A pleasant surprise
Laura Blows meets Legal & General’s Director of UK Pension Risk Transfer Phill Beach to discuss how de-risking may be more achievable than expected for pension schemes
Why are some pension schemes looking at de-risking options?
The first thing to think about with de-risking is the long-term objectives of both the sponsor and the trustees, what does their journey plan look like. From the trustees’ perspective, the main aim for them is to protect their members’ benefits long into the future. From the sponsor’s point of view what they are finding is the pension scheme is an unrewarded risk. By unrewarded risk, I mean that if experience turns out better than expected then they are not allowed to take any of that surplus out of the scheme, but if performance and experience turns out worse than expected they are still expected to make up the deficit. So there is a huge benefit for both the trustees and the sponsor to de-risk the pension scheme.
Many schemes will have buyout as their long-term objective, where they transfer the risk to an insurance provider. For other schemes they may be looking at self-sufficiency and to manage each risk individually. Regardless of what the end game is insurance can play a key role. A survey commissioned by Legal & General undertaken in February of the largest pension schemes found 64 per cent of schemes are looking for insurance solutions as part of their de-risking journey.
For those looking to de-risk, what are the options available to them?
There are three key products that people should think about when looking to de-risk. The first is longevity insurance. Under longevity insurance you are transferring that longevity risk from the scheme to a provider. The way they achieve that is by locking into a fixed longevity assumption and the insurance provider will then pay for any deviation in actual experience from that assumption. What that means for the scheme is that they can retain their assets and they get the opportunity to manage those assets in a way they see fit to meet their goals.
The second option is buy-in insurance. With buy-in insurance the scheme is transferring both the longevity and asset risk to a provider. It allows them to hold the buy-in policy as an asset of the scheme and therefore it’s a perfect match for their liabilities. The scheme still retains responsibility and that link to the members.
The final option is the buyout policy. This is where you transfer the whole scheme, including all risk, such as regulatory risk, across to the insurance provider. In that example the insurance provider takes over administrative responsibility and they will have the relationship with the end members. So from a company’s point of view they remove the pension scheme liability from the balance sheet.
A common problem with these options can be the funding levels. For instance the 2014 PPF Purple Book said only 5 per cent of schemes had funding levels greater than 100 per cent of the buyout pricing level. What would you say to these schemes that are facing difficulties with funding?
The first thing is that buyout is often not as expensive as people’s expectations. What we’ve found is for many trustees and sponsors, buyout prices can be 10-20 per cent cheaper than their expectation. The trustees and the sponsor’s expectation is always anchored around the actuary’s estimate but there are some key differences around what the insurer will do and what the actuary is estimating. On top of that there are different views on the longevity experience, there may be some sponsor commitment to top up the scheme, plus the expense of running the scheme, so you may quickly find the gap is actually much smaller than you ever realised.
If that doesn’t close the gap, there are other things to think about, such as timing. This is often the most important point. The actuary’s estimate is all based on one day, but the reality is markets move up and down. We did some analysis and found that buyout pricing could be moving by typically 4-5 per cent over the course of the year. So that gap can close by monitoring the market.
The second thing to consider is bespoke solutions. You do not have to treat this as an ‘all or nothing’ solution. There are ways of carving up the risk and passing some of these risks over to the insurance company.
The third point to mention is member options. Many schemes are starting to look at liability management exercises. The idea of this is you are giving your members more options, while possibly being able to remove certain risks that are expensive and more difficult to hedge.
The ‘so what’ of all of this is that you can take something that appeared unachievable and out of reach and quickly turn it into something that is achievable. Maybe not today or tomorrow, but certainly over the journey plan.
Please could you further explain about these bespoke options?
This is an area where the market has really developed. In reality what you will probably find is that the scheme, the consultant and the insurer are all working together to try and deliver a solution that is perfect for that scheme’s needs.
However there are a few off-the-shelf solutions out there. The first is what we mentioned earlier, longevity insurance. We’ve seen in the press a number of large and groundbreaking deals. At Legal & General we have developed a solution so that longevity insurance is available across the market and not just available for the largest schemes.
The second option is around carving up the liability and the risks. We have worked with clients to find a way to ensure that they can insure some of the key risks without using all of the scheme’s assets. One example may be a deferred start annuity. Under this example, you choose a point in the future and you insure all of your cash flows after that point, eg 10 years into the future. The benefit of this option is that you get to insure all of the main risks and the tail risks in the scheme whilst retaining some of the assets in the scheme as well.
Another way of carving up the liabilities may be to just insure the pensioners in payment or even something called ‘top slicing’ where you may wish to only insure the largest pensions within the pension scheme.
The final product I would like to mention is one we have just launched at Legal & General, the accelerated buy-in. As the name suggests, this accelerates the ability to buy-in even if full funding is not available within the scheme. Put simply, Legal & General provide a loan to the sponsor. This makes the funds available for the scheme to do a total buyout from day one and the scheme is able to swap the pension for a guaranteed loan repayment.
So, for a scheme wanting to de-risk, how do they prepare to take that next step?
Preparation is absolutely key and I would probably split that preparation out into four key points. The first one is early engagement across the sponsor and trustees, making sure you have got alignment of all of those long-term objectives.
The second one is engagement with the market, the insurance providers and the consultants. This will allow you to work out what steps you need to take to make it more affordable and possibly price monitor.
The third one, and possibly the most important, is thinking about data. Getting that data as clean and accurate as possible will remove uncertainty. The removal of that uncertainty might allow the insurer to remove reserves for that uncertainty and maybe make it more affordable.
The fourth is asset strategy. It might make sense for the scheme to move into assets that are more aligned with the insurance pricing. If you do this at the point of buyout, you may be able to use these assets as a part-premium
for the insurance and therefore make it cheaper.
Bringing all of this together, preparation is key. By being planned and prepared you may make something that was once unattainable and unaffordable become absolutely achievable. At Legal & General we are really committed to working with the trustees, the sponsors and the consultants to make those de-risking objectives become a reality.
This is not an advert for pension members or employees. It’s intended for professional financial advisers and pension trustees and should not be relied upon by pension scheme members, employees or any other persons.
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