Feature: The introduction of Solvency II last month has made buying out in full even trickier than before, but there are things trustees can do to make it more likely to happen.
One of the much-debated effects Solvency II will have on the risk transfer market, the industry seems to agree, is a rise of around 3 per cent in pricing for deferred members. This could have repercussions for full buyouts.
During the year to September 2015, buyout volumes stood at around £5.2bn, lower than the roughly £6.4bn of buy-ins, according to consultancy Hymans Robertson.
The higher price for deferreds is driven by the fact it will be harder to reinsure these members, who have many options still open to them.
They’re going to be more selective about which ones they target, to make sure they’re still winning the same proportion of the transactions
Charlie Finch, LCP
Charlie Finch, partner at consultancy LCP, says it is not impossible to secure reinsurance for a full buyout, but it will make the transaction more complex, particularly for larger schemes.
“You can get reinsurance for full buyouts, but it’s more tricky,” he says, citing the example of the Philips UK Pension Fund buying out with Pension Insurance Corporation last year. PIC reinsured the longevity risk for 26,000 members with Hannover Re, including deferreds.
Finch says there will still be a number of buyouts coming through post-Solvency II, however, despite the added complexity.
“The difference in price is less than the fall in the FTSE 100 [on January 20], so you have to see it in the round, but it’s an additional challenge,” he says.
So perhaps more important for full buyouts than the European solvency regime are scheme funding levels, which are not being helped by the recent stock market falls and historically low interest rates.
Closing deficits will be a challenge in current circumstances. According to LCP’s 'Pensions derisking 2015' report, only around one in 10 schemes are more than 80 per cent funded on a buyout basis. The report states this number could double if return-seeking assets move up 15 per cent, and triple if they move up 30 per cent.
The right assets
Assets are key in the preparation for a buyout, and the journey traditionally involves derisking into bonds and gilts.
But LCP’s head of buyout practice, Clive Wellsteed, says larger schemes should not assume insurers would take any amount of gilts.
The insurer “needs to get a higher return to be able to set the premium at a level a pension scheme would want to pay”, he says, adding that insurers would generally accept gilts worth up to around £500m. For larger transactions he recommends holding corporate bonds as well as gilts.
Focusing purely on assets insurers like to use for matching can sometimes be a decision forced on trustees, suggests Adam Levitt, partner at law firm Ashurst.
He says trustees are in a difficult place because of the ever-present discourse about the ability and advantages of doing a buy-in or buyout.
“They are told, ‘If you go on this journey, make sure your assets are right’. On the other hand you are constraining your options as a trustee by focusing on those assets… in as much as you’re not going to take advantage of the more exciting assets,” he explains.
Selective insurers
What type of assets pension funds hold will be just one of the criteria insurers will apply when selecting which deal to pursue.
As well as needing more capital to purchase and hold annuities, insurers are facing increased competition, making their quotations less likely to lead to business.
“They’re going to be more selective about which ones they target, to make sure they’re still winning the same proportion of the transactions,” says Finch about possible developments this year.
Francis Fernandes, senior adviser at covenant specialist Lincoln Pensions, says trustees need to be especially well prepared now. “Insurers have appetite and can pick and choose,” he says.
I wouldn’t be surprised to see a lot more automation and online-type activity this year
Phillip Beach, Legal & General
Good member data, including postcodes and marital information, are part of that preparation. “The fewer the gaps given to insurers, the fewer the contingency margins for uncertainties,” Fernandes says.
Trustees also need to look at their trust deed and rules to understand whether they actually have the power to invest in a policy, notes Sasha Butterworth, partner and head of the pensions team at law firm TLT solicitors.
Whether a transaction is in the best interest of all scheme members is just as important. “They need to think is this something that helps with the scheme’s solvency, can that asset be used to benefit all members if there were a winding up, not just specific members,” she says.
An insurer’s stability should be a further point on the checklist. Trustees have to look at the issues around financial protection from the Financial Services Compensation Scheme, in case the insurer becomes insolvent, she says.
Once these blocks are in place, doing the actual deal can be “pretty speedy”, says Butterworth, citing an example where a fund transacted within four weeks, closing just before the year-end of 2014.
“We had started discussing it and done the beauty parade bit, that was from mid-November to December 24. If you are doing that… you need to delegate authority to one of the trustees or trustee director,” she says.
Weekly call-backs were also made, “and in the last few days it was two to three times a day, and we got it sorted.”
Timing more important
The ABC of risk transfer innovations
Funding issues might not be insurmountable when it comes to bulk annuity transactions. Insurer Legal & General’s Phillip Beach says: “There’s lots more talk about ways of making a deal happen when otherwise it may not look achievable, for some of the schemes that are underfunded.”
Accelerated buy-in – a scheme sponsor takes a loan from an insurer to fill a pension deficit and then transfer liabilities to that insurer, effectively swapping pension liabilities with a short-term loan
CPI switching – a scheme with CPI increases can agree for RPI and switch to CPI on buyout
Deferred payment – if a scheme is not fully funded, part of the premium can be paid at a later date
Forward-starting buy-in – a scheme insures future cash flows, rather than all cash flows from the point of transaction
Medical underwriting – a scheme can improve on pricing by giving members’ health and lifestyle information to the insurer
Post-deal medical underwriting – a scheme gets a guaranteed price which can be improved on by the later addition of medical data. The price only changes if members’ life expectancy is lower than originally priced
Top-slicing – where only those members representing the biggest liabilities, usually high earners, are transferred to an insurer
Paul Darlow, head of proposition development at consultancy Xafinity, says trustees tend to put more thought into the timing of transactions than they used to.
Historically, trustees would approach insurers for a quote once, but by the time they had received it, pricing might have moved away.
“But increasingly trustees are turning that on its head a bit,” he says, as trustees are becoming more flexible, transacting only when market conditions are good.
Consultancies are investing to make this possible. Skyval, the joint venture of technology company RiskFirst and consultancy PwC, is one tool that aims to do this.
Legal & General’s head of core business for UK pension risk transfer Phillip Beach says more could follow: “I wouldn’t be surprised to see a lot more automation and online-type activity this year.”
He says automation will help insurers “turn quotes around much quicker at the initial stage, but then secondly plug into these consultant systems so we can regularly update pricing”.
However, Stephen Lowe, group communications director at insurer Just Retirement, says the problem with timing is not how quickly the quote is turned around, but the frequency of trustee meetings.
“The trustees’ meeting schedule works against getting the right pricing,” he says.
