Creative accounting

Gill Wadsworth asks whether the falling cost of moving into a buy-out for schemes is a sustainable trend

A flurry of activity in the pension fund buy-out insurance market has sparked predictions that 2008 will be a bumper year for the fledgling sector.

The first quarter of this year alone has outstripped the entire of 2007 in terms of business volume and insiders say the market could quadruple in size over the rest of this year.

May was a particularly busy month with Pension Insurance Corporation announcing its first buy-out deal after securing the assets of the £67 million Swan Hill pension fund, while one of the most successful entrants to the market, Paternoster, added mining firm Lonmin to its client list, and announced the largest buy-out deal to date after it secured the £400 million Powell Duffryn pension fund. Norwich Union also completed its first major contract, landing a buy-in with the £350 million Friends Provident pension scheme.

This rush of activity is largely explained by the falling cost of buy-out. Figures from Paternoster found the cost of securing pension liabilities for a 'typical' UK scheme fell by eight per cent in Q1 this year, opening the market up to a wider audience.
Mark Wood, chief executive at Paternoster, says recent changes in the economic landscape have made buy-out more affordable.

"Favourable markets are causing the cost of buy-out to fall. Bond spreads have widened to reflect growing concerns about both liquidity and default rates. In consequence the amount of capital projected to be required to settle incomes for individuals in retirement falls."

He adds: "At the same time, equity markets are not reflecting general concerns about the real economy with the consequence that pensions schemes that hold equities have not suffered a loss of value. A combination of the two has, for many schemes, closed the gap to the price of buy-out to a level where it is affordable for the sponsoring employer."

Paul Marks, technical consultant at Gissings, agrees costs are falling and says an influx of new buy-out providers, which ended the Legal & General/Prudential market duopoly, has made prices more competitive.

"The cost reduction is due, in part, to greater competition in the market, but new entrants have also brought greater innovation in pricing and the models used are more sophisticated. That might be down to the fact that in the past there was no perceived need for innovation due to the effective duopoly that existed," Marks says.

The falling cost of buy-out has been a long time coming and is widely welcomed, but trustees should be aware that it may not last for long. April saw a rise in the cost of buy-out as investors believed liquidity was returning to the market, prompting Paternoster's Wood to warn trustees against missing the "window of opportunity".

Capacity
Further, the headline grabbing predictions of a four-fold increase in buy-out business fail to capture questions about whether providers have sufficient capacity to cope with large inflows of pension fund liabilities.

Sir Mark Weinberg, chairman of Pensions Corporation, argues that as more pension schemes move into buy-out, strains on capacity could force prices back up.

He says: "With credit spreads at their current levels and increased competition in the market, insurers are offering very attractive prices. However, while this may change in the medium term, trustees and sponsors need to consider all of the risks they are running and the value they should attribute to them. As more pension funds look to insure their risk, capital will become scarcer, thereby causing upward pressure on pricing."

Tiziana Perrella, consultant and actuary at Pension Capital Strategies, also doubts whether there is capacity in the market to cope with a large influx of clients. She says: "The buy-out market really has grown but I don't think there is enough capacity to take on even a proportion of the defined benefit (DB) liabilities that exist."

Perrella adds that with at least two providers refusing to quote for business on pension schemes with less than £20 million in assets, smaller funds may find it hard to secure a provider. "It might be difficult for schemes with £20 million or less to secure a quotation at the moment, never mind having their benefits bought out," she says.

Gissings' Marks agrees that it is already becoming more difficult to obtain a quotation. "If activity levels increase still further as predicted, then we suspect that the providers will simply become much more selective about the business they want."

Indeed, Paternoster is close to capacity for quotations as it readies itself for an increase in transaction volume, while Pensions Corporation's Weinberg adds: "We have a full pipeline of deals of various stages in the buyout process and are extremely confident in the future development of the market."

Alternatives
For corporate sponsors unable to find a willing buy-out partner there are other solutions when it comes to removing pension fund liabilities from the balance sheet.

Among the alternatives is Occupational Pensions Trust (OPT), which launched last year targeting schemes with assets of between £10 million and £500 million. The offering sees the plan sponsor make a cash injection to its existing scheme and then transfer the assets to a new company with a plan that mirrors the benefits of the original scheme. OPT then buys the new company and takes responsibility for running the pension assets. "There has certainly been growing interest in the alternatives [to buy-out] and some of these undoubtedly merit consideration as part of a risk-management exercise for pension schemes," says Marks.

However, he adds: "That has to be balanced by trustees' desire and need to ensure that members’ benefits remain secure, and the recent announcement of further powers for the Pensions Regulator in relation to primarily non-insured buy-outs may well make these less attractive."

Given that the 'window of opportunity' for securing a buy-out deal might only be open for a short period of time, it is necessary for trustees considering such a move to get their house in order. A clear strategy and the ability to move quickly are critical.

John Broker, director at ITM, a data and administration consultant, says trustees should ensure their record-keeping is clean and up-to-date.

"Our recommendation is that trustees carefully consider data risk as part of the preparation for buy-out and undertake data due diligence well before going to market," he says.

Over a relatively short period of time, buy-out providers have established themselves as a viable option for sponsoring companies struggling to cope with running their occupational pension plans.

However, it is clear that as things stand there is only space for a select number of DB plans to take advantage of the solutions on offer. For smaller pension schemes or those that are still heavily underfunded, buy-out is unlikely to be a realistic strategy, at least for the foreseeable future.

- Pensions Age June 2007