Press coverage

Pensions World

Long Acre Life aims to capture slice of £1 trillion buyout market

By Pensions World, 12 Dec 2011

Former chairman of the Pensions Regulator, David Norgrove, is launching an insurance company to deliver de-risking solutions to UK defined benefit (DB) pension schemes. Long Acre Life, set to gain Financial Services Authorisation, in early January is targeting schemes with liabilities in excess of £500m, with the aim of delivering cost savings of up to 20% over traditional insurance buy-outs.

"To date, there has been a lack of viable and affordable solutions in the market to help pension schemes reduce the levels of risk that they are running. This should change outcomes for both schemes and sponsors," says Mr Norgrove.

The initiative - which has been designed by PensionsFirst, a solutions provider to the global DB pensions industry and shareholder in Long Acre Life - will create a mutual insurance solution, owned by schemes, sponsors and outside investors. Similar to captive insurance it is hoped that the company will delivers both a lower cost of buyin or buyout for pension liabilities and the removal of associated balance sheet volatility.

While the cost of buy-out varies according to the specifics of each scheme, they have typically been priced at approximately 140% of the IAS19 liabilities and generally been regarded as unaffordable. By allowing sponsor and pension schemes to participate in the insurance profit that would otherwise accrue to a third party insurer, Long Acre Life aims to reduce the ultimate cost of buyouts to around 120%.

Full article

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The Financial Times

Insurance venture to take on pension liabilities

By Paul J Davies, 06 Dec 2011

David Norgrove, former chairman of the Pensions Regulator, is launching a specialist insurance vehicle to take over the "toxic industry" of the UK's defined benefit pension schemes.

Long Acre Life believes it can offer companies a lower-cost way to offload their pension liabilities than other insurers, but only if those companies also take an equity stake in the new venture, enabling them to share in its profits over time.

The business model has been developed by consultants at PensionsFirst, where Mr Norgrove has been chairman since the summer.

PensionsFirst will also be a shareholder in Long Acre Life and said it had lined up a number of third-party investors willing to buy stakes alongside scheme sponsors.

"This is a toxic industry that needs to be decommissioned," Mr Norgrove told the Financial Times.

"It is hugely important to pensioners in defined benefit schemes for decades and decades to come and they should be protected. But companies and most of their employees do not have any interest in these schemes, so it is just a burden."

The majority of UK companies that have defined benefit schemes - those that promise to pay out a proportion of an employee's final salary - have closed them to new members.

Those companies have been increasingly looking to offload all or part of these large liabilities to banks or insurers.

However, only £30bn ($47bn) out of about £1,000bn of defined benefit liabilities have been passed on to the financial sector in recent years.

That is partly because only fully-funded schemes can make such trades, but also because it can be a very costly transaction that takes many months to agree and is highly dependent on stock markets and gilt yields.

Mr Norgrove, the first chairman of the Pensions Regulator from 2005 until the end of last year, said part of the reason why so-called buy-out and buy-in transactions were so expensive was because the insurers offering them took a significant chunk of their profits upfront.

The idea of offering pension schemes and their sponsors the chance to invest equity in Long Acre was to enable them to retain the profit that normally would be handed over to an insurer. That equity ought to generate an internal rate of return of about 15 per cent, Mr Norgrove added.

Pensions consultants and rival pension scheme insurers, such as Goldman Sachs' Rothesay Life, Pensions Corporation or Legal & General, are likely to question why a company would want to spend extra money to buy a large stake in an insurer rather than just wash their hands of their scheme from day one.

Full article

Long Acre Life is not responsible for content on third party websites.

Investment & Pensions Europe

Former TPR chairman launches firm to tackle DB pension liabilities

By Cecile Sourbes, 07 Dec 2011

UK - David Norgrove, former chairman of the UK Pensions Regulator, is set to launch an insurance company to deliver de-risking solutions to UK defined benefit (DB) pension schemes.

According to Norgrove - who was named chairman at PensionsFirst in July - the new insurance vehicle, called Long Acre, will aim to reduce buyout costs by as much as 20% for pension funds over traditional insurance buyouts.

Long Acre Life, which was designed by consultants at PensionsFirst, will target schemes with liabilities of more than £500m (€583m) and create a mutual insurance solution owned by schemes, sponsors and outside investors.

The concept, which is similar to captive insurance, will deliver both a lower cost of buy-ins or buyouts for pension liabilities and the removal of associated balance-sheet volatility, according to PensionsFirst.

Timothy Lyons, chief executive at PensionsFirst, said: "To date, there has been a lack of viable and affordable solutions in the market to help pension schemes reduce the levels of risk that they are running.

"Many large companies use captive insurance to insure their property and casualty risks so as to retain the profit that would otherwise be paid to an insurer.

"But a pure captive solution for delivering pension buyouts would consolidate the pension liability on the sponsor's balance sheet."

While the cost of buyouts varies according to the specifics of each scheme, they have typically been priced at approximately 140% of the IAS19 liabilities and generally been regarded as unaffordable, PensionsFirst argued.

Norgrove told IPE: "Broadly speaking, it wouldn't be unrealistic to assume that if a pension scheme sponsor went to an insurance company and asked for a price to enter into a buyout deal with liabilities of 100 on IAS19 basis, the insurer would charge the fund a 40% premium."

According to Norgrove, this price increase is mainly due to the fact that insurance companies need to take a much more prudent view of the liabilities and adopt a more prudent discount rate, which justifies a first 20% increase.

In addition, Norgrove pointed out that insurance companies tend to charge pension schemes their profits upfront, which adds an additional 20% premium to the total cost of such a buyout deal.

By allowing sponsor and pension schemes to participate in the insurance profit that would otherwise accrue to a third-party insurer, Long Acre Life aims to reduce the ultimate cost of buyouts to around 120%.

Long Acre expects to receive authorisation from the FSA in early 2012.

UK pension schemes have increasingly considered buy-ins and buyouts as part of their de-risking plans in recent months.

The Pension Buyouts 2011 report published by consultancy LCP in June found that nearly £30bn of business had been written by 10 different insurance companies over the past five years, including at least 40 transactions worth more than £100m.

Full article

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Professional Pensions

Insurance firm launched to challenge buyout market

By Hannah Brenton, 07 Dec 2011

The Pensions Regulator's former chairman David Norgrove has launched an insurance company that aims to cut the cost of buyouts by encouraging sponsors to take an equity investment in the initiative.

Long Acre Life estimates it will be able to cut the cost of buy-outs from 140% to 120% of liabilities for schemes with liabilities of over £500m.

Buyouts have become an increasingly attractive proposition in the defined benefit market as sponsors look to pass their liabilities onto a third party.

But the insurance initiative - designed by PensionFirst - said the current buy-out take-up was less than 0.5%, while 10-20% of the market would become interested should the cost drop by 20%.

Norgrove (pictured) said liabilities were becoming a "toxic problem" for companies, but the number being moved off sponsors' balance sheets remained "trivial".

He said: "The current solutions just aren't working. The amounts of money that have been transferred to insurance companies are trivial in comparison to the trillion pounds of liabilities that's out there. So a fresh approach is needed."

PensionsFirst chief executive Timothy Lyons said Long Acre could "unlock" the buyout market. He said there were 290 schemes in the UK that fit the criteria for the new insurer, who hold a total of £750bn of liabilities.

Insurance companies traditionally charge around 140% of the IAS19 liabilities for a buyout, which includes an expected profit to the insurer of around 20% of the liabilities. The insurer then provides around a further 20% of equity, which alongside the expected profit, provides its regulatory capital of around 40.

In the Long Acre Life structure, companies would also pay a buyout premium of around 140% plus 20% by way of an equity investment in Long Acre Life.

Their equity investment would entitle them to the profit traditionally earned by a third party insurer and reduce the cost of buyout from around 140 to around 120.

The profit traditionally returned to the insurer would instead be recycled to the sponsor through dividends and an internal return rate on their investment of between 12 and 15%. This rate will also be used to encourage third-party investors to take a stake in Long Acre.

PensionsFirst anticipates Long Acre to receive authorisation from the FSA early next year.

Full article

Long Acre Life is not responsible for content on third party websites.

City Wire

Ex-pension regulator's new venture to take on DB liabilities

By Alex Steger, 07 Dec 2011

The former chairman of The Pensions Regulator is set to launch an insurance vehicle aimed at consolidating the UK's defined benefit pension schemes, according to reports.

David Norgrove (pictured), former chairman of The Pensions Regulator, will launch Long Acre, which will aim to offer companies a low-cost means of offloading their pension liabilities but only if those companies take an equity stake in the new venture allowing them to share in its profits over time, the Financial Times has reported.

The paper said Long Acre has been developed by consultants at PensionsFirst, of which Norgrove has been chairman since the summer, which will also be a shareholder in the business.

Norgrove told the paper: 'This is a toxic industry that needs to be decommissioned. It is hugely important to pensioners in defined benefit schemes for decades and decades to come and they should be protected. But companies and most of their employees do not have any interest in these schemes, so it is just a burden.'

Despite companies with defined benefit schemes seeking of offload all or part of these large liabilities to banks or insurers only £30 billion out of around £1,000 billion of defined benefit liabilities have been passed on to the financial sector in recent years due in part to the fact only fully-funded schemes can make such trades, and also because they can be very costly transactions, taking months to agree and are highly dependent on stock markets and gilt yields.

Norgrove said the concept of offering pension schemes and their sponsors the chance to invest equity in Long Acre would enable them to retain the profit that was normally handed over to an insurer and the equity should generate an internal rate of return of around 15%.

Full article

Long Acre Life is not responsible for content on third party websites.

Life & Pensions Risk

New insurer 'to cut buy-out costs' for DB schemes

By Michael Faulkner, 07 Dec 2011

Long Acre Life will use mutual concept to reduce ultimate buy-out cost for pension funds.

An insurance company is being launched, which claims it can slash the cost of pension scheme buy-outs.

Long Acre Life is targeting UK defined benefit schemes with liabilities in excess of £500 million, and aims to reduce the cost of a buy-out by up to 20 percentage points, compared with the cost of a traditional insurance buy-out.

The initiative, launched by a former chairman of The Pensions Regulator, is based around a mutual insurance solution, owned by schemes, sponsors and outside investors.

The concept is similar to captive insurance but delivers both a lower cost of buy-in or buy-out for pension liabilities and the removal of associated balance sheet volatility, claims Long Acre Life.

By allowing sponsor and pension schemes to participate in the insurance profit that would otherwise accrue to a third-party insurer, Long Acre Life aims to reduce the ultimate cost of buy-outs to around 120% of IAS19 liabilities, compared to the typical buy-out price of 140% of liabilities.

David Norgrove, chairman of Long Acre Life, says: "To date, there has been a lack of viable and affordable solutions in the market to help pension schemes reduce the levels of risk they are running. This should change outcomes for both schemes and sponsors."

The initiative has been designed by PensionsFirst, which is a shareholder in Long Acre Life.

Timothy Lyons, chief executive of PensionsFirst, says: "Many large companies use captive insurance to insure their property and casualty risks so as to retain the profit that would otherwise be paid to an insurer. But a pure captive solution for delivering pension buy-outs would consolidate the pension liability on the sponsor's balance sheet.

"The solution we have designed for Long Acre will deliver the economic benefits of a captive solution through a mutually owned insurance company, removing the need to consolidate the liability."

Long Acre Life expects to receive FSA authorisation in early 2012.

Full article

Long Acre Life is not responsible for content on third party websites.

Plan Sponsor Europe

PensionsFirst Eyes European Expansion for Risk Transfer DB Solution

By Plan Sponsor Europe Staff, 07 Dec 2011

PensionsFirst is looking at rolling out its new risk transfer Defined Benefit (DB) pension solution across Europe and beyond.

At an event at London's Savoy hotel to launch the product, the firm confirmed that the application it has made to the Financial Services Authority (FSA) includes passport elements so authorisation will permit operation across the Europe.

At the event the firm announced the launch of Long Acre Life, an insurance initiative focussed on delivering buy-in and buyout solutions to companies with defined benefit (DB) liabilities of £500m and above.

The group of solutions is known as CapFirst which uses the concept of captive insurance, where large companies insure their property and casualty risks to retain the profit that would otherwise be paid to a third party. CapFirst provides a captive insurance framework which aims to deliver a lower cost for buy-in or buyout of pension liabilities and reduce or remove associated balance sheet volatility.

Timothy Lyons, CEO at PensionsFirst, said: "This proposition can be used to effectively consolidate the transfer of risk across a wide number of schemes. We cannot cover the US at the moment but it is certainly within our thoughts that if this works as we expect it to in the UK and in Europe, that it would be very interesting to look at the US market too."

Full article

Long Acre Life is not responsible for content on third party websites.

Pensions Insight

Ex-pension regulator's new venture to take on DB liabilities

By Sourced from City Wire, 08 Dec 2011

The former chairman of The Pensions Regulator is set to launch an insurance vehicle aimed at consolidating the UK's defined benefit pension schemes, according to reports.

David Norgrove (pictured), former chairman of The Pensions Regulator, will launch Long Acre, which will aim to offer companies a low-cost means of offloading their pension liabilities but only if those companies take an equity stake in the new venture allowing them to share in its profits over time, the Financial Times has reported.

The paper said Long Acre has been developed by consultants at PensionsFirst, of which Norgrove has been chairman since the summer, which will also be a shareholder in the business.

Norgrove told the paper: 'This is a toxic industry that needs to be decommissioned. It is hugely important to pensioners in defined benefit schemes for decades and decades to come and they should be protected. But companies and most of their employees do not have any interest in these schemes, so it is just a burden.'

Despite companies with defined benefit schemes seeking of offload all or part of these large liabilities to banks or insurers only £30 billion out of around £1,000 billion of defined benefit liabilities have been passed on to the financial sector in recent years due in part to the fact only fully-funded schemes can make such trades, and also because they can be very costly transactions, taking months to agree and are highly dependent on stock markets and gilt yields.

Norgrove said the concept of offering pension schemes and their sponsors the chance to invest equity in Long Acre would enable them to retain the profit that was normally handed over to an insurer and the equity should generate an internal rate of return of around 15%.

Full article

Long Acre Life is not responsible for content on third party websites.

Insurance ERM

New de-risking pension venture set up

By Insurance ERM staff, 07 Dec 2011

The former chairman of the Pensions Regulator, David Norgrove, has launched an insurance company to deliver de-risking solutions to UK defined benefit (DB) pension schemes.

Long Acre Life is targeting schemes with liabilities in excess of £500m ($781m), with the aim of delivering cost savings of up to 20% over traditional insurance buy-outs.

The initiative -- designed by PensionsFirst, a shareholder in Long Acre Life, where Norgrove has become chairman -- will create a mutual insurance solution, owned by schemes, sponsors and outside investors.

The concept is similar to captive insurance but delivers both a lower cost of buy-in or buy-out for pension liabilities and the removal of associated balance-sheet volatility, according to PensionsFirst.

Full article

Long Acre Life is not responsible for content on third party websites.

The Actuary

New insurer aims to challenge pension buyout market

By Sourced from Professional Pensions, 07 Dec 2011

The Pensions Regulator's former chairman David Norgrove has launched an insurance company that aims to cut the cost of buyouts by encouraging sponsors to take an equity investment in the initiative...

Long Acre Life estimates it will be able to cut the cost of buyouts from 140% to 120% of liabilities for schemes with liabilities of over £500m.

Buyouts have become an increasingly attractive proposition in the defined benefit market as sponsors look to pass their liabilities onto a third party.

But the insurance initiative - designed by PensionsFirst - said the current buy-out take-up was less than 0.5%, while 10-20% of the market would become interested should the cost drop by 20%.

Norgrove (pictured) said liabilities were becoming a "toxic problem" for companies, but the number being moved off sponsors' balance sheets remained "trivial".

He said: "The current solutions just aren't working. The amounts of money that have been transferred to insurance companies are trivial in comparison to the trillion pounds of liabilities that's out there. So a fresh approach is needed."

PensionsFirst chief executive Timothy Lyons said Long Acre could "unlock" the buyout market. He said there were 290 schemes in the UK that fit the criteria for the new insurer, who hold a total of £750bn of liabilities.

Insurance companies traditionally charge around 140% of the IAS19 liabilities for a buyout, which includes an expected profit to the insurer of around 20% of the liabilities. The insurer then provides around a further 20% of equity, which alongside the expected profit, provides its regulatory capital of around 40.

In the Long Acre Life structure, companies would also pay a buyout premium of around 140% plus 20% by way of an equity investment in Long Acre Life.

Their equity investment would entitle them to the profit traditionally earned by a third party insurer and reduce the cost of buyout from around 140 to around 120.

The profit traditionally returned to the insurer would instead be recycled to the sponsor through dividends and an internal return rate on their investment of between 12 and 15%. This rate will also be used to encourage third-party investors to take a stake in Long Acre.

PensionsFirst anticipates Long Acre to receive authorisation from the FSA early next year.

Full article

Long Acre Life is not responsible for content on third party websites.

Employee Benefits

Defined benefit pension scheme de-risking company to launch

By Jennifer Paterson, 08 Dec 2011

Former chairman of The Pensions Regulator David Norgrove is to launch an insurance company called Long Acre Life, which will deliver de-risking solutions to UK defined benefit (DB) pension schemes.

The firm is targeting schemes with liabilities in excess of £500 million, with the aim of delivering cost savings of up to 20% over traditional insurance buy-outs.

Norgrove said: "With the DB market now clearly focused on the end-game, we have developed an approach which delivers the certainty of an insurance buy-in or buy-out for trustees, and a value proposition for sponsors and their shareholders."

Full article

Long Acre Life is not responsible for content on third party websites.

Pensions Week

‘Mutual’ buyout firm gets a less than warm reception

By David Rowley, 12 Dec 2011

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Pensions Week

It's a long shot, but it might work

By David Rowley, 13 Dec 2011

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Long Acre Life is not responsible for content on third party websites.

gtnews

Breaking Down the Barriers to Buyout

By David Norgrove, 21 Feb 2012

Despite the pension industry's increasing focus on the 'end-game' there have been very few full scale pension buyouts over the past few years. Yet innovative new approaches to buyouts mean that chief financial officers (CFOs) concerns no longer need be deal-breakers.

Rising longevity, poor investment returns and, some would argue, increased regulation have seen the costs of providing defined benefit (DB) pension schemes increase significantly over the past 10 years. While the death of DB - which has been predicted from as far back as 2004, when I joined the Pensions Regulator - may not be upon us quite yet, it is clear that more and more pension scheme sponsors are looking towards the end-game.

Some scheme sponsors have gone down the road of benefit re-design in search of a solution, but an increasing number are opting to close their schemes completely. And with typical labour turnover of about 15%, it does not take long for a closed scheme to become purely a legacy issue. Yet, as most chief financial officers (CFOs) are well aware, this does not make the scheme an irrelevance to the sponsoring company. Closing a scheme does not remove a company's obligation to pay its previously accrued liabilities, which means the need to fund and to manage risk remains.

Left unmanaged, DB pension risk can seriously impact the core business with implications for both shareholders and scheme members. Changes in regulatory and accounting rules in 2004 made this impact more acute and apparent to the markets. There can be damage to a company's credit rating, its share-price, its ability to attract capital and even its contracts with clients. And in some cases, DB pension liabilities are so large and volatile that they pose a serious threat to the financial viability of sponsoring companies - 10 of the FTSE 100 now have pension liabilities greater than their market capitalisation, for instance.

It is therefore little wonder CFOs have begun to take a growing interest in pension buyouts, which, in essence, enable the company to pass the problem on to an insurance company. Yet despite the substantial attractions of a buyout, very few have been completed. That said, a new approach to pension buyouts may now be altering the balance, making buyouts more affordable for sponsoring companies.

Substantial Interest, Little Action

Given sponsors' anxiety about the impact that DB pension risk may have upon the financial viability of their company, the actual number of buyout transactions has been paltry. Since 2007 - when buyouts seemed to be taking off - the market has witnessed merely £25bn of business, and that figure includes buy-ins (bulk annuities). While a large number in isolation, £25bn is only the equivalent of roughly 2.5% of the total value of DB liabilities sitting alongside the balance sheets of private UK companies.

There are five core reasons why CFOs have been so reticent to move this volatile risk off their balance sheet:

1. Prohibitive cost

A large part of the problem lies with the nature of the insurance industry, which has so far failed to deliver solutions that are economically attractive for those considering transacting. Undoubtedly, this is not helped by the need to move between different regulatory environments and, in particular, move into the solvency capital regime required within the regulated insurance sector. Buyouts have commonly been priced at about 140% of the valuation of a scheme's liabilities on an IAS19 basis - a price greater than most CFOs are willing to pay.

Indeed, a survey conducted by Punter Southall back in 2008 suggested that at buyout prices of around 140% of IAS19 liabilities, only about 0.5% of CFOs would be willing to transact. In many respects this is understandable. Even where a pension scheme is fully funded to IAS19, it seems improbable that many will be reaching for their chequebooks to pay a 40% premium to an insurance company to take the risk away - especially given that the premium will be an immediate hit to the sponsor's profit and loss (P&L).

2. Cash flow problems and return on investment concerns

Investment losses over the past few years have reduced the funding levels of many schemes and, until the economic climate really begins to improve, few CFOs appear willing to pour more cash into the pension scheme to allow a buyout to take place.

With a whole host of other corporate opportunities vying for funds, many CFOs favour channelling cash into projects offering a more obvious short-term return on investment. In trying economic times, justifying an investment in more efficient technology, for instance, is often easier than justifying a transaction to remove a long-term, uncertain obligation.

3. Poor timing

The cost of implementing a buyout strategy is intrinsically linked to the scheme's current funding measure as well as the position of the scheme with respect to volatile investment markets. Recently, opportunities have existed to transfer components of risk from pension funds to insurance companies for a small premium over their Technical Provisions or IAS19 liability. For instance, many pension schemes were in a favourable funding position back in 2008 and similarly early last year when the combined deficit of the schemes of the FTSE 100 fell to £80bn (from a high of £134bn in August 2010).

Yet the vast majority of schemes failed to take the opportunity to lock in improvements in funding levels by removing risk, resulting in them slipping back into deficit when markets took a turn for the worse. Currently, global long-term economic uncertainty has meant a struggling FTSE (reducing pension scheme assets) while AA bond yields remain low (meaning large pension liabilities). Given this, there is a sense that it may be preferable to wait for favourable conditions to return before transacting.

4. A lack of board-level incentive to transact

Pension liabilities are a complex and long-term obligation and too many boards of sponsoring companies have not completely understood the problem. This has not been helped by a lack of corporate disclosure on the exact nature of the risk at hand. While 95% of the FTSE 100 detail their key enterprise risk exposures within their annual accounts - and further outline the hedging strategies that have been put in place to deal with them - only a small handful of companies do the same with DB pension risk, despite the fact that it may constitute the largest risk faced by the business.

And this lack of disclosure means that pension risk management still struggles to make it on to board-level agendas. Indeed, in a recent survey of over 200 CFOs from the head offices of UK quoted companies 82% of them said the company pension scheme features as an item on the agenda at fewer than half of company board meetings each year. Any pension scheme is in effect a financial services business - the FSA would certainly, and rightly, not countenance this level of scrutiny.

5. A lack of understanding about the exact nature of the risk posed by schemes

Undeniably, scrutiny and management of scheme risk has improved in recent years. But there is still a way to go. And a key requirement is better and more up-to-date information. Pension scheme liabilities, in general, are only fully evaluated once every three years during the triennial valuation process. Frequently, by the time the valuation is finalised - up to 15 months after the valuation date - the information is out-dated and inappropriate for decision-making.

Funding positions fluctuate dramatically with market movements and over a period of months or years the changes can be substantial. While liability information may be adjusted for changes in membership and economic conditions in between full valuations, such 'roll-forwards' remain mere approximations. This can contribute to a gross underestimation of the actual risk posed by the pension scheme.

A Captive Solution: Reducing the Price of Buyout

For full buyouts to work and for the market to fulfil its potential to offer a solution to the DB problem, it is clear that the insurance industry has to come up with a better proposition than is currently available to CFOs and trustees. First of all, the issue of price must be addressed.

Studying the economics of buyout in more detail, the 140% of IAS19 buyout cost mentioned earlier is made up of the insurer's best estimate of the value of the liability (say roughly 120% of the IAS19 liability) plus an additional 20% that represents the insurer's profit. That 20% of profit counts towards the capital the insurer is required by the regulatory authorities to provide to back its liabilities. Then, roughly speaking, the insurer itself is required to put up another 20% of capital as equity, making in all 40% of capital to back the 120% liability.

This poses an interesting question for CFOs - what would happen if, rather than provide half of the regulatory capital, they instead invested the full amount in order to recapture the insurance profit? After all this is what quite a number of large companies do when they set up captive insurance companies to handle other forms of risk. Were they to do the same with their pension risk, the cost of buyout in the example would be reduced, as they would not have to pay the premium to an insurance company. The problem is that a pure captive solution such as this for delivering pension buyouts would consolidate the pension liability on the sponsor's balance sheet - often hugely distorting it - and would not remove balance sheet volatility.

The solution offered by Long Acre Life - a new insurance initiative focussed on delivering buy-in and buyout solutions - addresses this concern. Long Acre Life aims to deliver the economic benefits of a captive solution yet also borrows from the world of mutual insurance, enabling multiple parties to participate in the same entity (the insurance company), thereby removing the need for any single party to consolidate. The financial implications of this insurance type structure (one allowing access to insurer capital) are substantial - giving the potential to reduce the cost of buyout from 140% to around 120% of the value of IAS19 liabilities.

Addressing the Other Objections

Once the cost of buyout is reduced, the other barriers to transacting outlined in this article appear far from insurmountable. With the cash position of UK plc looking remarkably healthy right now (UK companies' cash flow has grown 40% since the depths of the financial crisis ), most CFOs are looking for investments to put their cash to good use. For many, the opportunity to remove a volatile risk in return for an asset on the balance sheet offering a stable annuity-based income would be seen as a good use of shareholder's funds.

A further, board-level, incentive for such a solution is the increasing pressure from shareholders and analysts on sponsoring companies to bring the amount of disclosure on their pension risk exposures in line with that afforded to all other corporate risks on the balance sheet. Of course, pension risk disclosure and management requires a detailed understanding of the exact nature of the liability. Yet technological developments (Long Acre Life uses PensionsFirst's PFaroe, for instance) provide precisely the right tools for such an analysis - allowing CFOs to access up-to-date and accurate valuation information at a click of a button. With this level of timely and detailed analysis, CFOs can be both better informed and much better placed to seize opportunities as they arise.

Which brings us to the final barrier - timing. Admittedly, prices in the buyout market in general may compare unfavourably to those of 2008, or even the start of last year. But CFOs may have to accept that the heady days when schemes could transact at not too much over their technical provisions may never be seen again. Innovative solutions offered by new entrants into the market, however, mean that the end-game need not also be out of sight.

Full article

Long Acre Life is not responsible for content on third party websites.

City A.M.

Devastating pensions crisis requires companies to take a more inventive approach

By David Norgrove, 31 Jan 2012

DEFINED benefit (DB) pension schemes are rarely out of the news these days - the latest headlines being from Shell, which has become the last of Britain's biggest companies to scrap its final salary scheme for new entrants. And while the death of DB - which has been predicted from as far back as 2004, when I joined The Pensions Regulator - may not be upon us quite yet, it is clear that rising longevity, poor investment returns and, some would argue, increased regulation, have resulted in the provision of DB pension schemes becoming too costly for many to bear.

Scheme closure does not remove a company's obligation to pay its previously accrued liabilities, however, which means the need to manage risk remains. Left unmanaged, DB pension risk can seriously impact the core business with implications for both shareholders and scheme members: its credit rating, share-price, and ability to attract capital can all be affected, for instance. And it is not an exaggeration to say that, in certain cases, DB pension liabilities are so large and volatile they can pose a serious threat to the financial viability of sponsoring companies. Indeed, the FTSE 100 is home to no fewer than 10 companies with pension liabilities greater than their market capitalisation. And other companies are pensions zombies: they really only exist to support their pensions schemes.

The buyout market - which essentially allows a pension scheme to transfer the risk over to an insurance company - seems to offer an answer to the DB problem. Yet the statistics paint a sorry picture. Since 2007 (when buyouts seemed to be doing well), the buyout market has seen only £25bn of business (and this figure includes buy-ins) - equivalent to just 2.5 per cent of the total value of DB liabilities sitting alongside the balance sheets of private UK companies. For the buyout market to fulfil its potential, the insurance industry has to come up with a better proposition than is currently available to chief financial officers and trustees.

A PENSIONS SHAKE-UP
There is no better time than now to address this issue. With the cash position of UK PLC looking remarkably healthy - UK companies' cash flow has grown 40 per cent since the depths of the financial crisis - most chief financial officers are looking for investments to put their cash to good use.

But to make the most of this, the whole industry needs a shake-up. Shareholders must pressure sponsoring companies to treat pension risk disclosure in line with that afforded to all other corporate risks on the balance sheet. Meanwhile, companies must embrace new technologies to improve their understanding and ability to manage pension risk.

First of all, however, insurers need to innovate to reduce the costs of buyouts. Traditionally, buyouts have been priced at about 140 per cent of the valuation of a scheme's liabilities on an IAS19 basis - a price greater than most chief financial officers are willing to pay. And while it would be unfair to lay the blame for this solely at the door of the insurance industry (insurance companies are constrained by the solvency capital regime required within the regulated insurance sector) there has been a lack of innovation targeted towards making solutions more affordable.

Certainly, even where a pension scheme is fully funded to IAS19, it seems improbable that many will be reaching for their chequebooks to pay a 40 per cent premium to an insurance company to take the risk away - especially given that the premium will be an immediate hit to the sponsor's profit and loss.

A CAPTIVE SOLUTION
One way forward may be via the world of captive insurance, where a company forms its own insurance company subsidiary to carry its risks. Used by many large companies to insure their property and casualty risks, captives - if set up by a pension scheme - would naturally retain the profit that would otherwise be paid to an insurer. But a pure captive solution for delivering pension buyouts would also consolidate the pension liability on the sponsor's balance sheet - compounding the problem. A solution is therefore required that delivers the economic benefits of a captive through a mutually owned insurance company, which removes the need to consolidate the liability. It may also tackle perhaps the greatest barrier to a buyout - the cost. Pension schemes conducting such a buyout could ultimately reduce the price they have to pay by as much as 20 per cent.

Current economic conditions, many would argue, may mean that such innovations will struggle to solve the buyout conundrum. Yet companies may have to accept that the heady days of 2008 - when schemes could transact at a price just over the value of their liabilities - may never be seen again. And that leaves the way clear for new entrants to offer innovative solutions to the DB pensions issue.

David Norgrove is the former chairman of The Pensions Regulator and the current chairman of Long Acre Life.

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The Treasurer

Are buy-outs inevitable?

By David Norgrove, 01 Mar 2012

With the need to manage pension risk moving up the corporate agenda, many treasurers and CFOs have looked towards the buy-out market. Yet few have transacted. The insurance industry needs to create a better proposition than what is currently available.

Rising longevity, poor investment returns and, it could be argued, increased regulation have seen the cost of providing a defined benefit pension scheme soar beyond a level most treasurers or CFOs are willing to tolerate. Hence an increasing number have moved to close their schemes to new members in order to cap their pension costs, with Shell merely the latest in a long line of blue-chip companies to take such action.

Yet while scheme closure signals a significant step on the road towards the end game, it does not remove a company's obligation to pay its previously accrued liabilities - hence the need to manage pension risk remains. Left unmanaged, DB risk can impact a company's credit rating, share price, ability to attract capital and even its future viability. Indeed, the FTSE 100 includes no fewer than 10 companies with pension liabilities greater than their market capitalisation.

Some schemes have attempted to address this problem by looking to derisk distinct groups of members or by removing risk components individually through hedging or swap contracts, with limited success. Undoubtedly, buy-outs - where all accrued pension liabilities are completely transferred to an insurance company in return for a premium - offer the most holistic solution. Yet to date the market has only attracted £25bn of business (a figure that includes buy-ins), or 2.5% of the total value of DB liabilities sitting on the balance sheets of UK plc. For the buy-out market to fulfill its potential, it is clear that the industry needs a shake-up.

A lack of corporate disclosure about the true nature of the DB pension risk, and the infrequent use of technology to measure and manage this risk, are undoubtedly key barriers that need addressing. But first, the insurance industry must tackle perhaps the greatest hindrance to a buy-out: the cost.

Understandably, most pension schemes are unwilling to pay a 40% premium to remove their DB risk, especially as this premium will be an immediate hit to the sponsoring company's P&L.

The answer may come in the form of captive insurance, where a company forms its own insurance company subsidiary to carry its risks. If set up by a pension scheme, captives would naturally retain the profit otherwise paid to an insurer. Yet a pure captive solution for delivering pension buy-outs would also compound the pension liability (and the problem) on the sponsor's balance sheet.

So a solution is required that delivers the economic benefits of a captive through a mutually owned insurance company (the idea behind Long Acre Life). This solution not only removes the need to consolidate the liability, it offers significant cost savings.

Indeed, such a buy-out could ultimately reduce the hit to the company's P&L by 20% or more. Of course, the cost of implementing a buy-out strategy is also intrinsically linked to the scheme's current funding measure and its position with respect to volatile investment markets. Recently, opportunities have existed to transfer components of risk from pension funds to insurance companies for a small premium over their IAS 19 liability (even as recently as early last year when the combined deficit of the schemes of the FTSE 100 fell by £54bn in six months). Yet the vast majority of schemes failed to take the opportunity to lock in improvements in funding levels, and so slipped back into deficit when markets took a turn for the worse.

Unfortunately, CFOs may have to accept that such heady days may never be seen again. Yet continuing to leave their schemes exposed to a significant amount of financial risk, which, given the volatility of the markets, could have a significant impact on the company's financial performance, should not be an option. And with the cash position of UK plc looking remarkably healthy (UK companies' cashflow has grown 40% since the depths of the financial crisis, with that cash earning negligible returns), now may be a good time to act. For many, the opportunity to remove a volatile risk in return for an asset on the balance sheet offering a stable annuitybased income would be seen as a good use of shareholder funds.

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Pensions Week

Sponsors withholding billions from scheme liabilities

By Katie Morley, 26 Mar 2012

UK plc is holding 5% of GDP (£750bn) it should be using to pay off pension liabilities, a former Pensions Regulator chief will claim this week.

At a Westminster & City pensions conference on Wednesday, David Norgrove will condemn employers for relatively inactive management of defined benefit liabilities.

And he will warn that, at the current rate of action, UK companies are hypothetically "centuries" away from reaching their endgames.

His comments follow BT announcing a lump-sum payment of £2bn into its pension scheme this month from existing cash resources.

He toldPW: "Companies are feeling underconfident and are reluctant to part with cash for investment as they're worried about the returns and the premium on risk transfer is unpalatable for most.

"The £10bn currently in the derisking market is trivial compared with the £1trn of UK liabilities that need dealing with. And unless they do something about it soon, they'll be carrying liabilities for another 80 years or so, until all their members die.

"They can't carry on running as underfunded financial services businesses, which is essentially what they are."

He added many analysts and investors are still ignorant to the significance of pension schemes on businesses, but more of them are now "waking up to the reality", which is being reflected in the price of loans and in merger and acquisition contracts, as previously reported by PW.

More than a quarter of FTSE 100 companies could afford to buy out their pension schemes in full now, claimed LCP derisking partner Charlie Finch, but added timing is also important.

"The real question is whether a buyout will offer them good value for money," he said.

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Finance Director

Pension buyouts: Capitalising on windows of opportunity

By David Norgrove, 18 Jun 2012

Innovative new solutions have started to make a pension buyout economically attractive for FDs of companies with defined benefit pension schemes. However, many are keen not to lock-in to a transaction when market conditions are unfavourable, says David Norgrove, former Chairman of The Pensions Regulator and current Chairman of Long Acre Life. Proactivity is therefore essential to seize opportunities to de-risk when economic conditions take a turn for the better.

RISING LONGEVITY, poor investment returns and, it could be argued, increased regulation have seen the cost of providing a defined benefit (DB) pension scheme soar beyond a level most finance directors are willing to tolerate. Hence an increasing number are opting to close their schemes to new members, and now future accrual too, in order to cap their pension costs.

Yet while scheme closure signals a step on the road towards the end game, it does not remove a company's obligation to pay its previously accrued liabilities - hence the need to manage risk remains. Left unmanaged, DB risk can impact a company's credit rating, share-price, ability to attract capital and even its future viability. Indeed, the FTSE 100 includes no fewer than ten companies with pension liabilities greater than their market capitalisation.

In this respect, pension buyouts -where all accrued pension liabilities are completely transferred over to an insurance company in return for a premium - offer the most complete solution to this problem. Yet, to date, the market has failed to convince finance directors of its full value proposition. Indeed, it has only attracted £25bn of business (and this figure includes buy-ins), or 2.5% of the total value of DB liabilities sitting alongside the balance sheets of UK plc.

Understandably, premiums traditionally required by insurers - about 140% of the value of a scheme's liabilities on an IAS19 basis - have been a turn-off for many finance directors. Yet innovative new solutions, which allow pension schemes to make an equity investment in a mutualised insurance company and hence recapture some of the 40% premium that is traditionally accepted as insurance profit, may go some way towards making a buyout economically attractive.

A matter of timing
Of course, the absolute price of a buyout is also intrinsically linked to the individual scheme's current funding measure, as well as its position with respect to volatile investment markets. Currently, global long-term economic uncertainty has meant a struggling FTSE (reducing pension scheme assets) while interest rates remain at record lows (meaning large pension liabilities, as they are discounted using this value). Given this, many finance directors are holding tight until market conditions take a turn for the better, rather than risk locking in to a buyout when funding levels are low and liabilities high.

However, patience may not necessarily be a virtue. While pension scheme funding levels may compare unfavourably to those before the financial crisis, or even the start of last year, finance directors may have to accept that better conditions will continue to recede into the future. Indeed, interest rates have been at record lows for three years, with little indication this will change any time soon. Add to this the fact many pension schemes have already completed interest rate swaps - mitigating their risk, but also reducing their upside benefit from interest rate swings as well as moving the valuation of liabilities closer to that of an insurer - and one could argue that this could be as good a time as any to remove pension liabilities from the balance sheet, or at least to start the process.

For those schemes that have left themselves more exposed to fluctuations in interest rates or the equity markets - and therefore stand to gain from changing market conditions - patience may be more understandable, however. That said, finance directors should not simply sit back and wait for economic conditions to improve and funding levels to increase before hastily trying to snatch the opportunity to transact. Indeed, preparing for a major transaction itself takes many months - meaning that any delay to the start of this journey could result in missed opportunities.

History provides a useful lesson here - many pension schemes were in a favourable funding position back in 2008 but failed to take the chance to reduce risk and subsequently slipped back into deficit when the financial crisis hit. And there are more recent examples - Long Acre Life research, for example, suggests that the combined deficit of the DB pension schemes of the FTSE 100 decreased from approximately £43bn on an IAS19 basis at the end of 2010 to about £27bn by the middle of last year.

Yet given the volatility of pension scheme's investment strategies and their exposure to market risk, these windows of opportunity are often short-lived, which means that - if pension schemes do not act quickly and efficiently to lock in improvements in funding levels - they risk a widening of their deficit the next time the FTSE takes a hit or bond prices rise yet further. Indeed, Long Acre Life data shows that merely three months later, with most schemes failing to engage in any de-risking activities, the deficit had increased by as much as £15bn to over £42bn on an IAS19 basis, driven by a combined 13.5% fall in UK equities (which accounts for about 18% of the FTSE 100's asset portfolio) and 14% fall in global equity prices (which accounts for about 23%).

Historically, an inability to measure pension scheme funding positions on a continuous basis, an incomplete understanding about the exact nature of the risk pension schemes faced, a lack of board-level incentive to transact, and, of course, expensive buyout premiums, have all contributed to the lack of action in the buyout market. Yet, many of these barriers to buyout (and de-risking in general) are now diminishing. What's more, the impending implementation of new IAS19 accounting standards may remove some of the profit and loss benefit that certain companies currently enjoy from holding riskier assets in their pension schemes - and may therefore make risk-transfer activity more attractive for such companies.

But to be able to take opportunities as and when they arise, schemes need to engage with buyout experts able to advise them on the potential routes through the thickets. Risk-transfer activities such as longevity swaps, synthetic buy-ins or deferred buy-in/buyouts all are legitimate precursors to a full buyout, for instance, moving schemes well on the way to an insurer's best estimate of the liability and reducing the extra cost of a buyout. The journey towards a buyout may be a long one for some schemes, but this makes it all the more important for them to get started.

David Norgrove is the former chairman of The Pensions Regulator and current chairman of Long Acre Life

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SchemeXpert

Why now is the time to start the journey towards a full buyout

By David Norgrove, 01 Jun 2012

While adverse market conditions may make some schemes wary about transacting on a full buyout now, proactivity is essential to seize opportunities to de-risk when economic conditions become more favourable , says David Norgrove, former Chairman of The Pensions Regulator and current Chairman of Long Acre Life

Given the legacy nature of UK defined benefit (DB) pension schemes, and the size of the risk they pose to their sponsoring companies, it is unsurprising that more and more scheme managers are seeking the "end-game". Some have attempted to address this by looking to de-risk distinct groups of members or by removing risk components individually through hedging or swap contracts.  While these measures have their place, buyouts - where all accrued pension liabilities are completely transferred over to an insurance company in return for a premium - offer the most complete solution for scheme members, trustees, and shareholders alike.

What's more, the buyout market is beginning to move in pension schemes' favour. Understandably, premiums traditionally required by insurers - about 140% of the value of a scheme's liabilities on an IAS19 basis - have been a turn-off for many scheme managers. Yet innovative new solutions, which allow pension schemes to make an equity investment in a mutualised insurance company and hence recapture some of the 40% premium that is traditionally accepted as insurance profit, may go some way towards making a buyout economically attractive.

Of course, the absolute price of a buyout is also intrinsically linked to the individual scheme's current funding measure, as well as its position with respect to volatile investment markets. Currently, global long-term economic uncertainty has meant a struggling FTSE (reducing pension scheme assets) while interest rates remain at record lows (meaning large pension liabilities, as they are discounted using this value). Given this, the general consensus among scheme managers is that it may be preferable to wait for favourable conditions to return before transacting - thus avoiding locking in to a buyout when funding levels are low.

This strategy may not necessarily pay dividends for all, however. While pension scheme funding levels may compare unfavourably to those before the financial crisis, or even the start of last year, scheme managers may have to accept that better conditions continue to recede into the future. Indeed, interest rates have been at record lows for three years, with little indication this will change any time soon. Add to this the fact many pension schemes have already completed interest rate swaps - mitigating their risk, but also reducing their upside benefit from interest rate swings as well as moving the valuation of liabilities closer to that of an insurer - and this could in fact turn out to be a good time for some companies to take pension risk off the table.

Clearly every scheme is different, however, and for those schemes that have left themselves more exposed to fluctuations in interest rates or the equity markets - and therefore stand to gain from changing market conditions - patience may be more understandable. That said, scheme managers should not simply sit back and wait for economic conditions to improve and funding levels to increase before hastily trying to snatch the opportunity to transact. Indeed, preparing for a major transaction itself takes many months - meaning that any delay to the start of this journey could result in missed opportunities.

History provides a useful lesson here. For instance, many pension schemes were in a favourable funding position back in 2008 but failed to take the chance to reduce risk and subsequently slipped back into deficit when the financial crisis hit. And there are more recent examples - Long Acre Life research, for example, suggests that the combined deficit of the DB pension schemes of the FTSE 100 decreased from approximately £43 billion on an IAS19 basis at the end of 2010 to about £27 billion by the middle of last year.

Yet given the volatility of pension scheme's investment strategies and their exposure to market risk, these windows of opportunity are often short-lived, which means that - if pension schemes do not act quickly and efficiently to lock in improvements in funding levels - they risk a widening of their deficit the next time the FTSE takes a hit or bond prices rise yet further. Indeed, Long Acre Life data shows that merely three months later, with most schemes failing to engage in any de-risking activities, the deficit had increased by as much as £15 billion to over £42 billion on an IAS19 basis, driven by a combined 13.5% fall in UK equities (which accounts for about 18% of the FTSE 100's asset portfolio) and 14% fall in global equity prices (which accounts for about 23%). 

Many of the barriers that have previously hindered a buyout transaction - such as an inability to measure schemes' funding position on a continuous basis, an incomplete understanding about the exact nature of the risk schemes face, a lack of board-level incentive to transact, and, of course, expensive buyout premiums - are now being removed. What's more, the impending implementation of new IAS19 accounting standards may remove some of the profit and loss benefit that certain companies currently enjoy from holding riskier assets in their pension schemes - and may therefore make risk-transfer activity more attractive for such companies.

But to seize increasingly attractive opportunities, schemes need to engage with buyout experts able to advise them on the potential routes through the thickets. Risk-transfer activities such as longevity swaps, synthetic buy-ins or deferred buy-in/buyouts all are legitimate precursors to a full buyout, for instance, moving schemes well on the way to an insurer's best estimate of the liability and reducing the extra cost of a buyout.  The journey towards a buyout may be a long one for some schemes, but this makes it all the more important for them to get started.

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Treasury Management International (TMI)

Defined benefit pensions: Overcoming the obstacles to buyout

By David Norgrove, 29 May 2012

In recent years, full scale pension buyouts have been rare despite an increasing corporate focus on the pensions "end-game". Yet innovative new approaches to buyout may prove more tempting for treasurers and CFOs, says David Norgrove, former Chairman of The Pensions Regulator and current Chairman of Long Acre Life.

Over the past decade there has been a substantial increase in the cost of defined benefit (DB) pension schemes as a result of rising longevity, a more demanding regulatory environment, and the combination of falling equity prices and lower interest rates. The result is that DB schemes are now entering their own phase of retirement and, although the death of DB may not be upon us quite yet, it is clear that the end-game has fast risen to the top of the agendas of many treasurers and CFOs of companies with significant pension obligations.

In search of a solution, some sponsoring companies have turned towards benefit re-design, while an increasing number are closing their schemes completely. Recently, Shell - one of the last bastions of DB provision within the FTSE 100 - announced that it too was to close its scheme to new members. Yet closing a scheme does not end a company's obligation to pay its previously accrued liabilities -which means that the risk management burden remains. Certainly, there are serious implications of unmanaged DB pension risk, which can impact the sponsoring company's core business - affecting its credit rating, share-price, ability to attract capital and even its contracts with clients - with significant knock-on effects for shareholders and scheme members.

In the worst case, DB pension liabilities may be so large and volatile that they endanger the entire financial viability of sponsoring companies. One only needs to look at the FTSE 100, where no fewer than 10 companies now have pension liabilities greater than their market capitalisation, to realise that this is a very real threat.

It is here that pension buyouts ­ - which enable sponsoring companies to pass their pension risk over to an insurance company, at a cost - could potentially offer a way out. Yet, despite the theoretical benefits of a buyout, very few have been completed in the market to date, as insurance companies struggle to persuade treasurers and CFOs of their value. In this respect, the emergence of a new approach to pension buyouts - aimed at making transactions more affordable for sponsoring companies - may help.

Five key barriers to buyout

Given treasurers and CFOs' anxiety about the impact that DB pension risk may have upon the financial viability of their company, the actual number of buyout transactions since 2007 (when they seemed to be taking off) has been minimal. Indeed, since then, the market has witnessed only £25 billion of business - the equivalent of roughly 2.5% of the total value of DB liabilities sitting alongside the balance sheets of private UK companies - and that figure includes buy-ins (bulk annuities).

To explain the reluctance among treasurers and CFOs to move this volatile risk off their businesses' balance sheets, I would suggest that there are five key barriers to buyout:

1) The cost barrier

For those treasurers and CFOs considering transacting, a major obstacle to date has been the absence of economically attractive solutions. On an IAS19 basis, buyouts have commonly been priced at about 140% of the valuation of a scheme's liabilities. Even where a pension scheme is fully funded to IAS19, it is understandable that most CFOs have been reluctant to pay a 40% premium to an insurance company to remove their pension risk, especially as this cost will be an immediate hit to the sponsor's P&L. 

2) Cash flow issues

In recent years, schemes have experienced significant investment losses as a result of the volatile economic environment. The prospect of funnelling significant amounts of cash into a pension scheme to enable a buyout has therefore become less appealing - with projects offering a more obvious short-term return on investment taking precedence. In trying economic times, justifying an investment in more efficient technology, for instance, is often easier than justifying a transaction to remove a long-term, uncertain obligation.

3) Not the time to transact

The cost of a buyout is intrinsically linked to the pension scheme's current funding measure, as well as the position of the scheme with respect to the markets. In 2008 and early last year, pension schemes failed to exploit opportunities to lock in improvements in funding levels by removing risk. Many have slipped back into deficit or seen their deficit increase since, as   economic volatility - including a struggling FTSE and low AA bond yields - reduced pension scheme assets and increased already substantial pension liabilities. In such an environment, there is naturally caution and a reluctance to transact.

4) A lack of board-level incentive to transact

Pension liabilities are a complex and long-term obligation and too many boards of sponsoring companies have not completely understood the problem. This has not been helped by a lack of corporate disclosure on the exact nature of the risk at hand. While 95% of the FTSE 100 detail their key enterprise risk exposures within their annual accounts, only a handful of companies do the same with DB pension risk, despite the fact that it may constitute one of the largest risks faced by the business. And this lack of disclosure means that pension risk management still struggles to make it on to board-level agendas.

5)  A lack of understanding about the exact nature of the risk posed by schemes

Undeniably, scrutiny and management of scheme risk has improved in recent years. But there is still a way to go. Analysis is often out-of-date and presented in a way that is hard to get to grips with, particularly since board members of even large companies may have had little exposure to the issues presented by pensions. And without an understanding of the true nature of the risk they face, analysing and engaging in effective de-risking transactions is almost impossible.

Addressing affordability

For buyouts to fulfil their potential to offer a genuine solution to the DB problem, it is clear that the issue of price must be addressed. And, in order to do this, untangling the economics of an insurance buyout is essential.

Typically, buyout costs are around 140% of the IAS19 value of a pension scheme's liabilities (see Figure 1) - combining the insurer's best estimate of the value of the liability and, about, a further 20% which represents the insurer's profit. Insurance companies treat this 20% profit as part of their regulatory capital. Additionally, the insurer must put up around another 20% of capital as equity, totalling 40% of capital to back the 120% liability.  In other words, the scheme and sponsor provide around half of the insurer's regulatory capital, with the insurance company itself putting up the rest.

For CFOs, this raises an important question - if the buyout premium contributes half of the insurer's regulatory capital, why not consider making an equity investment to recapture all of the insurance profit? After all, this approach mirrors the captive solutions used by many large companies to manage other risks (such as property and casualty). This approach would potentially reduce the cost of buyout by allowing the sponsor to capture some, or all, of the profit that would otherwise be paid to an insurance company.

However, on closer inspection, using a stand-alone captive would mean consolidating the pension liability on the sponsor's balance sheet which is not an ideal solution.  There would also, at least at the beginning, be no transfer of risk.

Long Acre Life - a new insurance initiative focussed on delivering buy-in and buyout solutions - has been created to allow companies to secure the economics of a captive without the disadvantages that come from consolidating the risk. The framework is highly flexible but the essence is a mutual solution, giving a more affordable route to buy-in and buyout - with the potential to reduce the cost from 140% to around 120% of the value of IAS19 liabilities.

Breaking down the remaining barriers

There is no alchemy in this. While it does reduce the long-term cash cost of buyout, as well as minimise the immediate P&L impact, companies must still find the cash to invest upfront to enable their participation in the profit-sharing element. That said, sourcing this cash may now be less of a barrier than it was previously. Indeed, companies' cash flow has grown 40% since the depths of the financial crisis, which means CFOs are seeking-out opportunities to put shareholders' funds to good use. And the opportunity to remove a volatile risk in return for an asset on the balance sheet offering a stable annuity-based income appears to tick this box.

Long Acre Life also tackles the problem of transparency. With this approach all assumptions, transactions, risks and rewards are visible and shared among stakeholders (the sponsor, the scheme and any outside investors). Crucially, there are no black boxes. And with the right technology (Long Acre Life uses PensionsFirst's PFaroe, for instance), CFOs and trustees have easy access to up-to-date and accurate information about scheme liabilities, assets and risks, at the click of a button. The result is that all parties can make timely and more efficient decisions about when to transact.

And this leads us to the final hurdle - timing. It is fair to say that buyout and buy-in prices have increased, yes, but innovative solutions offered by new entrants into the market now put buyouts within reach for many schemes. Of course, on the flipside, it is clear that there are also schemes that are some way away from being in a position to conduct a full buyout - yet this does not mean that they should simply sit back and do nothing.

Indeed, preparing for a major transaction itself takes many months and to delay the start of this journey may mean missing a window of opportunity when it opens. Schemes must therefore engage with buyout experts as soon as possible, who will be able to advise them on the potential routes to buyout - longevity swaps, synthetic buy-ins or deferred buy-in/buyouts are all legitimate precursors to a full buyout, for instance. The journey to buyout may be a long one for some schemes - which means that now is the time to begin.   

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Pensions Age

A new lease of life

By Graham Buck, 01 Jun 2012

Innovation and creativity has introduced a more positive tone to the world of scheme buy-ins, buyouts and longevity swaps, reports Graham Buck

Recent months have been marked by significant innovation in the buyout market, such as last month's deal between Prudential and Centro (formerly West Midlands Integrated Transport Authority), which featured a comparatively rare occurrence - a buyout involving a local authority, which followed a handful of buyout deals already struck in the public sector. Prudential is acquiring £272 million of assets from the £7.7 billion West Midlands Pension Fund, and will protect the fund and its sponsor against volatility in the investment market and unanticipated increases in the life expectancy of the pensioners.

The deal follows other 'firsts', such as the pension insurance buyout agreement announced in March between Pension Insurance Corporation (PIC) and the motor components manufacturer DENSO Corporation.

The agreement devised between PIC and the trustees and sponsors of two of the Japanese multinational's UK pension schemes covers around £200 million of liabilities and covers accrued pensions, allowing scheme members to continue accruing future final salary benefits through insurance provided by PIC.

As the provider notes, the deal marks the first time that pension funds have entered into a buyout accommodating future accruals in a similar way to an open defined benefit scheme, but with added security of the insurance regulatory regime protecting benefits.

"This meant dismantling the current scheme and moving it from a pensions framework to an insurance framework within an insurance contract, after the company secured the necessary tax and regulatory clearance," says PIC's co-head of business origination Jay Shah.

"The net result is that DENSO has no further liabilities relating to benefits accrued by members in the past, and thus no further charges or other costs to be incurred."

Captive solution
Also attracting attention is the debut of Long Acre Life, a new insurer that launched in December with the remit of devising more affordable buy-in and buyout solutions to companies with defined benefit liabilities in excess of £500 million.

The new company, with a manage­ment team headed by former chairman of The Pensions Regulator, David Norgrove, expects to begin transacting business later this year, once approved by the Financial Services Authority. It has announced its aim as delivering the economic benefits of captive insurance traditionally applied to property/casualty insurance to buy-ins and buyouts.

Although the cost of buyout varies from one scheme to another, typically the pricing has been calculated at around 140 per cent of the IAS19 liabilities. Long Acre's initiative - designed by PensionsFirst, which is also a shareholder in the insurer - is to create a mutual insurance solution owned by schemes, their sponsors and outside investors that will share in the insurance profit that would otherwise be paid to a third party insurer. By adopting the captive model, the aim is to reduce the buyout cost to around 120 per cent.

"The company aims to sign up its first scheme later this year, but we have no set timetable or targets as we recognise it will take time for people to become familiar with the concept," says Norgrove. "It has, nonetheless, already attracted considerable interest from companies which like the idea of shareholders' money not going to third parties."

At the other end of the scale, insurer Partnership has been developing the concept of enhanced de-risking for smaller schemes, typically with up to 200 members and liabilities of less than £30 million and with a sizeable proportion of enhanced annuity candidates. The basis is on underwriting individual lives and its director of corporate partnerships, Will Hale, says that the company is working with leading employee benefit consultants with the aim of concluding its first deals over the next few months.

An active market
All of this innovation takes place against a resurgent market for pension and longevity risk transfer, with £12.4 billion of deals concluded in 2011 after a highly active fourth quarter.

The total, comprised of £5.3 billion in buy-ins/buyouts and £7.1 billion in longevity hedging deals, was the second-best since the risk settlement market hit its stride six years ago and surpassed only in 2008. As Spence & Partners head of employers advisory services Alan Collins notes: "Longevity swaps have been promoted as the new 'big thing' for several years, but never appeared to gain that much traction."

This could reflect the lengthy period often needed to structure deals, with activity from previous years now finally coming to fruition.

Market volume in 2011 was helped by the mega deals that secured approval from The Pensions Regulator, says MetLife Assurance chief executive Wayne Daniel. The first was the £830 million 'deficit for equity' swap concluded for food group Uniq in December with Goldman Sach's insurance arm Rothesay Life. "The deal was a 'last resort' measure involving a company in considerable financial difficulty with a sizeable deficit," says Daniel. It involves 90.2 per cent of the company's equity being transferred to the scheme, with Rothesay covering liabilities and guaranteeing payments to members "at least equal in value" to compensation levels provided under the Pension Protection Fund.

Even bigger was the £1.1 billion bulk annuity buyout engineered by Legal & General for Turner & Newall's pension scheme, a decade after asbestos claims forced the building materials manufacturer into administration. "We can expect to see more of these structured transactions being placed within the re/insurance sector instead of with the banks," adds Daniel.

Two other longevity deals for companies in rather better financial health were a £1 billion agreement for glassmaker Pilkington, also involving L&G plus German reinsurer Hannover Re and a £3 billion swap with Deutsche Bank for trustees of the Rolls-Royce Pension Fund.

"L&G learned a great deal from structuring the Pilkington transaction and it's likely that they will be able to replicate the model elsewhere and more cheaply," says JLT Pension Capital Strategies head of buy-out services Tiziana Perrella. "Longevity can now be offered on schemes with liabilities of no more than £50 million, whereas until recently the minimum figure was £200 million."

She adds that L&G has also demonstrated flexibility in accepting less conventional assets, such as intellectual property rights, as collateral in deals. Among those gaining media attention was that agreed with drinks group Diageo two years ago, under which its pension scheme will own a range of maturing whisky under a 15-year partnership.

"Asset-backed contributions to schemes are becoming more popular, although they can be both complicated and costly to set up - particularly when the asset used as collateral is property."

Price worth paying
After the more subdued activity in the period after the financial downturn, it seems likely that more employers will look to insurance providers to take over the risk of active schemes.

"I'm loath to suggest that the markets have settled down, but it's true that insurers are becoming more comfortable with pricing as they come to grips with Solvency II's requirements and as credit spreads remain stable," says Aon Hewitt managing principal and head of risk settlement Martin Bird. "The insurance market has learned much since 2007 and relatively 'plain vanilla' annuities can usually be executed quite quickly."

"Buyouts admittedly still appear expensive, but that's really only the case if the company genuinely can't afford it," says Collins. "My advice to those that can is to go ahead so that you can remove the liabilities off the balance sheet."

Another positive development, for companies seeking to de-risk their defined benefits schemes but deterred by the cost, is the ability to spread the cost over several years. Aviva's recent introduction of deferred payments has really opened up the buyout market says Xafinity principal consultant Ian Johns.

"Although yields are low, there is nonetheless considerable competition among providers and most are bullish on prospects for writing new business," he adds. "So they are looking for flexible and innovative solutions to attract new business in."

These are likely to include more staged buy-ins as the prelude to an eventual buyout, and what Bird dubs the "pick and mix approach" - with the market more amenable to schemes deciding which risks they are willing to retain and those that they prefer to hedge.

Although uncertainty over Solvency II's impact on pricing, the repercussions of the ECJ's gender discrimination ruling (which is likely to start affecting annuity rates late this year) and continued volatility in the equity markets all cast a cloud, Bird believes that competition and innovation are set to continue.

"Sponsors and trustees are also talking to the capital markets as well as to insurers and reinsurers," he reports. "So the overall picture is quite an upbeat one compared to that of 2009 and 2010."

Written by Graham Buck, a freelance journalist

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gtnews

Pension buyouts: the best use of a company’s capital?

By David Norgrove, 13 Jul 2012

Many companies are looking for opportunities to put shareholders' funds to good use having built up significant cash balances over recent years. One use being considered is a full-scale pension buyout. With innovative new structures in the offing, what situations represent strong opportunities for a sponsoring company of a defined benefit pension scheme asks David Norgrove, former Chairman of The Pensions Regulator and current Chairman of Long Acre Life.

Faced with the rising cost of defined benefit (DB) pension provision - driven by rising longevity, a more demanding regulatory environment and the combination of falling equity prices and lower interest rates - an increasing number of sponsoring companies are seeking to de-risk, with the "end-game" the ultimate goal. In seeking this finality, some sponsoring companies have turned towards benefit re-design, while an increasing number are closing their schemes completely. However, closing a scheme does not end a company's obligation to pay its previously accrued liabilities, which means that the risk management burden remains.

Certainly, there are serious implications of unmanaged DB pension risk, which can impact the sponsoring company's core business and financial performance, with significant knock-on effects for shareholders and scheme members. Recently, pension risk has even affected a company's ability to borrow, with lenders becoming more cautious given recent high-profile insolvency cases where pension schemes have been given "super-priority" - requiring pension liabilities to be paid prior to any other debts.

In this respect, a full buyout - which involves the transfer of all pension liabilities to an insurance company - offers the most complete solution. However, it is fair to say that the buyout market has, to date, failed to take off, attracting only £25 billion of business (and this figure includes buy-ins). To put this into context, this represents only 2.5% of the total value of DB liabilities sitting alongside the balance sheets of UK PLC.

Yet there are signs the landscape is changing (there have already been a few large buyout deals this year) as the rationale for full buyout becomes better understood by financial directors and company board members, as well as by analysts and shareholders. Furthermore, with companies' cash flow growing 40% since the depths of the financial crisis[1], many companies are looking for opportunities to put shareholders' funds to good use. Whether it makes sense to use this excess cash to transact on a pension buyout depends very much on the individual company and its alternative use of capital. That said, innovative new approaches to pension buyouts may increase the appeal from a corporate finance perspective, with positive accounting implications to boot. 

Addressing the corporate finance implications

To address whether a conventional pension buyout is a good use of a company's capital, we must first consider the economics of the transaction in more detail. Buyouts have commonly been priced at about 140% of the valuation of a scheme's liabilities on an IAS19 basis - made up of the insurer's best estimate of the value of the liability (say roughly 120% of the IAS19 liability) plus an additional 20% that represents the insurer's profit. That 20% of profit counts towards the capital the insurer is required by the regulatory authorities to provide to back its liabilities. Then, roughly speaking, the insurer itself is required to put up another 20% of capital as equity, making a total of 40% of capital to back the 120% liability.  

Typically the insurance profit component of the buyout premium is calculated by targeting a return on capital (ROC) of 12-15% per annum (this is what the insurer's shareholders expect to earn). To put it simply, in a conventional buyout, pension scheme sponsors are implicitly renting capital at 12-15%. Whether it makes sense or not to do so depends entirely on the company's alternative use of its capital.

In this respect, companies have four main options as an alternative: return cash to their shareholders as dividend, invest it in assets, use it to fund their core business, or just sit on it. With a return of cash to shareholders suggesting a lack of strong corporate leadership on the best way forward, and with equity markets relatively strong in comparison to expectations for the economy, most companies are either opting to re-invest in their day-to-day business operations or just sit on it, earning very low returns.

Compared to re-investment in the business, if the company's ROC is equal to or exceeds 12-15%, then entering into a conventional buyout to remove all of its DB exposures would in fact prove a more economically-attractive option.  However, if the ROC of the business is lower, a conventional buyout may represent a significant transfer of value from the company's shareholders to those of the insurer.

Analysing the decision in this way raises an important question - if the buyout premium contributes half of the insurer's regulatory capital, why not consider making an equity investment to recapture all of the insurance profit? After all, this approach mirrors the captive solutions used by many large companies to manage other risks (such as property and casualty). This approach - which has been adopted by Long Acre Life - reduces the eventual cost of buyout as it allows the retention of some or all of the profit (at a 12-15% ROC) that would be paid to an insurance company. And so long as there is an appropriate proportion of external capital the pension scheme should not need to be consolidated on the company balance sheet.

From an accounting perspective, this structure involves an initial hit to the profit and loss account similar in value to a conventional buyout. However, the key point here is that the equity investment (which can be up to 20% of the total value) will be recognised as an asset on the company's balance sheet. Without going too deep into the technicalities, regardless of whether a sponsor accounts for its investments on a fair-value or equity accounting basis, it can expect an immediate increase in the value of its initial investment - with this increase recognised as a profit in its income statement at the time of buyout. This profit will partially offset the buyout loss recognised in the sponsors financial statements and may reduce the final buyout cost from 140% to around 120% of the value of IAS19 liabilities. 

Falling barriers to buyout    

Furthermore, many of the barriers that have previously hindered a buyout transaction - such as an inability to measure schemes' funding position on a continuous basis, an incomplete understanding about the exact nature of the risk schemes face, a lack of board-level incentive to transact, and, of course, expensive buyout premiums - are now being removed.  The impending implementation of new IAS19 accounting standards may also remove some of the profit and loss benefit that certain companies currently enjoy from holding riskier assets in their pension schemes - and may therefore make risk-transfer activity more attractive for such companies.

However, while performing a buyout using a structure that allows the scheme to recapture some of the insurance profit may ultimately reduce the relative price of buyouts, the absolute price is intrinsically linked to the individual scheme's current funding measure and therefore linked to its position with respect to volatile investment markets. Given global long-term economic uncertainty (which has reduced pension scheme assets) and record-low interest rates (meaning large pension liabilities, as they are discounted using this value), the general consensus among scheme managers is that it may be preferable to wait for favourable conditions to return before transacting. The theory is that this will allow schemes to avoid locking in to a transaction when funding levels are low.

While pension scheme funding levels may compare unfavourably to those before the financial crisis, or even the start of last year, companies may have to accept that better conditions continue to recede into the future, however. Indeed, interest rates have been at record lows for three years, with little indication this will change any time soon. Add to this the fact many pension schemes have already completed interest rate swaps - mitigating their risk, but also reducing their upside benefit from interest rate swings as well as moving the valuation of liabilities closer to that of an insurer - and one could argue that there may be no better time than now to prepare to remove pension liabilities from the balance sheet. But only as long as the economics make sense.

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Professional Pensions

Seizing opportunities to de-risk

By David Norgrove, 26 Jul 2012

Innovative new solutions have finally put a full buyout within the grasp of many schemes, yet adverse market conditions may mean some are hesitant to transact immediately, says David Norgrove.

Faced with the rising cost of defined benefit provision, some sponsoring companies have turned towards benefit re-design, while an increasing number are closing their schemes completely.

Yet closing a scheme does not end a company's obligation to pay previously accrued liabilities so the risk management burden remains.

Certainly, there are serious implications of unmanaged DB risk, which can affect the sponsoring company's core business and financial performance, with significant knock-on effects for shareholders and scheme members.

While the threat posed by DB pension risk has driven the industry as a whole to seek more prudent investment strategies, extend recovery periods and attempt to make up for funding deficits by increasing contributions (BT recently announced its commitment to plough £2bn into its pension to halve its £4.1bn deficit, for instance), there is also an increasing acceptance that a more definitive solution is required.

Given the legacy nature of UK DB schemes, it is unsurprising that a move towards de-risking, and ultimately the end-game, is in principle attractive.  In this respect, a full buyout offers the most complete solution.

What is more, in recent times, there have been opportunities where market conditions have combined favourably to boost funding levels and reduce the ultimate cost of such de-risking transactions.

Many schemes were in a favourable funding position back in 2008, for instance. And there are more recent examples - Long Acre Life research, for example, suggests the combined deficit of the DB schemes of the FTSE100 decreased from approximately £43bn on an IAS19 basis at the end of 2010 to about £27bn by the middle of last year.

Unfortunately, given the volatility of pension schemes' investment strategies and their exposure to market-directional risk, these windows of opportunity are often short-lived - which means that, if schemes do not act quickly to lock in improvements in funding levels they risk a widening of their deficit the next time the FTSE takes a hit or bond prices rise. Indeed, that is exactly what happened in these examples.

The reasons for schemes' inactivity in this respect can be attributed to an inability to measure their funding position on a continuous basis, an incomplete understanding about the exact nature of the risk they faced, a lack of board-level incentive to transact, and, of course, expensive buyout premiums. Yet, many of these barriers to buyout (and de-risking in general) are now diminishing.

Perhaps most importantly, the buyout premium has finally been addressed. Traditionally, buyouts have been priced at about 140% of the valuation of a scheme's liabilities on an IAS19 basis - a price above and beyond what most have been willing to pay.

However, the development of innovative solutions that allow pension schemes to make an equity investment in a mutualised insurance company - in order to recapture some of the 40% premium which is traditionally accepted as insurance profit - may be a watershed for the industry. We believe they may ultimately reduce the price of buyouts by as much as 20%.

While such solutions as this may put the end-game firmly in the sights of many pension schemes, they should not simply sit back and wait for economic conditions to improve and funding levels to increase before hastily trying to seize the opportunity to transact.

Indeed, preparing for a major transaction itself takes many months - meaning any delay to the start of this journey could result in yet another addition to the list of missed opportunities.

Schemes must engage with buyout experts as soon as possible about potential routes to buyout: longevity swaps, synthetic buy-ins or deferred buy-in/buyouts are all legitimate precursors to a full buyout, for instance. The journey to buyout may be a long one for some schemes, which means now is the time to plan ahead.

David Norgrove is a former chairman of The Pensions Regulator and current chairman of Long Acre Life

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Pensions World

THE END GAME: Your best bet?

By David Norgrove, 25 Sep 2012

David Norgrove, Long Acre Life, considers whether pension buyouts are necessarily the best use of shareholder funds

The latest headline pension deficit figures, which suggest that the total defined benefit (DB) pension deficit of UK plc has more than doubled over the past year, provide yet more evidence that schemes are continuing to run extremely large, and unhedged, risks. While some schemes may bemoan that bond yields and equity markets have been especially unkind over the past year - which is true - doing so misses the point. It is becoming increasingly clear that continuing to run such large bets on equity prices, interest rates, inflation and longevity - bets that have consistently gone against pension schemes for many years - threatens the financial viability of some corporate sponsors.

Indeed, the financial health of many of the UK's large public companies is intrinsically linked to their DB pension scheme, with the funding position acting as a conservative indicator of how much cash the company is likely to have to contribute into their pension schemes in future years. Left unmanaged, DB pension risk leads to funding volatility with implications for a company's balance sheet, cashflow and income statement. In most cases, these risks are far from insignificant. Indeed, the FTSE 100 is home to no fewer than ten companies with pension liabilities greater than their market capitalisation. And other companies are pension zombies: they really only exist to support their pension schemes.

What is more, regulatory and accounting changes are not only making the impact of pension risk more pertinent, but also making it more visible to the markets, with knock on effects for shareholders and other stakeholders. The increasing visibility of pension risk is having a growing effect on borrowing ability, with lenders becoming more cautious given recent high profile insolvency cases where pension schemes have been given "super-priority" - requiring pension liabilities to be paid prior to any other debts.

Looking for opportunities

Against this backdrop, de-risking DB pension schemes is now one of the most crucial challenges faced by scheme sponsors. And with the "end game" the desired destination for most, the only remaining questions centre on how they get there and whether they are large and sophisticated enough to efficiently manage the journey themselves - and effectively become an insurance type undertaking - or instead pass the problem on to an insurer.

What is more, with companies' cash flow growing 40% since the depths of the financial crisis, many companies are looking for opportunities to put shareholders' funds to good use. Whether it makes sense to use this excess cash to transact on a pension buyout depends very much on the individual company and its alternative use of capital. That said, innovative approaches to pension buyouts may increase the appeal from a corporate finance perspective, with positive accounting implications to boot.

The return on capital

To address whether a conventional pension buyout is a good use of a company's capital, we must first consider the economics of the transaction in more detail. Buyouts have commonly been priced at about 140% of the valuation of a scheme's liabilities on an IAS19 basis - made up of the insurer's best estimate of the value of the liability (say roughly 120% of the IAS19 liability) plus an additional 20% that represents the insurer's profit. That 20% of profit counts towards the capital the insurer is required by the regulatory authorities to provide to back its liabilities. Then, roughly speaking, the insurer itself is required to put up another 20% of capital as equity, making a total of 40% of capital to back the 120% liability.

Typically, the insurance profit component of the buyout premium is calculated by targeting a return on capital (ROC) of 12-15% per annum (this is what the insurer's shareholders expect to earn). To put it simply, in a conventional buyout, pension scheme sponsors are implicitly renting capital at 12-15%. Whether it makes sense or not to do so depends entirely on the company's alternative use of its capital.

With managements sometimes reluctant to return cash to shareholders for fear of being seen to lack investment opportunities in their businesses and with equity markets relatively strong in comparison to expectations for the economy, most companies are either opting to re-invest excess capital in their day to day business operations or just sit on it, earning very low returns.

Compared to re-investment in the business, if the company's ROC is equal to or exceeds 12-15%, then entering into a conventional buyout to remove all of its DB exposures would in fact prove a more economically attractive option. However, if the ROC of the business is lower, a conventional buyout may represent a significant transfer of value from the company's shareholders to those of the insurer.

Analysing the decision in this way raises an important question - if the buyout premium contributes half of the insurer's regulatory capital, why not consider making an equity investment to recapture all of the insurance profit? After all, this approach mirrors the captive solutions used by many large companies to manage other risks (such as property and casualty). This approach - which has been adopted by Long Acre Life - reduces the eventual cost of buyout as it allows the retention of some or all of the profit (at a 12-15% ROC) that would be paid to an insurance company. And so long as there is an appropriate proportion of external capital, the pension scheme should not need to be consolidated on the company balance sheet.

From an accounting perspective, this structure involves an initial hit to the profit and loss account similar in value to a conventional buyout. However, the key point here is that the equity investment (which can be up to 20% of the total value) will be recognised as an asset on the company's balance sheet.

Without going too deep into the technicalities, regardless of whether a sponsor accounts for its investments on a fair value or equity accounting basis, it can expect an immediate increase in the value of its initial investment - with this increase recognised as a profit in its income statement at the time of buyout. This profit will partially offset the buyout loss recognised in the sponsor's financial statements and may reduce the final buyout cost from 140% to around 120% of the value of IAS19 liabilities.

A matter of timing      

However, even with the availability of solutions which allow pension schemes to recapture some or all of the profit that would otherwise be passed on to an insurer, there remains a reticence on the part of sponsors and trustees to transact. Some wish to avoid locking into a transaction when funding levels are low, others feel that they can benefit from an unmatched growth strategy.

The first of these concerns is perhaps the more legitimate - indeed, the absolute price of buyout is intrinsically linked to the individual scheme's current funding measure and therefore linked to its position with respect to volatile investment markets. Given global long term economic uncertainty (which has reduced pension scheme assets) and record low interest rates (meaning large pension liabilities, as they are discounted using this value), funding levels - and hence the cost of buyout - compare unfavourably to those before the financial crisis, or even the start of last year.

However, companies may have to accept that better conditions continue to recede into the future. Indeed, interest rates have been at record lows for three years, with little indication this will change in the foreseeable future. Add to this the fact that many pension schemes have already completed interest rate swaps - mitigating their risk, but also reducing their upside benefit from interest rate swings as well as moving the valuation of liabilities closer to that of an insurer - and one could argue that there may be no better time than now to prepare to remove pension liabilities from the balance sheet.

The idea that an unmatched growth strategy may be in some way beneficial is also fundamentally flawed. Indeed, bets made against interest rates, inflation, or longevity have to date destroyed tens of billions of pounds of shareholder value, with corporate sponsors forced to pour cash contributions into their schemes to make up funding shortfalls. And although interest rates are currently low, the expected benefit over the next three years from being underhedged is not significant - so pension schemes should have a plan in place to reduce this risk, along with any others they may be running.

To do so, schemes need to engage with buyout experts able to advise them on the potential routes through the thickets. Risk transfer activities such as longevity swaps, synthetic buyins or deferred buyin/buyouts are all legitimate precursors to a full buyout, for instance, moving schemes well on the way to an insurer's best estimate of the liability and reducing the extra cost of a buyout. The journey towards a buyout may be a long one for some schemes, but this makes it all the more important for them to get started.

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Insurance ERM

A clearer view of longevity swaps

By Hugo James, 31 Oct 2012

While full buy-out remains the ultimate goal of many pension scheme sponsors and trustees, longevity swaps are attracting interest as a step on that journey. But finding the right deal requires transparency around the amount of risk being removed, the ultimate recipient of the risk and the role of intermediaries, says Hugo James.

Defined benefit (DB) pension schemes have, in recent years, both destroyed tens of billions of pounds of shareholder value and caused significant concerns for corporates and scheme members alike. What is more, it is becoming increasingly clear that continuing to run such large bets on equity prices, interest rates, inflation and longevity damages company performance and even threatens the entire financial viability of some corporate sponsors.

However, many pension schemes are reticent to execute the most complete solution, a full buy-out, due to opacity of pricing and the transfer of shareholder value that could result from paying an insurer to take on the risk. In addition, unfavourable market conditions have tended to increase the funding gap to buy-out, making them relatively more expensive. Even so, schemes and sponsors need to take some steps towards a full buy-out in order to ensure deficits do not widen even further. As such, longevity swaps are attracting much interest, as they move schemes nearer to the insurer's view of the value of the pension liability and thus stabilise the cost of a buy-out in the future. 

To determine whether a longevity swap offers value for money, pension schemes need to be able to compare how much risk is being removed - that is to say, the potentially higher payments that the scheme may need to make in the future due to increasing life expectancy - to the cost of removing that risk, i.e. the price of the swap contract. Furthermore, it is also important that schemes assess how other risks - including inflation and interest rate risk - in the portfolio relate to each other in order that they can establish how significant removing longevity risk may be to the overall level of risk they are running.

However, a lack of transparency surrounding all risks and assumptions, as well as a lack of granular data describing the impact of a longevity swap on a scheme's future cashflows, can muddy the waters with regards to this assessment of risk versus reward. As described below, this is especially pertinent if banks or insurers reshape the cashflows underlying the swap, for instance. While this may make the transaction appear cheaper to pension schemes, it can also have unintended consequences - often increasing the scheme's exposure to interest rate and inflation risks. An understanding of these effects is hence required in order to correctly appraise a swap in terms of cost versus overall risk reduction.

The risk-reward trade-off: a case study

The advantages of having complete transparency around a longevity swap deal are perhaps best illustrated using a fictitious case study. Take the case of a pension scheme with £2bn ($3.2bn) of pensioner liabilities (measured on an IAS19 basis using an AA-rated corporate bond discount rate), which has undertaken substantive interest rate and inflation hedging, leaving longevity as its largest single risk in relation to its liabilities. As such, it wishes to reduce this risk, and hence its total risk position, by entering into a longevity swap.

The scheme's current risk position (measured in terms of 95% one-year Value-at-Risk) is shown in chart 1. Value-at-Risk is calculated by considering a large number of future outcomes for interest rates, inflation and longevity and their effect on scheme funding. In this case, the metric shows that there is a 5% chance that scheme funding reduces by more than £174m over a one-year period.

Chart 1

Chart 2 shows the cashflows that the pension scheme would have to pay out to a bank or insurer over the duration of the swap contract (blue line). This assumes that the insurer or bank's best estimate of the longevity increases the cashflows by approximately 1%, and it then charges a 6% premium for taking on the risk.

Chart 2

The swap has the effect of increasing the liability by around 7% as each and every pensioner cashflow is effectively uplifted by this amount. The present value of the estimated payments stands at around £2.14bn on an IAS19 basis. Were it to execute the hedge, the scheme would eliminate its longevity risk, but would conversely increase its exposure to interest rates and inflation (see chart 3) as the uplift in cashflows will tend to exaggerate the mismatch between the scheme's assets and liabilities. This means that, in effect, the scheme has paid £140m to remove £56 million of risk.

Chart 3

What is more, it is not uncommon that the longevity swap provider will seek to manipulate the cashflows underlying the swap to make the cost of hedging appear cheaper to pension schemes (chart 4 shows how such a swap might look). The value to the swap provider or cost to the pension scheme of putting in place the swap will depend on their view of the world and hence the discount rate they use to determine the present value of the liabilities - and it is here where transparency becomes a key issue.

Chart 4

In this case we assume that the swap provider assesses present value using the Libor curve so they are happy to offer an alternative set of cashflows with the same present value, but with a longer duration (see the thick blue line in chart 4 where the cashflows have been back-ended). However, because pension schemes discount liabilities using different measures to banks, this has the effect of making the swap appear better value to them. In this example, PensionsFirst Capital analysis estimates that the 'cost' would appear to drop by £4m if the pension scheme valued its liabilities on a technical provisions basis (where the discount rate is equal to gilt yields plus half a percentage point) and £34m on an IAS19 accounting basis (using an AA corporate discount rate).

However, this may have unintended consequences. In this case, the revised structure has increased the pension scheme's rates and inflation exposure by £50m and £27m respectively (see chart 5). This is because by reshaping the cashflows of the swap, the scheme has extended the duration of its liabilities, and hence its sensitivity to interest rates and inflation.  If the scheme were to enter into this swap, it would have paid £106m to remove £31m of risk - an entirely different proposition.

Chart 5

Clearly such information puts pension schemes in a much stronger position to quickly and precisely value the worth of de-risking instruments such as longevity swaps - breaking down many of the barriers that have, to date, halted transactions in their tracks. This puts the onus not only on pension schemes to seek more sophistication in their risk valuation processes, but also on the swap providers to provide complete transparency around the potential transactions. For example, it is perfectly possible to ensure transparency by conducting analysis of potential solutions on an open-book basis, with pricing and risk clearly presented and underpinned by available technology.

Accounting for the intermediary costs

However, while a more detailed understanding of the risk and reward involved in the transaction is a step towards getting the right deal, it alone is not enough. Indeed, transactions that may make economic sense from a risk-reward perspective can be poor value once the various costs surrounding the transaction are considered.

Intermediary costs come to the fore here. Given that historically the reinsurance market has been the ultimate holder of longevity risk, most transactions have seen pension scheme sponsors pay a significant premium (above the price the ultimate holder of the risk would charge to assume the risk) to hedge longevity through a bank or insurer. Assuming some of this premium can be accounted for in administrative costs, it works out that pension schemes often pay as much as 1.5%-2% of the value of liabilities simply to face an intermediary. While this could be justified in a situation where the intermediary offered a significant credit enhancement, it seems a high price to pay when the bank or insurer they deal with is in fact a weaker counterparty than the reinsurers who are the ultimate risk-takers.

With this in mind, pension schemes and sponsors should consider ways of accessing the terms of the reinsurance market directly, avoiding the additional costs of transacting through an intermediary. Not only will such steps ensure that schemes reduce their overall risk exposure at a fair price, but will also move them well on the way to an insurer's best estimate of the liability and reduce the extra cost of a buy-out, which should be the ultimate aim for all.

Hugo James is CEO of PensionsFirst Capital, a subsidiary of pension risk management specialists PensionsFirst Group. Email: hugo.james@pensionsfirst.com

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gtnews

Removing longevity risk: Why transparency is crucial to getting the right deal

By Hugo James, 12 Nov 2012

Treasurers and finance directors are becoming more and more concerned about the impact that increasing life expectancy may have on the financial viability of their defined benefit (DB) pension schemes, which is fuelling interest in the longevity swap market. Yet finding the right deal requires complete transparency around the amount of risk that is being removed.

Life expectancy has increased considerably over the past 50 years in the western world. What is more, this trend shows little sign of stopping. In response, actuaries have adopted increasingly conservative assumptions around longevity - driving up pension scheme liability valuations as more members are expected to live further and further into their 90s and beyond. And because the financial health of so many of the UK's large public companies is intrinsically linked to their DB pension schemes, many treasurers and finance directors are rightly convinced that improvements in mortality rates spell a real threat to their company's financial survival.

The much publicised deepening deficits of schemes has made it harder - that is, more expensive - to perform buy-ins and buyouts. Against this backdrop, it is clear why the management of longevity risk has now become an issue of good corporate governance and why schemes are interested in hedging the risk in the nascent longevity swap market. Indeed, last year was a record year for the longevity swap market, with over £7 billion worth of swaps negotiated between pension schemes and banks, insurers and reinsurers. But given the long-term nature of the risk, how can treasurers evaluate, and then justify to board-level executives, the value of such a longevity swap?

How treasurers can assess value-for-money of a swap 

Assessing the value of a longevity swap requires a comparison between the amount of risk being removed - i.e. the potential increase in benefit payments caused by members living longer - and the cost of removing that risk, which is effectively the price of the swap contract. But if treasurers are to establish how significant removing longevity risk may be to the overall level of risk they are running, they must also have a detailed understanding of how the scheme's other exposures, namely inflation and interest rate risk, relate to each other.  

However, a lack of transparency surrounding all risks and assumptions, as well as a lack of granular data describing the impact of a longevity swap on a scheme's future cashflows, can muddy the waters with regards to this judgement. This is especially pertinent if banks or insurers re-shape the cashflows underlying the swap, for instance. While this may make the transaction appear cheaper to pension schemes, it can also have unintended consequences - often increasing the scheme's exposure to interest rate and inflation risks. 

An understanding of these effects is hence required in order to correctly appraise a swap in terms of cost versus overall risk reduction, and is perhaps best illustrated using a fictitious case-study. This article looks at the case of a pension scheme with £2 billion of pensioner liabilities (measured on an IAS19 accounting basis), which has undertaken substantive interest rate and inflation hedging, leaving longevity as its largest single risk in relation to its liabilities. As such, it wishes to reduce this risk, and hence its total risk position, by entering into a longevity swap. This article assesses the cost versus risk reduction calculation under two scenarios; firstly, a conventional longevity swap and, secondly, a longevity swap where the provider seeks to alter the underlying cashflows.

Scenario one: A conventional longevity swap

Let's assume that the example scheme has exposure to interest rates, inflation and longevity (values shown in chart 1) which means that, including its positive diversification benefit, the scheme is running £174 million of risk. This is measured in terms of 95% one-year Value-at-Risk (which is calculated by considering a large number of future outcomes for interest rates, inflation and longevity and their effect on scheme funding). Put simply, this means that there is a 5% chance that scheme funding reduces by more than £174 million or more over a one-year period.

Chart 1

If the pension scheme were to enter into a longevity swap to remove its £141 million of longevity risk, it would be required to pay a fixed stream of cashflows to a bank or insurer, which will be based on the expected pension cashflow, under an expected initial rate of mortality and a set of longevity improvements agreed between the scheme and the provider. In return, the provider will pay a variable stream of payments based on actual levels of mortality. In this example, the insurer or bank's best estimate of the longevity increases the cashflows by approximately 1%, and it then charges a 6% premium for taking on the risk(see thick blue line in chart 2). 

Chart 2

The swap has the effect of increasing the liability by around 7% as each and every pensioner cashflow is effectively uplifted by this amount. The present value of the estimated payments stands at around £2.14 billion on an IAS19 basis. Were it to execute the hedge, the scheme would eliminate its longevity risk, but would conversely increase its exposure to interest rates and inflation (see chart 3) as the uplift in cashflows will tend to exaggerate the mismatch between the scheme's assets and liabilities. This means that, in effect, the scheme has paid £140 million to remove £56 million of risk.

Chart 3

Scenario two: The swap provider reshapes the cashflows

It is not uncommon that the longevity swap provider will seek to manipulate the cashflows underlying the swap to make the cost of hedging appear cheaper to pension schemes - and it is here where transparency is vital for treasurers.

The value to the swap provider or cost to the pension scheme of putting in place the swap will depend on their view of the world and hence the discount rate they use to present value the liabilities. In this case we assume that the swap provider assesses present value using the LIBOR curve so they are happy to offer an alternative set of cashflows with the same present value but with a longer duration (see the thick blue line in chart 4 where the cashflows have been back-ended).

However, because pension schemes discount liabilities using different measures to banks, this has the effect of making the swap appear better value to them. In this example, PensionsFirst Capital analysis estimates that the 'cost' would appear to drop by £4 million if the pension scheme valued its liabilities on a technical provisions basis (where the discount rate is equal to Gilt yields plus half a percentage point) and £34 million on an IAS19 accounting basis (using a AA corporate discount rate).

Chart 4

However, reshaping the cashflows in this way may have unintended consequences. In this case, the revised structure has increased the pension scheme's interest rate and inflation exposure by £50 million and £27 million respectively (see chart 5). This is because by reshaping the cashflows of the swap, the scheme has extended the duration of its liabilities, and hence its sensitivity to interest rates and inflation.  If the scheme were to enter into this swap it would have paid £106 million to remove £31 million of risk - an entirely different proposition.

Chart 5

Clearly such information puts pension schemes in a much stronger position to quickly and precisely value the worth of de-risking instruments such as longevity swaps - breaking down many of the barriers that have, to date, halted transactions in their tracks. Which means that the onus is not only on pension schemes to seek more sophistication in their risk valuation processes, but also on the swap providers to provide complete transparency around the potential transactions. At PensionsFirst Capital, for example, we ensure transparency by conducting analysis of potential solutions on an open-book basis, with pricing and risk clearly presented and underpinned by leading technology, in the form of the PFaroe risk management platform.

Not only will such steps ensure that schemes reduce their overall risk exposure at a fair price, but will also move them well on the way to an insurer's best estimate of the liability and reduce the extra cost of a buyout, which should be the ultimate aim for all.

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Financial News

Arguments for smoothing are not very soothing

By David Norgrove, 01 Mar 2013

For smoothing to make sense you must believe that, among other things, the move will reduce costs, drive investment and not set a dangerous precedent. Yet there are deep flaws in this thinking, says David Norgrove, former Chairman of The Pensions Regulator and current Chairman of PensionsFirst

Desperate to encourage growth, the government is consulting on whether to allow pension schemes to smooth gilt yields when calculating discount rates for valuing future liabilities, in order that sponsoring companies don't have to put as much money into their defined benefit schemes.  The response has been mostly negative: actuaries seemingly hostile on grounds of principle, the NAPF concerned that it doesn't go far enough. I'm in the hostile camp. Certainly, the flaws in logic are evident when you look at what must be believed for smoothing to make sense:

1)     Smoothing will drive investment and growth

Firstly, you must believe that a worthwhile number of companies are putting money into pension schemes that would otherwise be invested or used in other ways to grow their businesses - and that smoothing will rectify this. But companies currently have as much as £350 billion of cash on their balance sheets. Lack of cash is certainly not the reason that most aren't investing and growing. And I'm not even convinced smoothing will have the desired effect of freeing up cash, as trustees - rightly in my view if they have any sense - may insist on a strengthening of other assumptions to make up for an artificial reduction of the discount rate.

2)     Smoothing will reduce costs for scheme sponsors

Even if you can take this leap of faith, you must also believe that a reduction in discount rates will not be offset to some degree by smoothed and reduced asset values. Yet, it seems obvious that if liabilities are smoothed, asset values should be also. What is more, many schemes have hedges in place where smoothing would leave them unmatched. No one truly knows what the complications and costs might be.

3)     Interest rate rises will not counteract the smoothing effect

Undoubtedly, there is a chance that sponsors' gain when interest rates are low will be offset by the penalty they pay when discount rates lag a rise in interest rates. Of course, interest rates seem unlikely to rise for a while but sod's law could apply, with legislation going through just as the bond bubble - if that's what it is - bursts. Tied into this is the question whether the government will in fact stick to smoothing when interest rates rise, and not listen to more special pleading. I, for one, would not hold my breath.

4)     A move from marking to market here will not be seen as a precedent elsewhere

This is a slippery slope argument. There are always seductive reasons to ignore market pricing, but, as I see it, the costs of picking and choosing would be felt gradually and the damage would be insidious.

In sum, smoothing would have an uncertain (and, if any, probably slight) effect on economic performance.  The costs however would be felt in less well funded schemes, greater risk for scheme members, and a fundamental undermining of a pensions regime that has so far stood the test reasonably well. My stance is clear: don't change the rules, rather, deal with any problems case by case, through The Pensions Regulator.

Shareholders and the economy would be better served by cash rich companies doing more to de-risk their schemes, not less. In the past 10 years deficit contributions have totalled around £175 billion, and deficits have hardly changed.  The common perception is that it's always going to be cheaper next year to tackle the issues - but that hasn't played out so far. We're well into the end game for many pension schemes and it's time to recognise that. Progressively, we must move to a position where schemes can stand largely independently of their sponsors, even where they aren't transferred to insurance companies.

One final point. The government is also consulting on whether the Regulator should be given a new objective, "to consider the long-term affordability of deficit recovery plans to sponsoring employers".  Affordability is already one of the Regulator's key criteria, so on the face of it, no problem. But, in the long run the cost of a scheme is what it is. More importantly, it is in the short-term that the Regulator should - and does - take into account the company's ability to pay. Better in fact to refer just to affordability, with no reference to a time frame.

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Investment & Pensions Europe

Longevity swaps: Understanding your options

By Hugo James, 27 Mar 2013

Banks and insurers have led the way in originating and structuring the vast majority of longevity swap transactions to date, yet pension schemes are increasingly showing interest in hedging their longevity risk directly with the re-insurance market.  Deciding on the most suitable counterparty to face, and the best way to do it, requires pension schemes to assess their options in terms of cost, counterparty credit risk, flexibility of collateral  arrangements and how the potential deal may influence a future buyout, says Hugo James, CEO of PensionsFirst Capital

While banks and, to a lesser extent, insurers, have driven the development of the longevity swap market in the UK, neither have shown much appetite for holding this risk on their balance sheets. Put simply, banks entered the market as they saw an opportunity to make a spread between the price at which they could source longevity risk and the price at which they could hedge it. Meanwhile, the majority of insurers have little appetite to hold significant longevity risk on balance sheet as they are either overweight from their existing annuity businesses or mono-line insurers with no offsetting risks. As such, it is the reinsurance market, which has significant mortality risk to offset, that has historically been the ultimate holder of longevity risk.  

On the face of it, this presents pension schemes with two options when transacting on a longevity swap: go via an intermediary, or transact directly with one of the traditional re-insurers, such as Swiss Re, which has been active in taking on longevity risk through its insurance subsidiary ReAssure (formerly Windsor Life). However, supply via this route is finite owing to the fact that most reinsurers either do not wish to transact directly, and/or can't because of legal or regulatory issues.

As such, pension schemes should also consider a third, more innovative option of using a structure involving a special insurance company that exists only as a conduit to pass through longevity risk to the reinsurance market. This option gives the scheme access to the full depth and breadth of the reinsurance market without using a bank or conventional insurer to front the transaction

But this begs the question; why should pension schemes consider by-passing the intermediary to access the terms of the reinsurance market directly? The answer becomes clearer when the options are assessed in terms of cost, counterparty credit risk, flexibility of collateral arrangements and the ability to unwind or novate the contract as part of a subsequent buyout transaction.

Longevity swap cost breakdown: Intermediary costs come to the fore

For a pension scheme to decide upon the best way to reduce its risk exposure, it must first have an understanding of the components that make up the cost of a longevity swap:

1)     The difference between the scheme's view of future mortality improvements and the ultimate risk taker's view

2)     The fee that the ultimate risk taker charges to hedge the liability

3)     The intermediary fee charged by the bank or insurer.

If we assume that the scheme's view of longevity is consistent with the reinsurer's, then the cost of a longevity swap is made up purely of fees. And regardless of the swap provider, the ultimate risk-taker will more than likely be a re-insurer, which means that we can also disregard its hedging fee (which is usually in the region of 5% of the liability) as a point of differentiation.

Hence, the key discussion is whether it makes sense to pay a significant intermediation cost - which is often around 1.5-2% of the liability and can account for as much as 20-25% of the total cost of the swap - to hedge longevity through a bank or insurer.

The intermediary charges this fee in respect of its overheads, including the cost of structuring the deal, ongoing administration and, most significantly, the cost of the regulatory capital it needs to hold to intermediate the swap. This capital is made up of counterparty credit charges with regards to the reinsurers faced, as well as capital held against any basis risk it retains where the contract it has written does not exactly match that of the reinsurers on the other side of the transaction.

While the logic behind the size of this premium may therefore be clear, the benefit derived by the pension scheme is less so.  It may be that the intermediary matches the actual scheme benefits for example, whereas reinsurers may be inclined to provide a less exact match. Even so, it seems a high price to pay.

Credit exposure and flexibility of collateral terms

Entering into a swap contract involves taking on the risk that the provider defaults on its commitments, which brings to light two further considerations; firstly, the scheme's credit exposure in facing the provider and, secondly, the terms of the collateral arrangements that offer both parties protection in the event of default.

When assessing the three options outlined at the outset, therefore, schemes should consider the financial strength of the provider or providers they will face. Potentially this is another area where intermediaries can justify their premium if they are a stronger counterparty than the re-insurer, as the ultimate risk-taker. Given that most re-insurers are highly rated multinational companies, however, it is rare that the intermediary provides credit enhancement.

So, from a credit perspective, schemes may prefer to face a reinsurer directly and in doing so avoid the cost of intermediation. Yet, for a large transaction, it may be desirable to diversify the scheme's credit exposure. What's more, in some instances the sum total of the transaction may exceed the deal capacity limits of some reinsurers thus requiring a syndicate of ultimate risk takers to achieve the volume to get the deal done. In both of these cases, the requirements point towards using a fully transparent insurance structure which allows schemes to create a bespoke deal which can then be easily replicated if they wish to hedge further tranches of risk in the future.

Of course, even when facing a strong counterparty, longevity swaps are typically collateralised to minimise any losses in the unlikely event of default. Yet schemes must ensure that these collateral arrangements offer protection without being restrictive or burdensome and that the collateral terms can be serviced without jeopardising investment objectives.

The range of assets which a swap provider will allow as collateral is subsequently important and is often driven by its ability to re-post it to another counterparty, which in part will depend on the provider's motivations and regulatory regime. In this respect, the reinsurance market may once more offer the preferable solution - offering schemes more flexibility to post assets such as high-quality corporate credit as collateral. As a further consideration, there may also be differences between intermediaries and reinsurers with regards to the terms that are acceptable for the frequency of swap valuation, and the frequency with which collateral calls are made.

Having an understanding of some of these issues allows schemes to choose the deal that makes most sense to them, in terms of the providers they would like to use - be they an intermediary, reinsurer, or via a more innovative route - and their counterparty exposure and collateral terms.

The next steps: Navigating the path to buy-in/buyout

Longevity swaps are often used by pension schemes as one step on their journey towards a buyout, hence some planning as to how the swap could be novated (or unwound) in order to transfer the longevity hedge to an insurer as part of a future buy-in or buyout transaction is necessary. 

Under the intermediated model there are a couple of options. Schemes could novate the contract to have the insurer face the intermediary in the scheme's place, although the insurer's appetite to do this will depend on the intermediary, its credit quality and the way the contract has been structured. In most cases, however, the insurer is likely to prefer the status quo and face the reinsurance market directly (indeed, they may have similar reinsurance agreements in place with the reinsurers). And so the alternative is for the scheme to unwind the structure and novate the reinsurance to face the insurer rather than the intermediary, although this may be costly as the intermediary is likely to charge a significant fee to do this in respect of the lost income from unwinding the trade.

Again, accessing the reinsurance market directly offers schemes the most flexibility - in this respect it should be relatively straightforward to novate acceptable reinsurance agreements across without having to pay significant unwind fees to an intermediary.

By going through this procedure of analysing the implications of all options open to them when conducting a longevity swap, pension schemes should be in a much better position to reduce their overall risk exposure in a transparent, cost-effective and flexible manner, moving them well on the way to an insurer's best estimate of the liability. As such, they can reduce the future cost of a buyout, which should be the ultimate aim for all.

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Portfolio Institutional

Laying the foundations for pension scheme investment in long-dated assets

By Hugo James, 01 Mar 2013

At a theoretical level it is now well established that the cashflow streams emanating from long-dated assets provide a good match for the liabilities of defined benefit (DB) pension schemes. What is more, the market is increasingly throwing up opportunities for pension schemes to invest in assets that are simple to understand and secure relative to the advantages that they bring. Take UK Solar PV projects, for instance, where the cashflow profile is very similar to that of pensioner payments and the investment internal rate of return is both stable and higher than that assumed by most schemes for their equity return. Ground rents is another case in point - in a world of negative real returns, a bond secured against a portfolio of ground rents can provide a 30-50 year inflation-linked cashflow with a positive real return that would match deferred pensioner liabilities on a cost-effective low-risk basis.

So why are pension schemes not investing in these assets en masse and, more importantly, what may help open the floodgates?

 1.      A better understanding of risk is needed

It's worth starting with an analysis of the status quo. The best way to view the liabilities of DB pension schemes are as very long-dated inflation-linked contracts written with scheme members. It makes sense therefore that the profile of the assets that back these liabilities should be similar. Yet investment strategies used by pension schemes to date mean that this is rarely the case, with the majority turning to liquid assets - equities and corporate bonds - that have shorter durations and lack the benefit of explicit inflation linkage. While gilts are commonly used for their duration and inflation-matching characteristics, current low yields provide little help in remedying weakened funding positions.

Long-dated assets may provide the answer, but the first step is to lay the foundations. To appreciate the attractiveness of investing in long-dated assets, pension schemes need to understand their assets and liabilities at a granular level. Indeed, without knowing this detailed profile, how can they be expected to analyse how investing in differing assets may affect funding volatility, risk and the likelihood of meeting their pension promises?

Accurate information on assets, liabilities and risk is a starting point to enable a matching investment strategy. But sophisticated schemes should go further - employing analytics to stress test their assets and liabilities against different assumptions. That's not to say the results will make pleasant reading, however, as, for many, running stresses on interest rates and inflation will typically show a large duration and inflation mismatch. The key to plugging this gap is to exploit the scheme's liquidity by investing in long-dated, inflation-linked assets that give the scheme the duration and inflation protection it needs at a higher yield than traditional matching assets. Pension schemes would be well served by casting an eye at the insurance industry, which is leading the way in this respect (Pension Insurance Corporation recently purchased the first ever publicly-listed solar finance bond, which will mature in 2036).

2.      A well constructed investment strategy requires increased consensus between sponsor, trustees and consultants

Having this information available is invaluable, but the key is making it available to all decision makers. What is required is a common source of information that can be used by all consultants and advisers - both on the asset and liability side - and that can drive consensus and efficient decision-making.Only then can pension schemes hope to developwell-articulated funding objectives and risk strategies - and, crucially, an investment strategy that is consistent with these.

3.      Liability-driven benchmarks may offer fairer appraisal

Having defined a matching investment strategy, it is imperative that schemes then also employ a benchmark that tracks the liability, rather than focusing on share or credit indices. Certainly, if benchmarks are down because of poorly performing markets, it matters little if they are beaten if pensions cannot be paid. By using a liability-driven benchmark, schemes will be better placed to appraise potential investments in terms of their ability to meet their liabilities and the funding relief they provide compared to traditional matching assets.

4.      Path to buyout should be of paramount importance

There's no doubt in my mind that the pensions industry is moving towards the end-game, and moving all risk to an insurance company or vehicle should be the aim for all. As such, schemes must consider how their asset portfolio will affect the price of a buyout and the scheme's ability to lock into and track pricing as it gets closer to a potential deal. Of course, this requires specialist knowledge of the insurance value of assets when deciding on the portfolio - and schemes may have to seek help here.

My experience suggests that by delivering insurers a well-matched portfolio with little or no re-investment risk, pension schemes can reduce their buyout premiums since these assets will be consistent with the strategies and opportunities that insurers are also seeking to exploit. So, if buyout is the end destination, utilising liquidity in long dated assets may be a sensible first step.

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