How pension schemes are solving illiquid asset issues

It is less than two years since the gilts market crisis dramatically reshaped the funding position of the UK’s defined benefit (DB) pensions sector.

The period since then has brought a record calendar year for pension insurance volumes, an acceleration in the take up of new de-risking options and proposed new powers for accessing surplus funds.

However, for some schemes – those focused on buyout as their endgame – the sudden shift in funding levels has brought a different headache: what to do with illiquid assets?

Growth of private markets

Since the global financial crisis of 2007-09, pension funds have become big funders of asset classes such as private equity and private debt, as more restrictive rules affecting banks left a gap in the market.

In addition, income-generating assets have grown more popular as DB schemes have matured, and sustainability rules have accelerated the flow of capital into assets such as renewable energy infrastructure.

On top of this, the Pension Protection Fund’s (PPF) Purple Book data shows that DB schemes have more than 5% invested in property.

In a relatively short space of time, however, many schemes have found themselves having to re-evaluate their journey plans. A multi-year journey to buyout, aided by cashflow from illiquid assets, has suddenly become much shorter – and those same assets may now be a hindrance.

Recent research by Standard Life, part of Phoenix Group, has found that two thirds of employee benefit consultants reported that their clients had delayed bulk annuity transactions because of issues with illiquid assets.

Joe Evans, senior vice president at Redington, says: “For an increasing number of buy-in transactions, finding a solution for the illiquid assets is the critical hurdle in determining whether the deal is feasible or not. The right solution will vary for different schemes and can be nuanced, so it is important for trustees to understand the options available and engage with insurers on this topic early in the process.”

Innovation in approaches

Most consultants and professional trustees agree that engaging early with an insurer regarding illiquid assets will increase a scheme’s chances of getting a good result.

Adam Davis, managing director at K3 Advisory, says there are several options available to schemes when dealing with illiquid assets – many of which his firm has recommended to various clients.

In some cases, the best approach may be to secure a deferred premium – essentially delaying one part of the transfer while the illiquid asset is either sold or runs off. However, Davis points out that this option isn’t supported by all insurers and has become more expensive recently as interest rates have risen.

In one recent transaction, K3 helped an unnamed scheme secure a buy-in for the majority of its longer-term liabilities while keeping hold of short-term pensioner payroll. The scheme then used a combination of regular sponsor contributions, liquid assets and the income from the illiquid asset to pay monthly benefits – a method referred to as ‘deferred cover’.

“With that combination the trustees could afford the buyout premium,” Davis explains. “They’ve got a very short term liability to manage, which is quite neat because it’s not a deferred premium, so they’re not narrowing their market, and secondly they’re not borrowing money, so they are not getting an interest charge.

“They’ve transacted, they’ve insured everything but that very short term liability, and now they are in the phase of making those payments themselves. In a year’s time, the scheme will be fully bought out.”

What insurers want

Regulations require insurance companies to hold a portfolio of assets that can match their long-term liabilities closely. While pension schemes do this too, the requirements for insurers are much more detailed and restrictive.

This means that the kinds of assets they will accept from pension schemes are typically limited to government bonds and high-quality corporate bonds, even if insurers are also invested in other illiquid assets similar to pension schemes. Valuation criteria for these assets varies between insurers and discounting methods can mean assets are valued much lower by the insurer than the pension scheme.

“Sadly, there is generally little overlap between the illiquid assets that pension schemes hold and the ones that insurers want,” says Michael Abramson, partner and risk transfer specialist at Hymans Robertson.

“For any assets that fall into this category of not being wanted by pension scheme or insurer, one of these parties is going to have to sell the assets and the solution really boils down to who will do so and over what time period.”

While insurers will accept some kinds of illiquid assets, the work to do so can take a long time – longer than exclusivity periods often secured for buy-in pricing. This makes early engagement critical. For some schemes, Abramson says, they may be better off dealing with the assets themselves.

Future changes?

K3’s Davis adds that, while some schemes may be invested in similar asset classes as insurers such as secure income or long-lease property, often the investment funds themselves do not support or accept insurers as investors, so cannot be transferred.

“Pension schemes like illiquid assets because of the type of liabilities they have, and insurance companies like illiquid assets,” Davis says. “It seems a bit crazy that, to trade a buy-in, we have to make everything liquid, when both sides like a bit of illiquidity. There’s potential work here for the industry to think about how to solve this.”

Potential changes to solvency rules for UK pension funds could open up more avenues for illiquid asset transfers in the future.

Various parties have been lobbying for support for insurers to invest more in UK infrastructure. With the Mansion House reforms pushing pension schemes to do the same, joined-up thinking on the journey of assets from pension scheme to insurer could have a significant positive impact on directing more capital towards productive finance.

Further reading

LDI turmoil could reduce DB schemes’ investment in illiquids (23 January 2023)

Can a specialist service help endgame schemes manage illiquid assets? (25 July 2023)