Roundtable: How to get the best bulk annuity pricing

However, more companies could join Rentokil and hotels group IHG in the near future. Rolls-Royce has already bought out one of its schemes, and analysis from consultancy LCP now suggests that as many as 15 blue-chip employers will be in a position to buy out by 2021.

Excluding Rentokil, four are there already, and up to 40 of the index’s constituents could have this level of funding by the end of 2028. That improvement in funding is feeding through to smaller employers, and experts predict that bulk annuity volumes will take off in the coming years.

“We are at a bit of a tipping point,” says Charlie Finch, a partner and joint founder of LCP’s longevity derisking practice.

“For the past 10 years demand from pension schemes has been less than the supply the insurers have been able to offer, on the buy-in and buyout side at least.

If you are a small scheme, to me you are picking self-sufficiency and not buyout simply because somebody wants a lower number. That is the only reason to do it because, for a small scheme, the longevity risk does not make sense to run it

Naomi L’Estrange

“That has now changed. Over the past 12 months we have seen record volumes with more than £20bn now confirmed, which is more than a 50 per cent increase on the highest annual volumes we have seen before, and 2019 is showing no signs of slowing down. Pipelines from insurers are £20bn just for the first half of this year, potentially.”

So should schemes and employers still running their own assets join the crush of those looking for the exit? Buyout will not suit all DB schemes, even where they are well funded. For example, some schemes within LCP’s FTSE 100 analysis are likely to have such strong covenants that transferring to an insurer makes little sense.

Those schemes will likely follow a self-sufficiency strategy, matching their assets to predicted cash flows in a similar way to insurer portfolios. In many cases they will still access the longevity derisking market to insure against their members living longer than expected, a key risk left unhedged by even modern investment strategies.

However, industry consensus is that, unless the UK’s nascent superfunds take off in dramatic fashion, buyout will still be the final destination for most schemes. Indeed, one of the two consolidation models proposed so far still involves buyout, and the government has suggested that those schemes within five years of winding up should not consider a superfund.

“If you are a small scheme, to me you are picking self-sufficiency and not buyout simply because somebody wants a lower number. That is the only reason to do it because, for a small scheme, the longevity risk does not make sense to run it,” says Naomi L’Estrange, managing director at 2020 Trustees.

Buyout will always be more expensive than running a scheme on, due more to the increased certainty of payment than any excessive profit-taking by the receiving insurers. It is for that reason, and the fact the scheme is no longer dependent on the health of its sponsoring employer in these uncertain times, that it is such an attractive option for trustees.

Nonetheless, the steadily increasing volumes of bulk annuities written also show that buyout is increasingly within the reach of employers. 

Mr Finch says that pricing was particularly attractive in the first half of 2018, before tailing off slightly as insurers near their annual quotas. Ms L’Estrange has even seen “a couple of surplus cases” where pricing has come down sufficiently to allow employers to recoup some of their contributions.

Some might argue that the price of buyout, often judged in relation to the cost of holding ‘risk-free’ gilts, is dangerous to use in isolation as an assessment of value. “Trying to sit and call the market to hit a theoretical good time is, arguably… a danger for trustees or sponsors,” says Andrew Ward, Mercer’s head of risk transfer and a partner at the firm, suggesting that schemes reformulate the question to: “Is [the price] good enough and does it meet my wider objectives?”

“If it does that, then perhaps that is the time to do a deal, rather than waiting and continuing to run that risk for a period.”

But employers do not have bottomless pockets, and Mr Finch’s assessment of supply and demand in the market does suggest the potential for an upswing in price. This dynamic has been seized upon to argue those schemes that have not yet completed a bulk annuity could be priced out of a capacity-constrained market and left to hope their sponsor does not fall over, but these fears are likely overblown, according to the experts.

Demand and supply out of balance

For schemes to fulfil the prophesied explosion in annuity purchases, pricing will need to remain at its current attractive levels, despite the temptation for insurers in the market to extract a higher premium from the strong demand among schemes.

Insurers will also need to find huge capacity to absorb all of the liabilities in the UK, often estimated to be around £2tn when measured on a buyout basis.

The cost of a bulk annuity product is made up of three components. Insurers must source assets that will deliver the cash flows needed to pay out the scheme members being insured, and must then hold sufficient additional capital to make sure they can deliver these payments, even in a ‘one-in-200’ stress event.

Finally, the total premium will also include the operational costs of writing the transaction and the insurer’s profit margin. That means there are four factors that are likely to drive the pricing and availability of bulk annuities over the coming years.

While margins could theoretically increase, experts say this might invite other large European insurers with little set-up costs into the market. The resulting flood of supply should keep pricing keen.

Mr Finch says: “I think they are watching this space. If we do start to see upward pressure on pricing, that may well bring new entrants in. That should hopefully mean some of this ‘buy now while stocks last’ in practice is not an issue.”

They effectively have to do a full actuarial valuation and back it forever in order to quote on these things, so that takes time and effort and people to run deals and there is a limited supply there

Andrew Ward, Mercer

Another potential threat to attractive pricing is the availability of assets to back the pension payments secured by the contract.

Insurers must hold assets that are acceptable under the EU Solvency II directive, but increasingly they are finding they are not limited to low-yielding corporate bonds. Allocations to alternatives, along with a desire to build a strong reputation in the market, have led to the recent keen pricing.

Insurers have “got to grips with Solvency II and found assets that yielded slightly higher returns, but still met the requirements of matching adjustment” over the past year, according to Mr Ward.

Discussions around the capacity of the bulk annuity providers are less straightforward. For one, there is the question of whether insurers have enough people to process substantially higher volumes of business, despite the decline of individual annuities and recent hiring sprees.

“They effectively have to do a full actuarial valuation and back it forever in order to quote on these things, so that takes time and effort and people to run deals and there is a limited supply there,” Mr Ward adds.

Second, insurers have so far opted to pass on the longevity risk they take on in a buy-in or buyout to reinsurers. Pension Insurance Corporation, for example, finalised a £1.2bn longevity reinsurance contract with SCOR in December last year. Unless more reinsurers can be found, capacity may be limited, with pricing ultimately creeping up.

Efficiency drive will improve price

These problems are not insurmountable, and there are major inefficiencies waiting to be rectified, according to Frank Oldham, client director at Independent Trustee Services.

“All the insurers at the moment are also reinsuring some of their longevity risk,” he says. “If I, as a trustee, … go out to five insurers to get a quotation, each one of those insurers is going to the same reinsurance market with the same data to price the longevity risk.

“So if you are a reinsurer, you are potentially getting a request for a quotation from five different insurers from the same plan. You might not know it is the same plan. That is a huge inefficiency in the market.”

To solve this, consultants now say they are contacting reinsurers directly to keep them in the loop when looking for quotes on large transactions. This increased efficiency could help the market find extra capacity and keep pricing attractive despite the crush of schemes waiting to wind up.

I have been surprised by some sponsors’ reactions, who I would have expected to be eating the trustee’s right hand off to secure a full buyout and there has been significant reticence while they get comfortable

Robert Thomas, Law Debenture

If talk of slower schemes missing out on attractive pricing has been overblown, capacity constraints do still have an impact. There is reportedly little space for schemes to agree deals in the first half of 2019, such is the backlog from last year.

Mr Finch and Mr Ward report insurers turning down up to 75 per cent of requests, and say that with insurers asking to see their projected pipeline a year out, trustees and sponsors need to get serious if they approach the market.

Do sponsors really want to buy out?

This commitment from sponsors is not always as easy to secure as it might appear.

“I have been surprised by some sponsors’ reactions, who I would have expected to be eating the trustee’s right hand off to secure a full buyout and there has been significant reticence while they get comfortable,” says Robert Thomas, director at trustee company Law Debenture.

He says sponsors are still tempted to believe that “we must be giving up profit to do this that we could take somewhere, some time”.

Of course, regulation may be about to change that. Indications from the Pensions Regulator and the Department for Work and Pensions are that a new funding code may ask employers to recognise a long-term objective for their scheme and reflect this in their technical provisions.

But for the time being, trustees will have to exercise their diplomacy skills when faced with a sponsor who is reticent to commit to a timeline.

“My tactic has been to have that conversation one valuation before you hit TPs,” says Ms L’Estrange. “I have found the majority of sponsors willing to agree to some level of contributions as part of a whole conversation about investments and journey because it is a big gap [between full TP funding and buyout].”

Clean data means happy insurers

Once sponsors have been persuaded to think in terms of downside risk rather than cash flows, trustees have a number of administrative and investment hurdles to clear as they prepare for a transaction.

One obvious priority is to get an accurate picture of the scheme’s liabilities, via data-cleansing exercises. Pensions are often said to be about paying the right people the right amount at the right time, yet gaps in data and complicated benefit structures increase the difficulty of doing this. That uncertainty leads insurers to increase their costs.

Another area to consider is how discretions embedded in scheme rules, such as those giving trustees the power to grant increases to pensions, are dealt with before the buy-in or buyout is finalised. “It is surprising how many areas there can be an element of discretion, which is always a challenge when you turn that into a contract,” says Mr Oldham. Schemes that have already dealt with these issues will attract greater insurer interest, he adds.

If we start seeing some tensions in the market I wonder if we will see a few more of the larger schemes stepping into the longevity protection market

Frank Oldham, Independent Trustee Services

Similarly, guaranteed minimum pensions are another stumbling block. A recent court case on GMP equalisation has added millions on to some schemes’ liabilities.

The High Court confirmed that the standard industry practice for converting these features into regular scheme benefits did not treat men and women equally, although it accepted that past transactions cannot be unwound.

Some schemes have not even checked with HM Revenue & Customs that their data on GMPs is correct, known as reconciliation. Tackling these problems should not be postponed until buyout is near, according to Ms L’Estrange.

“It is difficult because it requires introducing some flat pensions, and there is a lot of constraint on the admin industry to do it. But I think we will end up with a lot simpler schemes at the end of it, which will be a lot easier to insure,” she says.

Cleaning, and to a greater extent simplifying, the liabilities owed by pension schemes can be shown to have a marked impact on the value trustees are able to extract from longevity insurers. A case in point is the buyout undertaken for the UK scheme of failed telecoms giant Nortel.

While members never saw their full benefits paid due to the insolvency of their former employer, the £2.4bn contract signed with Legal & General allegedly secured a higher level of payout than was offered by a commercial consolidator – purportedly a cheaper alternative. Much of the cost efficiency was attributed to member options exercises, offering members the option to reshape their benefits into more useful forms that are also cheaper to insure.

Alternatives block asset lock

The fact that buyout is now much closer than previously thought could also demand that some schemes rethink their investment strategies.

For example, DB plans in search of yield have flooded into alternative assets – which are often illiquid – in recent years. While an almost identical move has been made in insurer portfolios, allowing them to offer better pricing, many refuse to accept these assets from schemes.

This matters because without providing assets that can be transferred in specie to cover the cost of bulk annuities, trustees will be unable to secure a price lock and sponsors may have to top up with cash.

Insurers may show preferential treatment to schemes whose portfolios are predominantly made up of liquid, high-quality fixed income. Nortel’s price lock was achieved using a mix of gilts, corporate bonds and swaps that were able to be placed in a clearing house under the Emir regulations. “If they have two schemes sitting there and one of them can liquidate their portfolio tomorrow and the other one is going to take a while to get out of their current position, what would you do?” asks Mr Oldham.

However, experts also point out that proper planning will allow schemes to hold illiquid assets when it is appropriate, without sacrificing flexibility later on.

Mr Thomas says one useful goal is to be “buyout ready”. This does not commit the employer to purchase a bulk annuity, but leaves the scheme “in a position where it could be done, should the trustees and the sponsor of the day wish to take that decision”.

He adds: “Part of that must be looking at the investment portfolio and making sure you are not trapped into things that would be an impediment.”

Does ‘buy-in to buyout’ still hold?

These decisions become more nuanced when schemes are looking not to buy out their entire liabilities, but to insure a smaller population such as pensioner members in a buy-in.

Believing they are a long way from insuring their entire membership, many schemes have opted to ‘buy-in to buyout’, transferring members to insurers in tranches as they reach retirement. When members retire they decide whether to use discretions or not, making their cash flows much easier, and therefore cheaper, to insure. The Royal Mail Pension Plan, Reuters Pension Fund and Marks and Spencer Pension Scheme have all completed significant buy-ins during 2018.

Insurers are increasingly showing an appetite to write full buyouts and scheme funding levels are closer to this goal than they were previously, according to the experts, but the cost averaging of successive buy-ins means this is still the path many schemes will take.

“With a buy-in it is more clearly an investment decision and hence needs to be weighed up in terms of other investment opportunities,” says Mr Ward. “If the pricing apparently improves, it may be because yields on other assets have moved at the same time.”

You often conclude that anything, gilts or even corporate bonds, which you are not using… for collateral, matching purposes, it makes a lot of economic sense to move that into a buy-in

Charlie Finch, LCP

Mr Finch agrees: “The best way to think about buy-in is to start from the point of view of, ‘here are my assets, which of these assets would I prefer to invest in buy-in than where they are now?’

“You often conclude that anything, gilts or even corporate bonds, which you are not using… for collateral, matching purposes, it makes a lot of economic sense to move that into a buy-in,” he adds.

There is also the option for schemes to work towards buyout by agreeing longevity swaps, where a counterparty takes on the risk that members live longer than planned in exchange for a stream of cash payments. Longevity swaps combined with modern interest rate and inflation-hedging strategies allow schemes to replicate the characteristics of a buy-in in-house, a trend that could emerge if buy-in and buyout prices creep too high.

“If we start seeing some tensions in the market I wonder if we will see a few more of the larger schemes stepping into the longevity protection market,” says Mr Oldham. “You can replicate a very similar position outside the buy-in policy,” agrees Mr Ward, before conceding that “some schemes may be prepared to pay the extra to get the absolute certainty”.

Fast movers get the best prices

Trustees may be tempted to procrastinate on some of these tasks, but industry consensus is that the more nimble a scheme can be, the better its chances of getting good pricing.

Mr Finch says: “Some schemes do not realise how close they are to buyout. Pricing has improved a lot, not just for pensioner buy-ins but also for buyouts. We are expecting to get new tables out this month that will show a further reduction of life expectancy.”

Schemes that are unprepared will evidently take longer to agree an opportunity, but small schemes in particular could miss out on opportunities to secure a good price.

The UK market does contain insurers whose appetite is tailored towards smaller transactions, but in some cases nimble, smaller plans have been able to attract the kind of quotes usually reserved for schemes of a strategic importance to the insurer.

“One theme last year was where the insurers were bidding for large schemes and then obviously not all of them could win them,” says Ms L’Estrange. Schemes with assets of just a few hundred million “then got fantastic pricing off the back of it if they were ready to go”, she adds.