Myles Pink warns that putting a de-risking project on hold during challenging market conditions can leave trustees with insufficient time when markets turn

Good times don’t last long enough
Why do good times seem to pass more quickly than bad times? In investment markets there is evidence to suggest that for pension schemes, benign market conditions are sustained for shorter periods than unfavourable conditions. This is not surprising when one considers that most market triggers are associated with de-risking strategies that actually cause markets to turn as a result of investors’ actions.

Over the past five years, pension schemes have had perhaps four windows of opportunity to exchange their holdings for annuities at what they and their advisers would consider to be favourable levels. Such levels are defined not only by annuity pricing (i.e. the value of the liabilities) but also by the value of asset portfolios at that time. Some are able to move quickly and enter into annuity policies during those brief periods. However, many do not even get into execution mode before they refresh the numbers to discover that markets have turned and what they thought was affordable is now no longer. Some do de-risk but, with hindsight, not at the price they might have preferred to.

As with so many things, the issue lies in both preparation and process. Typically, a bulk annuity broking process is managed to finish simply when contract negotiations come to an end. Trustees rely on a fair mechanism for rolling forward an historical price to the date of execution and often little attention is paid to whether market conditions are optimal when price is locked in. For some, such a process is valid because they consider bulk annuity pricing to be driven more by insurers’ long-term actuarial assumptions and profit margins than by the effect of market forces on assets and liabilities. For them, a process that maximises competition between insurers is more important than how markets are behaving at the time of execution. But is this really right?

Market forces cannot be ignored
A pension scheme with a typical asset allocation that was fully funded on a buyout basis in March 2011 may now be sitting on a deficit to annuity cost equal to 15 per cent of its asset base – simply as a result of changes in markets, most importantly the fall in real yields in the second half of last year. Many pension schemes that were working towards purchasing an annuity before the summer have found themselves facing solvency challenges that make it appear unaffordable because of the impact it would have on scheme funding plans in a buy-in or on the need for cash in a full buyout. This is not the case for pension schemes that were heavily invested in gilts through the recent rally in that market; it is for these schemes that bulk annuities will currently offer good value-for-money even if their technical provisions discount rate is higher than the gilt yield.

For those other trustees who consider annuities currently unaffordable, it is natural to turn their attention towards other forms of de-risking (e.g. longevity swaps) and/or other matters in managing the pension scheme. This reaction is however flawed if it results in the project being put on hold until scheme assets and annuity pricing come back closer into line because preparing to purchase a policy takes time.

Don’t stop now!
Clearly trustees would not spend the time and money preparing to purchase an annuity if they had reason to believe it were an unsuitable de-risking solution or could not be afforded at some point. They should test annuity pricing and consider how prices from different insurers might move with changing market conditions. This ought to give them enough information to determine whether an annuity could be affordable, perhaps helped by a final contribution from the corporate sponsor. Many pension schemes already have this information, from when they approached insurers in the past.

If the trustees of a pension scheme are likely to purchase an annuity were it to be affordable, then they should not down tools while that transaction appears unaffordable. Instead they should address three important considerations:

• Decide whether an annuity is suitable and if so, establish a framework for selecting an annuity provider;
• Make all the necessary preparations to execute the bulk annuity policy; and
• Set a realistic target level at which they would be happy to transact.

Assessing annuities and annuity providers
In order to decide whether to insure pension scheme obligations, trustees should build a clear understanding of insurance regulation and how insurers manage annuity risks. This will also provide a firm foundation for designing the most appropriate structure for the transaction. Some of the questions that trustees should seek to answer include:

• Can the pension scheme generate a better return than implied in the annuity pricing after taking into account all costs, risks and operational challenges?
• Is it clear broadly how insurers’ pricing moves differently from one another and relative to the pension scheme’s asset portfolio?
• Can the insurer minimise price through optimising the point at which market conditions are locked in and then work quickly to execute the transaction?
• Are insurance protections well-understood?
• Has the insurance covenant been comprehensively compared with the pension scheme’s corporate covenant?
• Does it follow that all insurers are of equal financial strength because they are all subject to the same FSA regulation?
• How robust are each insurer’s administration arrangements?

Preparing for execution
Preparation is key to transaction success because of its impact on both pricing and execution speed. Trustees being well-advised is fundamental to their spending scheme resources effectively on preparation.

Annuity pricing can be reduced by improving the quality of scheme data because prudence in the insurer’s pricing assumptions can be eliminated. Particular areas to focus on should be longevity experience data, member tracing, marital status and spouse date of birth and benefit calculations. Once data has been cleansed in this way, trustees should test the impact on pricing with potential annuity providers.

It is natural for trustees to want to avoid unnecessary spending, particularly during times of weak scheme solvency, but such data cleansing is undoubtedly a good investment even if the scheme does not enter into an annuity because of the benefit it would bring in improving the scheme’s own evaluation of its liabilities.

Trustees should also spend time designing the structure of the transaction and settle on key terms. This could include work on codifying scheme benefits (e.g. the definition of financial dependant), equalisation of benefits and other legal processes. Working with advisers and insurers should ensure structure and terms are developing in a workable and cost-effective manner for the pension scheme.

Once detailed work has been completed on data, benefits and structure, trustees should have sufficient information on insurers’ prices and terms to appoint one or two preferred providers. This appointment would be made largely on the basis of criteria unrelated to price (such as financial strength, key terms and administration capabilities). Indeed, rather than comparing prices struck at a historical market conditions date, trustees should assess each insurer’s ability to access markets and hit the trustees’ target.

It is at this point that the transaction documentation should be prepared and asset transition planned, all in anticipation of the target being hit.

Monitoring price against a target
Some insurers have developed the systems and analytical capabilities to provide regular pricing updates within short turnaround times; trustees should take advantage of this development and work with an insurer that can monitor price regularly against a target. The target is likely to relate to both the value of the available assets and the annuity price. A difference between the scheme’s asset base and the assets in which an insurer would invest, provides an opportunity for market volatility to close the gap.

To increase their chances of hitting their target, trustees could ask two or more insurers that operate different investment strategies, to monitor price since one will inevitably hit the target before the other.

Provided all the preparatory work has been completed and the policy document is ready to sign, the transaction could be executed within hours of the target being hit. Managing the question of pricing in this way brings the pension scheme two significant advantages:

• The need for a price roll-forward mechanism has been removed; and
• If the target is correctly pitched, it is likely that the insurer will have had to work hard to secure appropriate assets in the investment markets and perhaps cut profit margin to hit that target.

Someone once said “success is where preparation and opportunity meet”. When it comes to purchasing an annuity, trustees should beware that from the point in time when they see an affordable opportunity to transact, they are unlikely to have the time to prepare to meet it.

In association with Rothesay Life

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