Why buy-ins/buyouts are not always the right answer

The reasons for this are well-documented – not least a combination of falling interest rates, underperforming equities and increasing life expectancy.

While pension schemes sponsors, trustees and their advisers devote significant energy and resources to monitoring and managing these risks, it remains the case that the only way to eliminate them completely is via purchase of a bulk annuity, ie a buy-in or buyout.

A large number of bulk annuity transactions have been completed over the past few years.

Last year was the busiest in terms of premium paid for the past five years, and 2014 could represent a further step change with in excess of £10bn of liabilities expected to be transferred to insurers.

Judging value

A major driver of activity is an increase in pensioner buy-ins due to a perception that pricing is cheap. 

An argument commonly used is that by exchanging gilts for an annuity policy, there is the potential for the following:

• Improved matching of cash flows between assets and liabilities;

• Removal of longevity risk;

• Minimal impact on the funding position.

The last point is explained by the opportunity to benefit from insurers investing in higher-yielding assets, where the additional return is more than sufficient to cover their reserving and profit margins. 

While a pensioner buy-in is undoubtedly the best matching asset for the members covered, this ignores the fact that the scheme’s assets are ultimately there to fund benefits for all members.

Importantly, a buy-in in respect of a subset of a plan's members may actually increase overall risk, depending on which assets are used to purchase the buy-in.

For example, where long-dated index-linked gilts are sold, this is likely to reduce the duration of the scheme's overall assets and hence increase interest rate and inflation risk.

This can more than offset the benefit of obtaining longevity protection.

In addition, although pricing may look attractive relative to gilts, bulk annuities remain historically expensive in absolute terms. Buy-ins are also rarely capable of being surrendered, removing the potential for future opportunistic investment.

Pensioner liabilities are the least risky, and therefore this may not be the best place to focus risk management efforts, particularly as some proposals have involved relatively small transactions for older pensioners only.

Arguably, completing a pensioner buy-in now could make full buyout more difficult in the future, as some insurers are less willing to quote for younger pensioners and non-retired members.

Plan B

So what should be done? A wide range of alternative approaches are available.

For example, if the driver for a transaction is to benefit from insurers investing to achieve a return above gilts, then rather than paying a premium to obtain a relatively small part of this benefit, why not try to mirror their approach?

Schemes are increasingly developing cash flow matching strategies involving a range of assets including credit, infrastructure and derivatives, in addition to gilts. This can potentially be a low-risk approach at a cost well below annuity purchase.

Alternatively, if longevity risk is a concern then perhaps a longevity swap might be appropriate, which crucially enables schemes to retain investment flexibility and avoids locking into underfunding.

Some schemes are considering fully buying out benefits. If a scheme is very well funded or the sponsor simply does not want the risk of a legacy scheme any more, then it is potentially difficult to argue with this approach.

However, the majority of schemes are not in this position, implying the need for a very significant cash injection.

In these situations it is worth considering whether the ultimate goal is worthwhile given the cost, or would targeting a low-risk strategy, with most significant risks closed off but some opportunistic return-seeking opportunities retained, be a more appropriate alternative.

It is rare that one investment strategy is clearly better than all others. Analysis is therefore recommended to ensure you are well-informed before making any decisions.

As always, maintaining the status quo is a valid alternative to consider.

Andrew Ward is a senior consultant at Mercer