Why bulk derisking is the answer for almost all schemes

This has led some commentators to question whether schemes are being herded towards buy-ins and if this is always the right destination for members.

The key is to approach them proactively rather than being herded

Well-timed settlement activity is in the best interests of all stakeholders in almost every pension scheme.

Most, if not all, schemes in the UK are naturally on a journey to full buyout, although this may be over a long timeframe.

Trustees and sponsors will be thinking about the best way to reach this destination, and could include the use of buy-ins along the way.              

The upside

The first thing to consider when assessing whether a buy-in is suitable is the scheme’s objective; this is generally to deliver guaranteed benefits with as much certainty as possible. Additionally, the sponsor will want to ensure this is done cost-effectively. 

A buy-in provides the increased security of an insurance policy that exactly matches the scheme’s benefits. 

All of the traditional risks faced by pension schemes, such as investment and longevity risk, are removed. 

Where a buy-in is affordable and fits with the long term journey plan it seems common sense that it offers the best outcome for members, and therefore the trustees. 

From the sponsor’s perspective, a buy-in also removes a volatile item from the company’s balance sheet and reduces the dread now commonly associated with the triennial valuation cycle.

Over the past 18 months there have been opportunities to secure buy-ins at attractive prices, particularly for schemes holding gilts to back their pensioner liabilities.

The improvements in funding levels as markets rose over the summer, combined with the pricing currently available in the buy-in market, means more schemes may be in a position to settle some of their liabilities.

The downsides

Following a buy-in, the pension scheme will face a different risk – counterparty risk against the insurer. But the insurance regulatory regime in the UK is strong, with insurers required to hold very significant capital reserves to back buy-in policies.

So swapping the security of the sponsor’s covenant for the backing of an insurer should not cause trustees concern.

The other potential downside of an insurance transaction is that it removes the potential for upside – for example, investment outperformance that reduces the requirement for sponsor contributions.

But these are all big what-ifs. Most trustees and sponsors understandably place a greater weight on having certainty for guaranteed benefits now.

The alternative

To understand whether a buy-in is appropriate for a pension scheme it is necessary to consider the alternatives – for example, implementing an investment strategy that matches the scheme’s liabilities as closely as possible, typically using swaps and gilts.

For smaller schemes, the cost and governance requirements from a sophisticated liability-driven investment strategy are likely to be disproportionate.

Even for larger schemes there are often inefficiencies – for example, it is difficult to exactly match certain pension increases. In addition, longevity risk will still remain, unless a longevity hedge is put in place.

For these reasons, buy-ins are typically viewed as more efficient than the do-it-yourself solutions, particularly with recent opportunities to swap gilts for a buy-in and get longevity protection for ‘free’.

How should companies and trustees approach transactions? Given buy-ins are normally the right destination for schemes, the key is to approach them proactively rather than being herded.

In particular, advance preparation is important to ensure the transaction is efficient and in the best interests of all stakeholders.

Specifically, it is important to understand the journey the scheme is on and the likely future investment strategy, so that everyone understands when it is appropriate to derisk – either into a buy-in or matching assets – and at what price.

Rather than following the herd, my view is that schemes that have taken advantage of the recent attractive pricing have been ready to act and had already thought through the longer-term implications, deciding that buy-in was the right option for sponsor, trustees and members.

Ian Aley is a senior consultant in Towers Watson’s retirement risk management solutions business