Nick Martindale reports on the growth in buyout interest

One of the more notable impacts of the economic downturn on the pensions landscape has been to accelerate the slow but steady decline of final salary and defined benefit schemes.

Taken alongside the wild fluctua-tions in scheme valuations seen over the past three years, as well as regulatory and accounting changes and the increased longevity of the population at large, this has led to a significant shift in the way in which pension commitments are viewed by organisations.

“Many schemes have closed to new entrants and future accrual and companies are now seeing their legacy defined benefit schemes as financial liabilities to be managed rather than an HR issue,” suggests Alex Hutton-Mills, managing director of Lincoln International. “The cocktail of market volatility and a bank-induced recession have put further pressure on sponsors to explore ways to reduce pensions risks on their balance sheets.”

The result of this has been a surge of interest in both buy-outs and buy-ins over the past four years, says David Collinson, co-head of origination and business development at Pension Corporation, with trustees and spon-sors now more aware of the true level of risk in pension schemes and more realistic in their expectations of both future expected investment returns and longevity levels.
“This has moved both trustees’ and sponsors’ views on the actual pension liability closer to the price charged by insurers for a buy-out, so there is now a smaller gap between how pension schemes are being funded and the cost of buy-out,” he says.

Emma Watkins, director of business development at MetLife Assurance, says premium volumes in 2010 exceeded those in 2009 as financial markets began to stabilise, and expects this upward trend to continue during 2011.

“In terms of bulk annuities, as in prior years, the majority of schemes completing a transaction will probably be at the smaller end of the market, although a small increase in the number of larger premium-sized transactions could result in an increase in the average transaction size to that seen in the last couple of years,” she says.

For many organisations, the process towards de-risking will be a gradual one, with a series of buy-ins often the prelude to an eventual buy-out. “Buy-ins cover only some of a scheme’s liabilities, such as the benefits owed to people who have already retired,” says Paul Kitson, senior consultant at Towers Watson. “They are therefore a more affordable first step to de-risking for sponsors with limited resources and sometimes they can even be financed without a cash injection from the sponsor.”

Tiziana Perrella, head of buy-out services at JLT Pension Capital Strategies, says pensioner liabilities are a particularly common buy-in in the current climate as these can be secured at a price very close to the scheme’s technical provisions.

“A buy-in deal would cap the scheme’s liabilities and a recovery plan can then be worked out based on a cost which is not going to alter at the time of the successive actuarial valuation,” she says. “It is very hard to argue a case against a buy-in deal if the price is sufficiently close.”

Eventually, though, complete buy-outs are likely to be the final destination for many defined benefit schemes, shifting the obligation to meet the pension promise from employer to insurer and completely removing the liability from their balance sheet.

“The advantages to the employer in securing liabilities far outweigh the downsides if they can afford to do so,” says Alan Collins, head of employer advisory services at Spence and Partners. “There is no upside for the employers in holding on to a scheme, especially one which is closed to future benefit accrual.”

There are, however, downsides to both buy-ins and buy-outs, however tempting it may be for organisations to rid themselves of what has become an increasing burden around their corporate necks.

“The corollary to the lack of downside risk in a buy-in or buy-out, subject to the insurer’s covenant, is the lack of any potential for upside gain due to favourable future expe-rience,” says David Ellis, a principal at Mercer, which recently advised on a buyout for the Radius Systems pension scheme, resulting in a transfer of obligations to Rothesay Life.

“This could manifest itself in terms of no more potential for discretionary benefit improvements in the future, or no more potential for a plan surplus which might benefit the sponsoring employer in some way.”

“The main disadvantages are the high price of buy-outs or buy-ins and the need to lock up capital that could be better to use to generate decent returns,” adds Phil Page, client man-ager at Cardano UK. “In particular, larger pension schemes can often do a cheaper and more capital-efficient DIY buy-out using interest rate, inflation and longevity swaps, relative to buying the same protection.”

For any organisation contemplating de-risking in this manner, getting the timing right is vital, from both an internal and external perspective. Kitson at Towers Watson stresses the need to be able to act quickly when economic circumstances are favourable. “Those defined benefit pension schemes that have achieved buy-out have had the systems in place to be able to react quickly during volatility and capture de-risking opportunities before they pass,” he says. “This has enabled them to strike when the price has been right for them.”

Aon Hewitt's recent global risk survey, meanwhile, found that most trustees and sponsors were looking to eliminate all pension risks, with three-quarters aiming to either become self-sufficient or buy-out benefits from an insurance company.

"The challenge is that this needs to be at a pace that is affordable and, in most cases, schemes need to continue to take investment risk now in order to be able to afford to reduce risk in the future, unless the sponsor is able to quickly repair deficits through large additional cash contributions,” points out Martin Bird, head of risk settle-ment at Aon Hewitt.

External factors may also come into play when deciding the best time to make a move. Collins at Spence and Partners suggests the effects of Solvency II and the European Court ruling on equal treatment of males and females could force insurers to raise prices, while conversely buying out now could mean schemes missing out on savings as a result of the change in inflation measure from the retail to the consumer prices index.

An alternative to either full-on buy-outs or buy-ins for schemes wishing to retain exposure to inflation and re-investment risks – or to hedge them individually – is to insure the longevity risk only, suggests Perrella at JLT Pension Capital Strategies.

“This can be done through the purchase of longevity insurance, where a scheme agrees to a series of fixed payments, based on a set population and mortality rates, in exchange for floating payments based on the actual population and mortality,” she says. “All the longevity-only deals written to date have been for very large schemes. As insurers are now offering the same product to smaller schemes, this is a segment of the market with significant potential for growth."

However schemes decide to proceed, ensuring members are kept informed is vital if what should, on account of a more secure promise, be good news is not to be greeted with suspicion.

“As with any change, members are likely to be cynical and will need reassurance that their benefits are secure,” says Pete Snelling, commu-nication consultant at SHILLING Com-munication. “Communication needs to be honest, factual and personalised so that individuals know exactly what is happening and understand how it will impact them.”

The move from seeing defined benefit schemes as a valued employee benefit to a legacy liability, though, means more organisations are likely to de-risk over the coming years, putting both buyouts and buy-ins firmly on the agenda.

“Most trustees and sponsors are working on their pension risk management strategy and exploring opportunities to remove some or all of the risk at a pace which can be afforded,” says Bird at Aon Hewitt. “The coming decade will be all about taking risk off the table as and when conditions permit.”

Nick Martindale is a freelance writer

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