a strong pipeline of deal if either the government or the Pensions Regulator give them a helping hand.
As sponsors of trust-based pension schemes, they do not technically need legislation to begin operating. However, in the absence of dedicated regulations, employers are unlikely to hive off their schemes without clearance from the regulator assuring that they have adequately mitigated risks to members.
New rules on DB consolidation were absent from the latest Pension Schemes Bill, which has returned to Parliament in January.
Mr Davis said L&G's pitching of its APPs as offering a 10 per cent discount to buy-in would bring it into competition with the two start-ups, while Mr Ward also noticed resemblances.
“It doesn't remove the sponsor covenant as the commercial consolidators do, but that bridge to buy-in or to buyout concept that is embedded in the Clara model, there are similarities here,” he said.
More innovation to come
Matthew Cooper, senior manager at PwC, said he expects significant developments for medium to large pension schemes in relation to outsourcing their ‘endgame’ journey.
Smaller-sized bulk annuity deals to increase in 2020
Fewer multibillion bulk annuity deals are expected in 2020, although the number of smaller transactions is set to increase, according to research from Willis Towers Watson.
He said: “A number of providers are developing capital-backed investment solutions. These solutions provide bespoke investment strategies that support pension schemes on the journey to being fully funded, to allow them to buy out at some future point.
“Providers may put up additional capital that further enhances the security of members and increases the likelihood of the pension scheme reaching the buyout destination.”
Mr Ward noted that while he is unaware of other insurers offering similar solutions to L&G’s APP, it is raising interest among pension schemes in certain circumstances.
