Buy-ins and buy-outs are typically undertaken by trustees of defined benefit schemes to help manage or reduce risk. While both buy-ins and buy-outs seek to reduce risk and secure member benefits, they differ fundamentally in three ways: their purpose, practicalities and potential investment impact. Consequently, the analysis you should conduct when you consider them needs to be different.
An insurance buy-out is the destination point at which trustees and sponsors can be confident of securing all the members’ benefits, i.e. an endgame solution.
An insurance buy-in is a potential investment option to help trustees move towards their endgame, which is usually a buy-out if choosing this option.
Under an insurance buy-out, trustees typically transfer all their assets and liabilities to an insurance company. The insurer takes on legal responsibility for fulfilling pension obligations to scheme members. The corporate sponsor divests all responsibility for the scheme, and scheme members become policyholders with the insurer. This allows the trustees to wind up the scheme, extinguishing all governance responsibilities.
Under an insurance buy-in, trustees typically transfer some of their assets to an insurance company in return for a cashflow stream that reflects the actual pension payments for a portion of the scheme membership (the members insured). The insurance company makes payments to the scheme, which in turn makes payments to the pensioners. The trustees retain the governance responsibility for managing the whole scheme, effectively making the buy-in an asset of the scheme.
Potential investment impact
Once a buy-out is complete, the pension scheme has wound up, and scheme members are individual policyholders with the insurer.
Following a buy-in, when looking at the notional portion of the members that have been insured, it can appear that there are no investment implications as their pension payments are matched exactly by the insurance contract (ignoring any governance costs incurred by the scheme for managing these member benefits). However, when looking at the scheme as a whole, there can be significant investment implications.
Buy-in transactions typically do not cover non-pensioners, and therefore the longer-dated and most risky liabilities typically remain uninsured. So, schemes may transfer disproportionately more assets than risks to the insurer. In addition, an insurance buy-in ties up a significant proportion of the scheme assets and cannot be reversed – this can reduce the ability to deal with unpredictable events.
The investment implications may be three-fold:
1. Impact on the return required from remaining assets
A buy-in typically leaves fewer assets under trustee control. Depending on the longer-term funding aspirations of the trustees, this could increase the return needed from the remaining assets, everything else being equal – meaning there may be a need to take on more investment risk. Additionally, in order to maintain a given liability hedge ratio, a portion of the remaining assets might have to be allocated to collateral. This could also push up the required return on the ‘free’ assets.
2. Impact on the time to achieve a full buy-out
The pursuit of higher returns following a buy-in increases the chance of negative returns, especially during times of market stress. The alternative – maintaining a lower return target – could lead to an increase in the time necessary to achieve a full buy-out.
3. Flexibility to deal with the unpredictable
Up to the point of a full buy-out there will always be risks affecting the assets or the liabilities that cannot be predicted or hedged. Examples could be poor short-term returns, transfer values forcing payments earlier than expected, or changes in legislation causing changes to benefits. The illiquid buy-in asset gives trustees less flexibility to deal with any setbacks.
The analysis when considering buy-outs and buy-ins needs to be different
An insurance buy-out is widely deemed the least-risk way to secure payments for all members’ benefits, provided the insurer remains solvent. However, insurers need to comply with stringent regulatory restrictions on investments and will also be seeking to generate a profit. This means buy-outs are typically relatively expensive compared to other options.
The usual reason trustees would not pursue a buy-out is a scheme’s inability to afford it. Another reason would be if the trustees believe an equivalent outcome could be achieved more cost effectively by adopting an investment strategy that incorporates techniques used by insurers, but without the regulatory and capital constraints insurance companies face.
When comparing an insurance buy-in to other options, trustees need to consider the impact on their certainty of achieving their target endgame. This involves considering the impact on a wider set of measures, such as the return required from remaining assets, the scheme’s ability to hedge its liabilities, time to achieve the endgame target, and flexibility to deal with the unpredictable.
|Purpose||• Endgame solution||• One option on the path to the endgame|
|Practicalities||• Transfer all assets and liabilities
• No further governance obligations
|• Transfer some assets in return for a cashflow stream
that reflects some liabilities
• Retain all liability and governance obligations
|Potential investment impact||• No further investment mis-match risk||• Asset that reduces the mis-match risk for a notional portion of the liabilities, but could increase the time to, and cost of, reaching the target endgame overall|
|Analysis required when comparing to other options||• Cost versus residual risk of managing
|• Return required from remaining assets
• Ability to hedge the remaining, or uninsured, liabilities
• Time to achieve the target endgame
• Flexibility to deal with unpredictable event
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