Small schemes needn’t feel restricted by options for de-risking, finds Andrew Sheen

As increasing numbers of schemes close to new members and future accrual, and employers look at legacy defined benefit (DB) arrangements as more of a millstone than a beacon for their business, scheme de-risking has risen up the agenda. While there has been an explosion in the range of options available, encompassing liability driven investments, bulk annuity-based solutions such as buy-ins and buyouts and more recently, longevity swaps, smaller schemes - or schemes of smaller employers – may feel they are being left out.

LCP partner and head of buyout business development Emma Watkins says one of the major barriers affecting smaller schemes is the information gap. “Trustees of smaller schemes may not be able to access information regularly about de-risking markets, so they don’t know what time is good to transact,” she says. While several consultants do produce de-risking price indexes, they can tend to be out of date – or at least, not current - by the time they are published, and favourable market conditions may have passed.

For smaller schemes considering de-risking via buy-in or buyout, a key concern is the cost – both financial and governance – in completing a transaction. Barnett Waddingham associate Gavin Markham says: “Governance is the biggest challenge for smaller schemes. Bulk annuity transactions require a lot of concentrated attention, education and resources.”

As a result, it is increasingly common for smaller schemes to use an independent trustee with experience of several de-risking deals, as well as appointing a dedicated sub-committee able to take decisions on a more regular basis than the full, quarterly trustee meeting.

Bulk annuity specialists Pension Corporation co-head of business origination Jay Shah says schemes should be prepared to incur costs in preparing a deal and as a result, they should be serious in their desire to transact when tendering for quotes: “There’s a reasonable amount to be done ahead of a transaction, and we find to do that cost-effectively needs pre-determined governance.”

Question of access
LCP’s annual Buyout Report shows that the vast majority (over 95 per cent) of bulk annuity deals are sub-£100 million with nearly 90 per cent under £50 million. Some sponsors are able to bridge the gap between scheme funding and buyout with a one-off injection of cash, which is often justified on the basis that a one-off cost is lower than the future costs of keeping the scheme open.

“It could be a higher cash flow in the short term, but cheaper in the long run,” says Watkins.

At the smaller end – Shah says Pension Corporation would be unlikely to quote on deals valued at less than £20 million, while the minimum practical size for buy-in or buyout deals is about £5 million – schemes are usually able to obtain two to three quotes. But given the limited capacity of the bulk annuity de-risking market, smaller schemes can be the first to lose out if larger deals come to the table. Markham says schemes need to “be prepared and demonstrate readiness” to transact in order to secure deals.

“If market activity increases, smaller schemes might be squeezed out,” adds Watkins.

Premier head of consulting services John Reeve says that while the market has opened up in terms of de-risking solutions for smaller schemes, their smaller size can make it more difficult to secure attractive terms with insurers. As many small schemes are not well-funded enough to afford full buyouts, many are looking to move incrementally, with a combination of exercises such as pension increase exchanges (PIEs) and enhanced transfer values (ETVs) to control liabilities ahead of a bulk annuity deal. Schemes may look to remove the inflation and longevity risk from tranches of the pensioner population via buy-ins, with full buyout as an endgame.

The last year has also seen the growth of medical underwriting in buy-ins, by annuity providers Just Retirement and Partnership, as well as Aviva and L&G, whereby annuities are priced according to member health. Due to the more bespoke nature of the annuities, LCP says that medical underwriting can be more attractively priced for smaller schemes with a proportion of members in poor health.

Markham says the entry of ‘household name’ insurers such as Aviva and L&G into this space is a positive move. “From a trustee perspective, it increases competition and gives them the comfort of having traditional bulk annuity providers in the market.”

Some schemes have also been able to complete bulk annuity deals with deferred or partial payment. “If you have assets that you don’t want to liquidate, or they are illiquid assets, then you can promise the disinvestment to the insurer,” says Reeve.

Shah says there is a “reasonable amount” of interest in deferred deals and that Pension Corporation has completed deals with as much as 5-10 per cent of the premium deferred for various reasons, although they are struck on a case by case basis. “It depends on the proportion paid up front,” he says.

Liability driven investing (LDI) is seen as a way of shoring up scheme finances on the way to full de-risking. But for much of the past decade, ‘full’ LDI has been the preserve of larger schemes, says F&C Asset Management head of global consultants and UK institutional Julian Lyne. He says a big concern is “how can small and medium, and low governance, schemes implement LDI and de-risking”?

Recent years have seen greater innovation and demand from smaller schemes, leading to the development of LDI structures using pooled funds, allowing smaller schemes to access LDI. Lyne also highlights the greater use of derivatives for hedging, and ‘dynamic LDI’, which uses both swaps and gilts opportunistically to access the best and cheapest form of liability hedging, as ways in which LDI has become more suitable for smaller schemes.

“More importantly, implementation techniques like triggers have become more commonplace. All of these tools and advice have meant barriers have come down,” he says.

Gilt written all over them
As schemes are natural holders of large amounts of gilts and bonds, they have been exposed to recent market conditions. With gilt yields at or near historic lows, this is having an impact on buy-ins and buyouts, as well as scheme efforts to close deficits.

Research from LCP shows that a lot of the current activity in the buy-in market is being funded by gilts bought several years ago, before yields fell, as the higher prices have caught up to - and in some cases exceeded - buy-in values. However, complete buyouts have become more expensive.

Markham says: “Schemes are looking to use their gilt holdings to secure buy-ins at minimal or neutral cost.”

Shah says the low interest rate environment means there is an “affordability gap” opening up. “It’s becoming more and more expensive to get to full buyout, but schemes holding full gilts or bonds have seen attractive pricing.” He says they’re selling up or passing gilts over to insurers for buy-ins.

Low yields are also causing problems for schemes using trigger points to move from risk to liability matching assets, as in many cases, triggers are not being activated. As a result, schemes are torn between remaining exposed to potentially risky investments or locking in at a low yields and crystallising their deficits.

Lyne says that schemes will have to be more pragmatic about trigger points and removing risk from their schemes, with many schemes looking for “unrealistic” levels to start to de-risk. “This isn’t an 18-24 month paradigm. Trustees now have to take small moves as they wait for trigger points that never come,” he says.

At the more esoteric and advanced end of de-risking, longevity swaps – derivative contracts that allow a scheme to make fixed payments that essentially insure it against higher than expected pensions as a result of longevity – seem to be the preserve of larger schemes.

While only a handful of such deals have been carried out – mostly at the larger end of the market – efforts are being made by insurers to make longevity swaps more suitable for smaller schemes. Index-based swaps that use general, rather than scheme-specific, mortality tables are available, although they remain a niche. However, there is a general scepticism over their suitability for smaller schemes.

Reeve says: “I don’t see longevity swaps as being on the route to buyout. They’re almost impossible to unwind.”

And while some insurers have relaxed terms for longevity swaps with smaller schemes – allowing quarterly, rather than daily, collateral calculations, and taking a more lenient approach to margin requirements, with extra collateral only required in the event of ‘material’ changes to the profile – Watkins remains unconvinced: “It’s still the remit of larger schemes. Unless there’s a good reason for smaller schemes to stay open, then otherwise, they’d be on their way to buyout.”

Shah says even index-based longevity swaps are “resource hungry” with specialist advisers needed. “They are not hugely practical for smaller schemes,” he says. “If your long term expectation is to buyout, then I’m not sure that a longevity swap is the best thing. Will another insurer accept it?”

Andrew Sheen is a freelance journalist

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