A buy-in increases the uncertainty of achieving a buy-out
As private defined benefit (DB) pension schemes continue to mature, trustees are increasingly focused on their long-term objective, which for many is an insurance buy-out.
Unfortunately, most pension schemes cannot afford the cost of undertaking a full buy-out in the near term¹, nor can they rely 100% on their sponsor for additional contribution support.
Therefore, they may ask themselves whether they should conduct a partial buy-in – a bespoke matching asset in the form of an insurance contract – for a portion of their liabilities in the interim.
Considering the irreversible nature of a buy-in, it is critical to understand the impact it would have on the scheme’s ability to achieve its final objective of full buy-out before execution. Our finding is that for the majority of schemes, a pensioner buy-in would increase the uncertainty of achieving a buy-out. This is driven by the reduced size of the residual asset portfolio left to cover longer-dated and more uncertain liabilities after the implementation of the buy-in.
In practice, a buy-in will likely translate into a:
1. Higher required return from the residual asset portfolio, or delay to the target date for buy-out
2. Higher proportion of assets allocated to support the rate/ inflation hedging strategy in the residual portfolio
3. Reduced liquidity and flexibility to deal with future unpredictability.
A closer look at the implications for returns, risk and flexibility
1. Higher required return or delay to reaching buy-out
Unless the implied yield of the buy-in is greater than the required return on the total assets to meet the long-term funding objective (allowing for the longevity protection embedded in the buy-in), a buy-in transaction leaves fewer assets available to generate the returns required to achieve the buy-out funding level within the chosen timeframe. In order to meet their long-term objective, trustees would have to either take on more investment risk in the residual asset portfolio or postpone the target date for buy-out.
At the scheme level, the combined risk (measured as expected return volatility) of a lower risk buy-in asset and a higher risk residual portfolio can be similar to that of the single ‘medium risk’ portfolio prior to the buy-in. However, the portfolio can have a much wider distribution of returns, increasing the chance of a poor outcome. For example, a very large negative return from the
residual assets may push the required returns in future years to uncomfortable, or even unattainable, levels to meet the desired funding target, especially if the residual portfolio is diminishing in size due to scheme maturity.
2. Increased risk due to hedging requirements
Typically, buy-ins cover pensioners, leaving the majority of deferred member liabilities uninsured. Deferred member liabilities are longer-dated and more uncertain by nature. This means that in a buy-in, schemes often end up transferring disproportionately more of their assets than risks to the insurer.
In order to maintain the pre buy-in level of interest rate and inflation hedge ratios, a higher proportion of the residual assets will have to be allocated as collateral to provide for the riskier nature of the liabilities in the residual portfolio. Collateral has to be held in cash or government bonds, reducing the total expected return of the residual asset portfolio.
To compensate for the higher allocation to the collateral pool, trustees will have to target a higher investment return from the non-collateral assets. This higher return can only be delivered by taking additional investment risk in the residual portfolio, exacerbating the challenge highlighted under item 1, above. Alternatively, trustees could decide to accept a lower hedge ratio or employ higher leverage, both of which would lead to increased funding-level volatility and increased uncertainty of achieving buy-out funding.
3. Reduced liquidity and flexibility to deal with future unpredictability
Up to the point of a full buy-out, there will always be risks affecting the assets and the liabilities that cannot be predicted or hedged. Examples include market volatility and liquidity constraints caused by the 2020 global pandemic, or inflation caps and floors in pension benefits which cannot be hedged easily. The illiquid nature of a buy-in asset leaves trustees with fewer resources to deal with any unexpected shocks impacting the economics of the scheme, which in turn increases the uncertainty to achieve full buy-out in the targeted time frame.
If the implied yield of the buy-in, adjusted for the cost of longevity protection, is greater than the required return on the total assets to meet the long-term funding objective, or if your sponsor is willing and secure enough to make up any deficit, a buy-in may be appropriate for you. However, the vast majority of schemes do not have these luxuries and a pensioner buy-in could increase the uncertainty of achieving a full buy-out in a given time frame.
¹According to Hymans Robertson, Pension scheme funding: benchmarking analysis, October 2020, covering 1,730 valuations, the median funding level on a buy-out basis is 67%.
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This article was featured in Pensions Aspects magazine July/Aug edition.
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