The development of the sector, which was up about 50 per cent on the previous year, was facilitated in large part by the growing economic recovery and the trend towards matching assets and liabilities. As gilt yields are the benchmark by which pension funds set their liabilities, a rise in the rate of return consequently brings down those liabilities, improving affordability of pension insurance for many pension schemes and their corporate sponsors. But yields have been volatile.
This development continued into 2014, with the market reaching nearly £7bn of buyouts and buy-ins in the first six months of the year – another record. Notably, during this period, the two largest transactions to date were completed, for ICI, which insured £3.6bn of liabilities, and for oil company Total, which insured £1.6bn of liabilities. We also saw the emergence of super large longevity transactions, including one by BT to hedge £16bn of longevity exposure, and a £5bn transaction by Aviva. Large figures perhaps, but small when you consider that there are approximately £1.8 trillion of DB liabilities in corporate DB schemes in the UK alone.
In the UK, this sector comprises the provision of wholesale insurance annuity products to defined benefit pension schemes. This takes broadly two forms. The first, a pension insurance buy-in, is a single annuity policy taken out by the trustees of the scheme in respect of some or all of its members and dependent beneficiaries in order to cover some or all of their benefit entitlements. Under this type of transaction, the trust structure remains in place and the sponsor is ultimately responsible for supporting the uninsured liabilities. This policy is typically taken out by trustees as a part of their investment strategy.
On the other hand, a typical pension insurance buyout will see all the liabilities of a pension scheme passed over to a specialist insurance company for an agreed amount of assets – usually requiring additional support from the sponsoring company. In this type of transaction, the pension trust is wound up, the scheme members become individual annuitants of the insurer and the former sponsoring company is divested of all further responsibility. This last point is important because it is often the case that these types of transactions have been driven by the company, perhaps in order to tidy up the group structure ahead of a corporate transaction. There are many examples – FTSE 100 companies included – of announcements regarding pension insurance buyouts being followed in the subsequent days or weeks by some sort of corporate action, such as a demerger, or rationalisation of subsidiaries.
There are several factors driving the growing numbers of pension insurance buyouts and buy-ins. However, the primary reason is perhaps because as successive pieces of legislation have hardened the pension commitment to a firm promise, it has become increasingly more expensive for the sponsor to support the scheme. As a consequence, employers have sought to reduce their financial exposure and ultimately this means closing the scheme.
The National Association of Pension Funds Annual Survey 2013, published in January 2014, confirmed that almost 90 per cent of DB schemes are now closed to new members, with around 35 per cent of them closed to future accrual. Given that the average time spent at an employer is in the region of seven years, and that many of these schemes have been closed for five or more, increasing numbers of schemes that are technically open to future accrual are economically in run-off.
Once the scheme has reached this point, it has become less of an HR-driven employee benefit and more of a legacy liability divorced from the core business of the company, whether that be drilling for oil, making chocolate, or manufacturing cars. It requires management time and effort to work out how best to manage historic pension liabilities or, more frequently, close a stubborn deficit – a diversion they can ill afford.
Furthermore, these commitments are not inconsiderable: from April 2009 to April 2013, that is, from the start of Quantitative Easing up to the last set of the PPF’s published figures, corporate sponsors had tipped £182bn of additional contributions into these schemes to help close their respective deficits. This figure is over and above the ongoing, regular contributions. Sponsors have been, and still are, running harder and harder merely to stay still.
So it is not surprising that DB schemes weigh heavily on the share price of their sponsor. A recent academic study, published by Llewellyn Consulting (The Influence of DB Pensions on the Market Valuation of the Pension Plan Sponsor), has looked into the unexplained gap between a company’s book value and market value by analysing data from the FTSE 100 between 2006 and 2012. The research aimed to track down what role having a DB scheme might play in that. The findings showed investor valuations over the review period are consistent with a representation of DB pension liabilities, that is, on average 20 per cent greater than the figures reported, and also that FTSE 100 companies with the largest DB pension schemes are penalised most heavily by the markets, even where a pension scheme is reported as being fully funded and regardless of the stated recovery plan.
In practical terms, this research implies that the share prices of the FTSE 100 companies have, on average, a 7.5 per cent reduction due to the drag created by sponsorship of DB schemes. For companies with larger pension liabilities this effect is much more significant.
So it is hardly surprising that companies are seeking to end their exposure to pension risk and to pass it across to specialist insurance companies.
In one recent case of a company seeking to lock down pension risk, one unnamed plc insured about £320m, or 60 per cent, of their pension liabilities, through a pension insurance buy-in. The buy-in meant that the insured liabilities were fully protected against interest rate, inflation and longevity risks. For the trustees and company, this was another step in their long-term de-risking plan, which had seen them gradually lower their exposure to investment risk as well as successfully conclude an Enhanced Transfer Value offer earlier that year. The transaction worked for the company because the premium payments tied into the company’s contribution schedule. Shortly after the transaction, the company announced it was demerging. The new sponsor of the pension scheme subsequently agreed to insure future tranches of pensioners at pre-agreed pricing, bringing a measure of certainty to the ongoing de-risking process.
So demand for pension insurance is increasing, but can be impacted by what is happening in the markets, and specifically by long-term gilt yields. Although narrowing credit spreads across fixed-income asset classes have been making insurers work harder to target attractive relative pricing and falling gilt yields have been pushing up pension scheme deficits, the fourth quarter is typically busy for these types of transactions.
But whatever happens in the short term it is clear the long-term trend is that there will be many more pension insurance transactions, and the market will continue to grow.
Jay Shah is head of origination of Pension Insurance Corporation
Key points
2013 was a record year for pension insurance buyouts and buy-ins, with approximately £7.5bn of liabilities insured.
It has become increasingly more expensive for the sponsor to support a DB scheme.
One recent buy-in meant that the insured liabilities were fully protected against interest rate, inflation and longevity risks