FOR PROFESSIONAL CLIENTS ONLY
A broader de-risking assessment
Today, many private defined benefit (DB) pension schemes are targeting a buy-out as their endgame. However, most schemes cannot afford the cost of undertaking a full buy-out in the near term and consequently require an interim solution. Therefore, they may ask themselves whether they should conduct a partial buy-in for a portion of their liabilities or simply evolve their current de-risking strategies, taking a ‘self-managed buy-in’ (SMBI) approach.
To help schemes make an objective comparison of different de-risking options, we examine:
1. Value for money
2. Impact on the overall portfolio
3. Flexibility to deal with the unpredictable
Value for money
A major driver of the increasing demand for buy-ins is the seemingly competitive pricing from insurers. Typically, buy-in contracts are priced on a ‘gilts plus’ basis, making them look attractive when compared to the cost of matching pension liabilities with government bonds. However, investors should not focus on price alone, but focus on what they receive for this price.
An SMBI approach is able to replicate many of the characteristics of an insurance buy-in, including longevity hedging, but at a lower cost due to the allowance in insurers’ pricing for capital and profit margin considerations, and more stringent investment restrictions.
Historically, we estimate that the difference has been up to 15% when considering the whole scheme membership. In the case of a typical pensioner-only transaction, the difference has been 5-10%, equating to a saving of £25-50m, assuming a buy-in of £500m1.
Because a buy-in is unlikely to cover non-pensioners, whilst the value of retained liabilities may fall, the risks (for example, the sensitivity to interest rates and inflation) will fall by less. Schemes may transfer disproportionally more assets than risks to the insurer.
Impact on total portfolio
An insurance buy-in offers security and cashflow matching in respect of a portion of the liabilities, but schemes should consider the broader impact on the overall portfolio. In particular, how does a buy-in impact the expected return needed on the remaining assets and/or the scheme’s ability to hedge its liabilities, and the expected time to reach the targeted buy-out?
1. Impact on the target return required from remaining assets
If a scheme is underfunded, the nominal level of deficit will vary following the buy-in depending on the valuation basis relative to the buy-in basis. The disclosed deficit may even fall. Crucially, however, a buy-in leaves fewer ‘free’ assets to make up any funding level deficit. This increases the target return needed from the remaining assets, everything else being equal.
Conventional insurance buy-in: A scheme transfers some of its assets to an insurance company, which in return covers the cost of the pension payments for some of the scheme membership, usually the pensioners.
Self-managed buy-in: A scheme aims to replicate the key characteristics of an insurance approach – such as hedging longevity risks and generating cashflows to match outgoing payments – directly and more broadly across the whole portfolio.
2. Impact on the scheme’s ability to hedge its liabilities
In order to maintain a given hedge ratio, a proportion of the remaining assets must be allocated to collateral, further pushing up the required target return on the ‘free’ assets. This would incur additional costs and could result in potentially selling assets at an inopportune time. Alternatively, schemes could decide to accept a lower hedge ratio.
3. Impact on the time to achieve a full buy-out
The pursuit of higher target returns following a buy-in increases the chance of defaults, negative returns and forced selling risk, especially during times of market stress. Ultimately, it potentially reduces the chance of the scheme being able to afford a buy-out at the target date. The alternative, maintaining a lower hedge ratio, could lead to an increase in liability mismatch risk.
Flexibility to deal with the unpredictable
Up to the point of a full buy-out, regardless of the adopted de-risking method, 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.
We suggest that schemes look beyond buy-in prices alone and assess the impact at the total scheme level, considering a wider range of factors, such as value for money, impact on the total portfolio and flexibility to deal with unpredictable events. We believe that this will help them reach their endgame with more certainty. When considering these wider criteria, we believe a self-managed buy-in offers a more efficient route to a buy-out for many schemes than an insurance buy-in.
Figure 1: An insurance pensioner buy-in can increase the target return needed from your assets
For illustrative purposes only
Past performance is not indicative of future results. Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
Insight calculations, 2019. Given current Solvency II regulation, we estimate that a pension scheme could achieve a net asset yield of circa 100 basis points more than an equivalent insurer. Around two-thirds of this difference is due to the pension scheme’s greater investment freedom, with the remainder reflecting the insurer’s cost of capital. We assume that, on average, pensioner liabilities have a duration of 10-15 years.
This document is a financial promotion and is not investment advice. Unless otherwise attributed the views and opinions expressed are those of Insight Investment at the time of publication and are subject to change. This document may not be used for the purposes of an offer or solicitation to anyone in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it is unlawful to make such offer or solicitation. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment. Issued by Insight Investment Management (Global) Limited. Registered office 160 Queen Victoria Street, London EC4V 4LA. Registered in England and Wales. Registered number 00827982. Authorised and regulated by the Financial Conduct Authority. FCA Firm reference number 119308. © 2019 Insight Investment. All rights reserved.
Head of Solutions Design – Insight Investment