In Depth: Will a rise in run-on strategies affect bulk annuity demand?

The government is exploring new powers for defined benefit (DB) pension scheme trustees to allow them to greater access to surpluses.

It follows an extended period of almost continuous funding improvements for many DB schemes, in part due to rising interest rates. The aggregate funding level of the DB scheme universe sat at 120% at 30 September 2024, according to the Pensions Regulator.

This raises questions about what is a suitable ‘endgame’ for a DB scheme – with a growing number deciding to run on for a longer period to generate further surplus funds.

Asset managers Schroders and Abrdn have both announced in recent weeks that their DB schemes will run on to generate surpluses.

Meanwhile, consultancy group LCP recently revised its forecasts for the bulk annuity market – in part due to the expected effect of schemes choosing to run on for longer.

“Last October, we moderated our projections for volumes of buy-ins and buyouts over the next five years, reflecting an expectation that a greater proportion of DB pension schemes will run on for a period before moving to full buy-in or buyout,” says Charlie Finch, partner in LCP’s de-risking team.

A recent survey of 21 DB schemes with more than £1bn in assets found there was an appetite for running on – if schemes are appropriately incentivised by the government to do so.

The survey, commissioned by Brightwell, the manager of the BT Pension Scheme, found that 38% of respondents plan to run on, while 24% intend to buy out. Another 38% have not decided on their endgame.

However, half of undecided schemes and 40% of those planning to buy out would consider running on if the government made the option more attractive, the research found.

Almost two thirds (62%) claimed that changes to surplus rules would incentivise them to run on instead of conducting a buyout.

To buy-in, or not to buy-in

With more schemes considering running on, have insurers started to see a change in how trustee boards are approaching the bulk annuity market? And what is the role of insurance if a pension scheme wants to generate a surplus over the long term?

“For insurers, if demand for buy-ins and buyouts reduces because a subset of schemes choose to run on then this will mean lower business volumes at least in the short to medium term,” Finch says.

This would likely affect larger schemes with more than £1bn in assets, he adds, with a potential slowdown in volumes if a significant number of schemes choose to run on and generate a surplus.

Demand for bulk annuities could be further affected if surplus rules are based on the Pensions Regulator’s ‘low dependency’ definition – which is a lower funding level threshold than buyout-level funding.

However, Finch highlights that the changes to LCP’s projections “only shifted the projected pace of the move to insurance”. Total assets transferring to insurers from DB pension schemes are still expected to remain at broadly £400bn to £600bn over the next decade.

The government’s ambition

Relaxing surplus rules is a clear priority for government, as demonstrated by the fact that both the chancellor Rachel Reeves and prime minister Sir Keir Starmer announced plans to change the rules in a statement in January.

The Treasury stated that trustees and the sponsoring employers could use money from surpluses to “increase the productivity of their businesses” through higher wages, or by paying more to pension scheme members.

It said: “Where trustees agree to share a portion of scheme surplus with a sponsoring employer, the employer may choose to invest these funds in their core business, for example to purchase equipment or supplies, and/or provide additional benefits to members of the pension scheme.”

Speaking at the Pensions and Lifetime Savings Association’s Investment Conference in Edinburgh last week, pensions minister Torsten Bell also supported greater flexibility around surplus access, but emphasised that benefit security and trustee approval were essential.

He also encouraged trustee boards to consider the circumstances of members with benefits accrued before 1997 that are not automatically increased in line with inflation.

The expected impact of surplus rule changes

Ultimately, consultants believe that the scope and ambition of the government’s proposals will dictate the nature of any wider impact.

Lara Desay, head of risk transfer at Hymans Robertson, says any impact on the insurance market will be “highly dependent on the nature of any changes proposed” by policymakers.

“However, running a surplus may well become more attractive for employers,” she says. “Done carefully with the right safeguards and guidance in place, the changes could open the door for more DB schemes running on.”

Desay explains that, whatever the new framework is, trustees will need to “carefully consider” their options and weigh them up along with the employer’s objectives and the security of member benefits.

“If the government changes the law to make it materially easier for sponsors to access surplus in their schemes without buying out, then this will lead to more schemes choosing to run on for a period before moving to buy-in and buyout,” LCP’s Finch adds.

However, LCP believes that “a large proportion of schemes” will still move towards a bulk annuity transaction “as soon as it is affordable”, largely due to pressure from sponsors to remove funding risk from their balance sheets.

Combining bulk annuities and run-on strategies

Could pension schemes use buy-ins to secure member benefits and keep their surpluses invested to grow it further?

Kevin Wesbroom, a professional trustee at Capital Cranfield, says the mindset shift needed to move from targeting a bulk annuity to operating a surplus longer term is significant.

Speaking in a personal capacity, Wesbroom says those pension schemes that have already transacted a buy-in “are likely to find pursuit of surplus even more challenging”.

“To generate surplus, you ideally need all of the scheme’s assets available to invest more aggressively,” he says. “A buy-in policy is a dead weight in this respect – you can’t dial up the risk-return characteristics of the buy-in policy.

“So, if you are pursuing a return-generating investment strategy, the assets outside the buy-in have to generate even higher risk and returns. And that may start to get uncomfortable.”

Wesbroom argues that “the route of security is likely to win out in many cases”.

The insurer perspective

Despite the adjustments made by LCP, most bulk annuity market forecasts continue to predict annual volumes in the region of £40bn to £50bn over the next few years.

Senior insurance company professionals tell Pensions Expert that, while potential changes to surplus rules would be a welcome addition to the options for trustees, the ultimate effect on insurers is likely to be negligible.

Mitul Magudia, chief origination officer at Pension Insurance Corporation, says he doesn’t see any significant change among pension scheme appetite for insurance.

“We don’t see any sign of trustees’ decision-making changing, since whatever the rules on surplus, those trustees will still be committed to serving members’ best interests – and the interests of members will still be best served by the security that insurers provide,” he explains.

While schemes are looking to run on, Magudia says this is still normally part of a longer-term journey towards the insurance market.

“We think it’s unlikely that a large number of schemes will opt to run on in perpetuity, so simply see running a surplus for a short period of time as a natural extension of how things currently operate,” he adds. “As such, we expect to see strong demand for years to come.”

Meanwhile, Legal & General (L&G) has targeted £65bn of new bulk annuity business by 2028, and John Towner, managing director for UK pension risk transfer, does not expect demand for buy-ins and buyouts to be dampened by any loosening of surplus rules.

“As yet we have not seen surplus changes having any noticeable impact on schemes’ overall appetite for buyout,” he says. “We wait to see whether the changes will influence scheme plans, but given the volume of fully funded schemes versus the market’s annual capacity, we expect to see strong demand for buyout with some clients also considering run-on solutions to ‘invest like an insurer’.”

He adds that, before the government tabled its surplus access proposals, most of L&G’s DB scheme clients were “expected to incorporate insurance into their long-term de-risking strategies”, meaning that “moving to buyout is generally a question of optimal timing”.

“Member security is enhanced through movement to a regulated insurer and if buyout happens alongside a payment of surplus to the sponsor, we believe that’s a good outcome for everyone,” Towner says. “As such, we expect that being able to utilise surplus should make the ultimate security of buyout an even more attractive option for schemes.”

Extending the DB journey plan

Hymans Robertson’s Desay agrees that schemes are likely to keep insurance as the ultimate endgame, even if generating a surplus means that goal is pushed back by a few years.

She adds: “It is possible that we see some larger schemes turn to longevity swaps in order to mitigate the risk of members living longer than expected, as this would typically be the largest unhedged risk in those schemes seeking to run on.”

“Running on will typically extend the time horizon until a scheme seeks to buy-in and buyout rather than take it off the table completely, so ultimately this will mean a continued flow of business to pension insurers,” Desay says.

Smaller schemes in particular will remain focused on insurance, according to Desay, as the cost of running on will usually outweigh any benefits they might get from the surplus.

Several insurers and consultants have introduced ‘streamlined’ services over the past two years to support small schemes in accessing the insurance market.

“Changing the rules around surplus is not likely to change the behaviour of these smaller schemes,” LCP’s Finch adds.

LCP is set to update its projections for the bulk annuity market in October this year. Finch says that, by this point, the industry should have received more details on the government’s proposed changes to surplus rules, “so we will be able to better judge the impact these will have on future demand”.

“The ultimate impact will crucially depend on how ambitious the government is in its changes to the surplus rules.”

Additional reporting by Alex Janiaud.