Why stalling on buyout could cost members

Given the legacy nature of UK defined benefit pension schemes and the size of the risk they pose to their sponsors, it is unsurprising more are seeking the endgame.

Some have attempted to address this by looking to derisk distinct groups of members or by removing risk components individually through hedging or swap contracts. 

While these measures have their place, buyouts offer the most complete answer for schemes as all accrued pension liabilities are completely transferred over to an insurance company for a premium.

A maturing market

What is more, the buyout market is beginning to move in schemes’ favour.

Premiums traditionally required by insurers – about 140% of the value of a scheme’s liabilities calculated on an accounting basis – have been a turn-off for many scheme managers.

But products that allow pension schemes to make an equity investment in a mutualised insurance company may go some way towards making a buyout economically attractive.

These recapture some of the 40% premium that is traditionally accepted as insurance profit.

Of course, the absolute price of a buyout is also intrinsically linked to the individual scheme’s current funding measure, as well as its position with respect to volatile investment markets.

Scheme managers should not simply sit back and wait for economic conditions to improve and funding levels to increase

Currently, global long-term economic uncertainty has meant a struggling FTSE, leading to a drop in pension scheme assets.

At the same time interest rates remain at record lows, meaning large pension liabilities, as they are discounted using this value.

The general consensus among scheme managers is that it may be preferable to wait for favourable conditions to return before transacting. This avoids locking in to a buyout when funding levels are low.

This strategy may not necessarily pay dividends for all, however.

While pension scheme funding levels may compare unfavourably to those before the financial crisis, or even the start of last year, managers may have to accept better conditions continuing to recede into the future.

Indeed, interest rates have been at record lows for three years, with little indication this will change any time soon.

Many pension schemes have already completed interest rate swaps, reducing their upside benefit from interest rate swings and moving the valuation of liabilities closer to an insurer's.

This could in fact turn out to be a good time for companies to take pension risk off the table.

Video: PensionsFirst chairman David Norgrove discusses different approaches to derisking

Clearly for those schemes more exposed to fluctuations in rates or equities, patience may be more understandable.

But scheme managers should not simply sit back and wait for economic conditions to improve and funding levels to increase before hastily trying to snatch the opportunity to transact.

The potential cost of delay

Indeed, preparing for a major transaction itself takes many months – meaning a delay to the start of this journey could result in missed opportunities.

Many pension schemes were in a favourable funding position back in 2008 but failed to take the chance to reduce risk and subsequently slipped back into deficit when the financial crisis hit.

Our research suggests the combined deficit of the DB pension schemes of the FTSE 100 decreased from approximately £43bn on an IAS19 basis at the end of 2010 to about £27bn by the middle of last year.

Merely three months later, with most schemes failing to engage in any derisking activities, the deficit had increased by as much as £15bn to over £42bn on an IAS19 basis.

Many of the barriers that have previously hindered a buyout transaction are now being removed

This was driven by a combined 13.5% fall in UK equities, which accounts for about 18% of the FTSE 100’s pension fund assets, and a 14% fall in global equity prices, which accounts for about 23%. 

If schemes do not act quickly and efficiently to lock in improvements in funding levels they risk a widening of their deficit the next time equities take a hit or bond prices rise yet further.

Many of the barriers that have previously hindered a buyout transaction are now being removed.

This includes an inability to measure funding position on a continuous basis, an incomplete understanding of risk, a lack of board-level incentive to transact and, of course, expensive buyout premia.

The incoming IAS19 accounting standards may remove some of the profit-and-loss benefit some companies currently enjoy in holding riskier assets in their funds, making risk-transfer activity more attractive.

But to seize these opportunities, schemes need to engage with buyout experts able to advise them on the potential routes through the thickets.

Risk-transfer activities such as longevity swaps, synthetic buy-ins or deferred buy-ins or buyouts all are legitimate precursors to a full buyout.

This could be by moving schemes well on the way to an insurer’s best estimate of the liability and reducing the extra cost of the transaction.  

The journey towards a buyout may be a long one for some schemes but this makes it all the more important for them to get started.

David Norgrove is chairman of Long Acre Life, an insurance company set up by PensionsFirst. He was previously chairman of the Pensions Regulator