Rising interest rates and the subsequent fall in liability valuations and deficits have now made buyouts more affordable for a larger number of pension funds, with consultants urging schemes to restructure their investment strategy to make it more palatable to an insurance company.
Over the past 16 years, the liabilities of UK closed defined benefit schemes have ballooned. In 2006, total assets stood at around £700bn, while liabilities on a buyout basis were £1.4tn.
By 2021, these figures jumped to £1.7tn and £2.4tn, respectively, according to Andrew Ward, partner and UK leader risk transfer at Mercer.
The collapse in interest rates to virtually zero in recent years, from 5 per cent in the mid-2000s, caused this rapid growth in the value of liabilities, he adds.
The current pricing could accelerate endgame planning for those schemes which had thought buyout was a long way off
Ross Fleming, Hymans Robertson
“The deficit level, in pound terms, has stayed relatively stable over the period, despite the billions of additional contributions paid in, while the funding level — on a buyout basis — has improved,” Ward tells Mandate Wire.
Improved funding levels
While the deficit has remained at around £700bn, the funding level has improved from around 50 per cent to 70 per cent.
Ward says: “Companies have paid in additional contributions to counteract what would have been an increasing deficit due to falling interest rates.”
As schemes’ funding levels improved and larger pension funds went to market, there was a sharp uptick in the volume of bulk annuity transactions completed.
“From 2013 to 2017, there was around £10bn to £15bn of transactions each year,” Ward notes.
This increased to around £25bn in 2018 and rose further to more than £40bn in 2019, with deals worth £30bn over the past few years.
“Over the entire period, the number of [buyout] transactions per year has stayed broadly constant at around 150 a year, despite the increasing volume of liabilities covered,” he adds.
Interest rate rises in recent months have further improved the prospects for these deals. “As most schemes are not fully hedged, this has led most schemes to improve their funding levels,” Ward says.
In other words, buyouts have become much more affordable for a wider number of schemes.
While rising interest rates have shrunk both sides of the balance sheet with both liabilities and asset prices falling, buyout deficits have decreased.
“That’s because even if the funding level has remained at the same percentage level, the value of the pound value [has declined],” Willis Towers Watson senior director Sadie Scaife says.
More affordable buyouts
The improvement in funding levels means the sponsoring company can now afford to provide the extra cash required to make it possible to implement a buyout, Scaife notes.
In addition, pricing in the bulk annuity market has improved, partly because credit spreads have increased and also the cost of the longevity risk is falling, she explains.
The decline in the cost of hedging longevity risk has been driven partly by Covid causing higher mortality, as well as a growing number of reinsurance providers entering this market and thereby increasing supply, she adds.
“This year looks like it could be similar to 2019 because — like that year — there are a significant number of large deals in the market,” Scaife points out.
“The last quarter of the year is always the most active and we do not expect it to be any different in 2022.” Buy-ins and buyouts should surpass £30bn this year, she adds.
With all the signs pointing towards an increased number of buyouts, this presents portfolio management challenges both for pension schemes and asset managers.
“In the current volatile market conditions, it makes little sense for schemes to sell their assets to procure cash for the buyout,” Scaife says.
It would be better to set the buyout premium to the value of the assets being transferred to the insurance company. “This also gives the insurance company some assets which hedges their interest rate and inflation,” she notes.
Insurance companies will also accept corporate debt. “While different insurers can accept different asset classes, a portfolio of gilts as well as buy-and-maintain corporate bonds will work well for most insurers,” she adds.
Current pricing
But while the prospects have improved for many schemes, it will take time for others to capitalise on current pricing.
Ross Fleming, partner and senior investment consultant at Hymans Robertson, says: “The current pricing could accelerate endgame planning for those schemes which had thought buyout was a long way off.”
Rising rates pose challenges for closed DB schemes’ LDI portfolios
While interest rate and inflation hedges have helped many defined benefit schemes stabilise their funding positions, the current macroeconomic environment is creating challenges for some closed plans, which might not have the necessary collateral in place to meet high payments.
That could change the way investment portfolios are structured. “In particular, schemes might be looking at their liquidity glide path over the next five or 10 years,” he notes.
Even if a buyout is going to happen in a decade, schemes need to be thinking now about how they are going to adjust their portfolio, to make sure it is ready to be accepted by an insurance company.
Fleming concludes: “This is particularly important when schemes are holding illiquid assets — they need to think about their run-off profile and if it matches their buyout time horizon.”
This article originally appeared on MandateWire.com
