‘Systemic risks’ in rushing to embrace insurer buyouts, warns SPP

Pension schemes need to be given more choice than an insurance buyout when it comes to securing the benefits of members, the SPP urged.

The SPP believes a more diversified gilt market could help trustees meet the challenges facing defined benefit (DB) pension schemes.

In its Vision 2030, the SPP said that many DB schemes were on track to achieve their endgame objective of self-sufficiency or insurance buyout within 10 years.

But it warned that there were “inherent risks” in so many schemes seeking their endgame in the insurance sector and that more needed to be done to support and encourage schemes to run on rather than feel they had to sell out.

Mansion House and gilts crisis

Steve Hitchiner, president of the Society of Pension Professionals, said pension schemes had become the focus of intense scrutiny in the past 18 months, in the wake of the gilt market volatility of late 2022 and the Mansion House reforms announced by Chancellor Jeremy Hunt in July 2023.

He added a call for evidence from the Government on options for DB schemes has sharpened the focus on their future further and the lifecycle of DB pension schemes had reached a critical tipping point.

Hitchiner said: “Schemes are, in general, continuing to mature and, following a decades-long battle against deficits, funding levels have improved with many schemes now finding themselves in surplus on a low-risk basis. 

“DB strategy has been a key focus across the policy agenda, and so our Vision 2030 paper takes a well-timed look at the future for DB pension scheme investment. We hope the issues explored help move the debate forward in this crucial area.”

Rush to buyout

The SPP said the suitability of a specific endgame target will depend on a scheme’s circumstances, but an insurance buyout was not always the answer.

The paper argues that pension schemes can secure their members’ retirement income with low reliance on their sponsor, meaning they could potentially invest for the long term.

Vision 2023's key findings:

Insurers bear potential for significant systemic risks: current proposals to adjust the Solvency II regulation in the UK are likely to further reduce the capital insurers are required to hold against liabilities. SPP said: “The Bank of England estimates this would lead to a 20 per cent increase in the annual probability of life insurer failure, if a firm met just the minimum regulatory standard. Assuming an insurance covenant will always be stronger than a strong corporate might be imprudent.”

Insurer failure would lead to Financial Services Compensation Scheme support for pensioners – but systemic risks still raise concerns: FSCS protection is contingent on future policy and political appetite. Coverage could fall back from 100 per cent if circumstances change; if insurers fail, the FSCS may not be able to charge sufficient levies on the sector to cover the funding required. Depending on the wider political and socioeconomic context, considering intergenerational inequality, it could be very difficult for a future government to bail out pensioners through financial support to the FSCS.

The SPP said some incentive changes could help pension schemes align with the Chancellor’s Mansion House three golden rules:

• Secure the best possible outcome for pension savers by enabling DB schemes to run on could lead to better outcomes for pension savers within and outside DB schemes.

• Prioritising a strong and diversified gilt market: DB portfolios today focus on gilts. Allowing DB schemes to run on gilts would enable them to maintain their existing holdings, while a transfer of that capital to insurers could lead to material sales of gilts.

• Strengthen the UK’s position as a leading financial centre to create wealth and fund public services: Once retirement income is secured, pension schemes’ excess surplus could be deployed over time, and its scope for investment in riskier markets could grow.

Index-linked gilts

The SPP also found systemic risks associated with inflation hedging. The inflation hedge of a scheme is imperfect because an RPI asset is used to hedge an inflation-linked liability, where the inflation linkage of the latter is limited by caps and floors.

This means the amount of index-linked gilt exposure needed will change as inflation levels and inflation volatility change, but if pension schemes need to adjust their index-linked gilt allocations at the same time, then that will cause problems with an asset that has few other natural buyers. 

Natalie Winterfrost, chair of the investment committee, also said that as pension schemes sought to better match their liabilities they were going to be ‘chasing their tails’, with their collective demand driving up liability valuations by driving down yields.

The problem was particularly acute in index-linked gilts, where pension schemes’ inflation-linked liabilities swamped the size of the UK inflation-linked gilt market. We saw the predictions of that paper borne out in practice with yields falling for the best part of a decade."

Index-linked gilt yields, at their least attractive, delivered an expected real return of -2.8 per cent per annum, explained Winterfrost.

Beyond government gilts

The chaos in gilt markets in September 2022, when pension schemes had to sell gilts due to a collateral squeeze. With yields so low, most other potential investors had little interest in the gilt market, meaning rapid price corrections for trade orders to be met, and ultimately the Bank of England needing to stabilise the market.

These dramatic events spelled the start of a new era of pension scheme investing.

Winterfrost said schemes hold much larger collateral buffers following the gilts liquidity crisis, and there was a greater focus on building investment resilience, including avoiding being a forced seller of assets.

"Assets which offer contractual cash flows and a return over gilts, such as high-quality corporate bonds, are likely to form the core of many DB schemes’ investment strategies, although as a result of the crisis there are many schemes that find themselves with higher allocations to illiquid assets than they would have chosen."