Aon highlights merits of synthetic credit for pension schemes approaching buyout

Pension schemes can use synthetic credit to keep assets in line with insurer pricing and help maintain liquidity to ensure an efficient and cost-effective transition to an insurer, according to a paper from Aon.

The research, titled Synthetic Credit When Approaching Buyout, said that having the flexibility to adjust credit exposure quickly to match insurer pricing was an important consideration for schemes as they get closer to transacting.

It listed the benefits of synthetic credit as including better diversification, capital efficiency, low costs versus physical credit, high liquidity and its complementary fit with liability-driven investment due to the flexibility for schemes to simply adjust the credit sensitivity of the portfolio without affecting the interest rate or inflation hedging positions.

The paper explained that the premium the insurance company asks for ahead of a buyout transaction would reflect the assets that the insurer is intending to invest in to back those liabilities.

Aon established that most insurers use corporate securities such as Investment Grade (IG) corporate bonds in their investment strategies alongside government bonds and illiquid private credit assets, with the range of exposure varying from insurer to insurer; from 14 per cent to more than 50 per cent in credit.

The paper continued: "As schemes get closer to the point of transacting, having a flexible credit portfolio which can be adjusted quickly and cheaply is crucial. Depending on the insurer, the credit sensitivity may need to be increased, for example to 50 per cent or reduced to 0 per cent.

"Using synthetic credit can provide this flexibility rapidly, at a low cost and allows better
matching of buyout liabilities."

The provider emphasised the importance of considering synthetic credit exposure by noting that its 2019 Global Pension Risk Survey showed that many UK pension schemes were less than 10 years away from buyout and securing their members’ benefits with an insurance company.

Aon partner, Lucy Barron, said: “When an insurer in a buyout transaction quotes a premium, the price will reflect investments the insurer will buy to cover a scheme’s liabilities. Having exposure to credit will help ensure a scheme’s assets move in line with insurer pricing, as all insurers hold investment grade credit albeit in differing amounts.

“The flexibility to adjust this credit exposure quickly and cheaply will ensure that a close match can be achieved regardless of which insurer is ultimately selected.”

She added that exposure to synthetic credit provided through index credit default swaps would “protect against market-influenced insurer pricing”, explaining that the swaps “are standalone contracts that bring a range of benefits by providing investors with liquid, standardised, synthetic exposure to the corporate bonds of a defined set of companies”.

Barron continued: “Credit default swaps typically hold their value better than physical credit during a credit sell-off. They can help schemes to track insurer pricing and are liquid due to being easier and cheaper to trade than physical corporate bonds. As schemes approach buyout, they should consider their exposure to credit – and purchasing synthetic credit is a low cost and flexible way to do this.”

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