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Pension buyouts: Capitalising on windows of opportunity

RISING LONGEVITY, poor investment returns and, it could be argued, increased regulation have seen the cost of providing a defined benefit (DB) pension scheme soar beyond a level most finance directors are willing to tolerate. Hence an increasing number are opting to close their schemes to new members, and now future accrual too, in order to cap their pension costs.

Yet while scheme closure signals a step on the road towards the end game, it does not remove a company’s obligation to pay its previously accrued liabilities – hence the need to manage risk remains. Left unmanaged, DB risk can impact a company’s credit rating, share-price, ability to attract capital and even its future viability. Indeed, the FTSE 100 includes no fewer than ten companies with pension liabilities greater than their market capitalisation.

In this respect, pension buyouts -where all accrued pension liabilities are completely transferred over to an insurance company in return for a premium – offer the most complete solution to this problem. Yet, to date, the market has failed to convince finance directors of its full value proposition. Indeed, it has only attracted £25bn of business (and this figure includes buy-ins), or 2.5% of the total value of DB liabilities sitting alongside the balance sheets of UK plc.

Understandably, premiums traditionally required by insurers – about 140% of the value of a scheme’s liabilities on an IAS19 basis – have been a turn-off for many finance directors. Yet innovative new solutions, which allow pension schemes to make an equity investment in a mutualised insurance company and hence recapture some of the 40% premium that is traditionally accepted as insurance profit, may go some way towards making a buyout economically attractive.

A matter of timing
Of course, the absolute price of a buyout is also intrinsically linked to the individual scheme’s current funding measure, as well as its position with respect to volatile investment markets. Currently, global long-term economic uncertainty has meant a struggling FTSE (reducing pension scheme assets) while interest rates remain at record lows (meaning large pension liabilities, as they are discounted using this value). Given this, many finance directors are holding tight until market conditions take a turn for the better, rather than risk locking in to a buyout when funding levels are low and liabilities high.

However, patience may not necessarily be a virtue. While pension scheme funding levels may compare unfavourably to those before the financial crisis, or even the start of last year, finance directors may have to accept that better conditions will continue to recede into the future. Indeed, interest rates have been at record lows for three years, with little indication this will change any time soon. Add to this the fact many pension schemes have already completed interest rate swaps – mitigating their risk, but also reducing their upside benefit from interest rate swings as well as moving the valuation of liabilities closer to that of an insurer – and one could argue that this could be as good a time as any to remove pension liabilities from the balance sheet, or at least to start the process.

For those schemes that have left themselves more exposed to fluctuations in interest rates or the equity markets – and therefore stand to gain from changing market conditions – patience may be more understandable, however. That said, finance directors should not simply sit back and wait for economic conditions to improve and funding levels to increase before hastily trying to snatch the opportunity to transact. Indeed, preparing for a major transaction itself takes many months – meaning that any delay to the start of this journey could result in missed opportunities.

History provides a useful lesson here – many pension schemes were in a favourable funding position back in 2008 but failed to take the chance to reduce risk and subsequently slipped back into deficit when the financial crisis hit. And there are more recent examples – Long Acre Life research, for example, suggests that the combined deficit of the DB pension schemes of the FTSE 100 decreased from approximately £43bn on an IAS19 basis at the end of 2010 to about £27bn by the middle of last year.

Yet given the volatility of pension scheme’s investment strategies and their exposure to market risk, these windows of opportunity are often short-lived, which means that – if pension schemes do not act quickly and efficiently to lock in improvements in funding levels – they risk a widening of their deficit the next time the FTSE takes a hit or bond prices rise yet further. Indeed, Long Acre Life data shows that merely three months later, with most schemes failing to engage in any de-risking activities, the deficit had increased by as much as £15bn to over £42bn on an IAS19 basis, driven by a combined 13.5% fall in UK equities (which accounts for about 18% of the FTSE 100’s asset portfolio) and 14% fall in global equity prices (which accounts for about 23%).

Historically, an inability to measure pension scheme funding positions on a continuous basis, an incomplete understanding about the exact nature of the risk pension schemes faced, a lack of board-level incentive to transact, and, of course, expensive buyout premiums, have all contributed to the lack of action in the buyout market. Yet, many of these barriers to buyout (and de-risking in general) are now diminishing. What’s more, the impending implementation of new IAS19 accounting standards may remove some of the profit and loss benefit that certain companies currently enjoy from holding riskier assets in their pension schemes – and may therefore make risk-transfer activity more attractive for such companies.

But to be able to take opportunities as and when they arise, schemes need to engage with buyout experts able to advise them on the potential routes through the thickets. Risk-transfer activities such as longevity swaps, synthetic buy-ins or deferred buy-in/buyouts all are legitimate precursors to a full buyout, for instance, moving schemes well on the way to an insurer’s best estimate of the liability and reducing the extra cost of a buyout. The journey towards a buyout may be a long one for some schemes, but this makes it all the more important for them to get started.

David Norgrove is the former chairman of The Pensions Regulator and current chairman of Long Acre Life

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