Grant Thornton - UK Pension De-risking: Longevity Hedging & Buying Out 2012


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This is an annual report where Europe-wide defined benefit pensions experts share their views on removing liability risks from pension schemes, engaging in longevity hedging and buy-outs as well as opportunities to remove scheme risk within the volatile market.

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Grant Thornton - UK Pension De-risking: Longevity Hedging & Buying Out 2012

  2. 2. WHITE PAPERMaking Buy-Outs & Buy-Ins More Affordable KELVIN WILSON Head of Pension Risk Solutions Grant Thornton UK LLPT he transfer of all pension liability risks to an insurance company through a buy-out transaction, is a goal thatmany trustees and employers of a defined benefit (DB) For poorly funded pension schemes, a pensioner buy-in that transfers large assets out of the scheme to an insurance company can leave the scheme in a worse funding position,pension scheme have. However, it is also a goal that many unless accompanied by significant capital injections fromof them consider to be prohibitively expensive to achieve. the scheme sponsor. Therefore, it is important that providersOver recent years, many pension schemes have used the consider how buy-in pricing can be made more attractivemore affordable "buy-in" structure as a means to reach their and/or how they can better structure the timing of premiumbuy-out (de-risking) objective. A buy-in involves insuring payments.a portion of the schemes liabilities (usually pensioners inpayment) and requires lower level of immediate funding The main reason why buy-ins and buy-outs are not pursuedthan a buy-out). However, a perfect storm combination of by pension schemes is due to unaffordability. That is, thelow interest rates, volatile investment markets, high inflation sponsoring employer, after allowing for assets in the scheme,and rising longevity expectations have seen the liabilities and cannot afford the funds needed to make up the deficitdeficits of many schemes rise to levels such that even the buy- between the on-going valuation of the liabilities and thein model is now in danger of becoming unaffordable. insurance premium – "the premium gap". Pension schemes have on-going funding deficits which, following agreementDuring the financial crisis of 2009, the de-risking market between the trustee and the sponsor, is paid down over aresponded to the unaffordability of buy-ins and buy-outs recovery period. A similar approach could be taken on fundingby developing the pensioner longevity swap. This solution the premium gap, whereby insurers and trustees/sponsorsrequired little, if any, additional scheme funding, which made execute a buy-in/buy-out but agree to fund its cost over ait a viable solution even for relatively poorly funded pension longer timeframe. This is an option that would be attractive toschemes. However, a longevity swap is not a comprehensive scheme trustees and solution and it is not favoured by, or suitable tomany schemes. Buy-out and buy-in solutions will need to The past eighteen months have seen significant volatilitybe restructured such that their implementation does not in investment markets. Corporate bond yields have fallen,deteriorate the funding position of schemes which are already government bonds yields are at record lows and the behaviourunderfunded. Additionally, the structure should make it of equity markets continues to be finances best illustration ofpossible for the sponsoring employer to fund the buy-out/ particle theory. Depending on the investment strategy of buy-buy-in without having to provide prohibitive, immediate out providers, falling bond yields can lead to an increase in buy-additional funding. in and buy-out premiums. If the premium is then financed by liquidating pension plan equity assets during an equity bearBUY-OUTS AND BUY-INS, WHILST COMPREHENSIVE RISK market, this would crystallise the loss on the schemes equityTRANSFER SOLUTIONS, NEED TO EVOLVE portfolio. This situation deters many employers and trusteesIn terms of complete risk coverage and executional simplicity, from using buy-out/buy-in to de-risk pension and buy-ins remain attractive to trustees andsponsoring employers. However, the large single premiums DEFERRED PREMIUM PENSION ANNUITY (DPPA) ALLOWSassociated with these transactions have deterred many BUY-INS AND BUY-OUTS TO BE PAID FOR OVER A NUMBERpension scheme sponsors and trustees from completing OF YEARSsuch deals. Providers need to address these challenges by In response to some of the above issues, we have started to seedeveloping structures that take account of three key issues insurance companies offering buy-in and buy-out solutionsfacing scheme trustees and scheme sponsors: where the premium is structured into two components – an initial premium, followed by a series of deferred premiuma. Deteriorations in funding levels payments. The solution is known as a DPPA. The diagram belowb. Affordability - large upfront cash outlay for buy-ins and illustrates how the solution and a transaction would work. buy-outs is not an option for many scheme sponsorsc. Weak equity markets deter trustees from liquidating equity portfolios to execute buy-outs/ buy-insCLEAR PATH ANALYSIS: PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012 2
  3. 3. Making Buy-Outs & Buy-Ins More AffordableFIGURE 1 Deferred premium + [LIBOR + %] Deferred premium + Insurer premium [LIBOR + %] Company Scheme Insurer Pension paymentsThe structure would see the insurer calculate the buy-in or a. The insurer calculates a risk transfer premium, £300m,buy-out premium on a commercial basis, say £200m. Rather based on its standard commercial pricing basisthan make a single premium payment for the full amount, the b. The insurer calculates another risk transfer premium,pension plan would make an initial payment of, say, £160m £250m, that incorporates an element of investment(80% of the total premium). The outstanding or deferred outperformance, zpremium of £40m would then be paid over an agreed schedule, c. The pension scheme/employer earmarks assets to thee.g. between 5 to 10 years, to suit the cash flow requirements value, £50m, which is the difference between theof the pension scheme and the sponsoring employer. If the commercial and outperformance pricing basisagreed schedule is not met then the default position is that - perhaps as collateralthe insured benefits would be scaled back. The insurer would d. The risk transfer transaction is entered into, for £250mcharge interest on the deferred premium – partly for the cost e. To the extent that a pre-agreed market index (or aof capital that it would need to hold against the transaction. combination of indices) does not perform better than z, the pension scheme/employer makes payments toThe structure addresses many of the concerns that we raised the insurer out of the £50m earmarked assetsabout buy-in and buy-out for underfunded pension plans. Thelower initial premium would result in: The above structure would need to consider a number of issues, including how the £50m is invested, who has legala. Reduction in the risk of further deterioration of funding ownership, and under what circumstances (if any) would the position, post a transaction £50m be retained by the employer/pension scheme.b. Lower (or even zero) capital injectionc. Deferred premium can be funded in same way as on- CONCLUSION going funding deficit The turbulent economic conditions of the last few years haved. Lower crystallisation of potential losses on equity caused many pension schemes, their sponsoring employers portfolio, if payment of the premium necessitates and investors in the sponsoring employers, to experience a liquidating these assets during an equity bear market, lot of pain! Whilst many pension plans now understand the as not all scheme assets are transferred to the insurer importance of good risk management and want to better on day one manage their risks, poor and deteriorating funding levels leave many of them believing that the option of buy-out and buy-PENSION SCHEME VALUATIONS ASSUMES INVESTMENT in remain out of their reach. However, the de-risking marketOUTPERFORMANCE is responding to trustee and employer concerns regardingBuy-out and buy-in premiums are higher than most pension the cost and financing of de-risking solutions. Solutions arescheme liabilities, due to insurers using lower discount rates now being offered that are bespoke to the profile of pensionto value the scheme’s liabilities than the rates used by the scheme liabilities, level of funding and the strength of thescheme. This "valuation gap" is a result of the pension plan employers covenant. Pension scheme trustees and sponsorsallowing for an element of equity outperformance in the should recognise that opportunities to transfer risk still existapplied discount rate, which the insurance company does not and the cost of transfer might not be as onerous as previouslyallow for. Where there are strong commercial grounds to do, it may be possible to negotiate with insurers to structure abuy-in deal that allows an element of equity out performancein the buy-in pricing basis. A high level description of this "riskand profit-share" structure might be as follows:CLEAR PATH ANALYSIS: PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012 3
  4. 4. ROUNDTABLE DEBATEWhat are the Anticipated Effects of the Recent Market Volatilityon Longevity Swaps & Buy-Outs?MODERATOR: PANELLISTS: ANDREW REID JOHN CHILMAN DEREK RUSHTON Managing Director, Group Pensions Director Group Pensions European Head of First Group PLC Manager Pensions Origination, Virgin Media Pensions CMTS Deutsche Bank STEPHEN TILEY KELVIN WILSON Group Pensions Head of Pension Risk Manager Solutions Wincanton Grant Thornton UK LLPANDREW REID: Thank you everyone However, in terms of the impact the issues swaps and full buy-outs at this time isfor joining me today. I’d like to begin by being discussed have on the longevity and curtailed by the cost involved. However,asking the panel, do you believe that buy-out market, that really depends on the that does not mean that we are taking norecent micro and macro events including individual pension schemes concerned. de-risking action, especially in terms of buy-low interest rates, inflation uncertainty For clients with fairly mature liabilities ins. As was just mentioned, it all dependsand difficulties within the Euro zone have below £100 million, we have found that on a schemes investment strategy andhad a significant impact on the longevity deterioration in their funding positions has liability profile and certainly the trusteesswap and buy-out market? What have not been so significant to make a pensioner have been looking very closely at utilisingyou noticed, John? buy-in or, in some cases, a buy-out buy-ins as a function to offset the liabilities completely unaffordable. Typically, this has of their more mature pensioners. We are inJOHN CHILMAN: I’m going to start on been due to the shorter duration of these the early days of looking at that, bearing inthe other side of that equation with, ‘What schemes liabilities. There are schemes out mind that one of our schemes is funded todoes it really mean for the underlying there who have a mature liability profile buy-out anyway. My view is that althoughpension fund?’ Obviously the low interest and who are still able to consider de- full buy-outs and swaps may have lostrate environment has meant we’ve seen risking using transaction structures such a little of their lustre over the last 12-18an escalation in liabilities. I’m sitting here as buy-ins and buy-outs because whilst months, I feel there is still a market for buy-thinking, ‘does it matter for buy-outs buy-out pricing may have increased, the ins which is likely to expand given currentbecause I’m so far away now from being increase hasnt been to a level that makes market conditions and gilt to afford a buy-out, it’s inconsequential it completely unaffordable. Schemes withto me’. I’m also not sure that capital is asset duration that matches their liabilities STEPHEN TILEY: It’s very much a case ofgoing to be available in the markets for and/or who have sponsors generating a looking at each scheme on its merits andtransacting longevity swaps, meaning the cash windfall, are quite happy to engage in the appetite of the sponsoring employermarket can’t continue to proceed at the a buy-out right now. to de-risk, whether it can afford to buy-pace it has in recent months. Looking at out, buy-in or put in other mechanisms tothe position my trustees are sitting in, their ANDREW: The relative price increase reduce volatility. There have been recentprimary focus is on how to get back to a depends upon what assets the scheme cases where schemes holding gilts overreasonable funding position, as opposed has been holding. Those that have been the last year have taken advantage of theto trying to lock down any of the liabilities largely in gilts have fared quite well over arbitrage between those and corporateand risks at this point in time. The focus the last few months. bonds. The spreads over gilts have certainlyhas changed from one of good funding been at a level where schemes havepositions into how do we recover from DEREK RUSHTON: Interesting to this wanted to look at buying out if the insurerwhere we are. discussion is that we have been looking at was prepared to meet the target price due de-risking the two defined benefit schemes to the arbitrage between the gilt yields andKELVIN WILSON: I understand John’s we have within Virgin Media. I agree with corporate bond yields. Similarly, it dependspoints and feel they are all very valid. John that the appetite for interest rate on what assets you are holding as a schemeCLEAR PATH ANALYSIS: PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012 4
  5. 5. What are the Anticipated Effects of the Recent Market Volatility on Longevity Swaps & Buy-Outs?and whether you can afford various forms 20% drop, that there are some plans that DEREK: I agree with Stephens point. Thereof de-risking. In respect to Wincanton, we are experiencing zero or even positive is an issue around trustee understanding ofhave gilts in our portfolio which has helped returns, then there must be a few that are longevity swaps. They are, by their nature,us but we are some way off buy-out. But a substantially lower or have a bigger fall to quite complex and trustees tend not tobuy-out isn’t the only target in the market. get back to that average. Hence the wide have the enthusiasm to pursue a longevitySelf-sufficiency is another form of target variety of solutions being considered. swap because they don’t necessarily findthat we would want to follow first. On it as easy to understand as a buy-in or athe longevity side it does depend on the Moving to the next question, assuming buy-out.demographics of the scheme because there is a demand for these productswe’ve always over estimated our longevity if the price and terms are right, what KELVIN: What you tend to see is therates. Certainly we wouldn’t want to enter challenges will possible future increases corporate becoming interested in longevityinto anything where we felt we were over in demand hold from both the pension swaps. They are often the ones takingpaying. Obviously, if you have the money scheme perspective and the provider’s the idea to the trustees and, togetherand you want to take risk off the table perspective with the advisers, helping the trustees toand you can afford to de-risk then most understand some of the more complicatedcompanies would have the appetite to do DEREK: This goes back to the employer structures. Most pension schemes nowso. covenant and how secure the trustees have a flight path or journey to some goal. are with that, along with what cash flows They are closed to new members so it is allANDREW: From a provider’s perspective, are available from the employer in the about managing the liabilities to that endI would echo the comment that it varies first place. It is going to be a challenge for goal, whether that be through buy-out orbetween schemes, and the solution the trustees to persuade sponsors to part self-sufficiency. That will require good riskinvestigated from one to another with any significant cash flows beyond a management of the pertinent risks in thevaries significantly. Many of the better basic minimum requirement. Certainly if pension scheme (interest rate, longevityfunded schemes are investigating bulk they are not at valuation in the next 12-18 or inflation). Longevity swaps, buy-ins orannuities. In the large to medium end months, then the likelihood of them trying liability reduction exercises are simplyof the pension scheme scale, there is to persuade the release of cash from their tools ‘that are in the locker’ of trustees andmore interest in unfunded longevity current employer is slim unless you happen scheme sponsors. The tools need to beonly hedges, where longevity plus a to have an extremely cash rich sponsoring explored as the cost of running off schemefew ancillary risks like the proportion employer. That cash has no better usage liabilities can prove very expensive. Whilstmarried and the age difference between within a commercial environment, so the price for buy-out is not right as of now,members and dependents are hedged, from the plan’s perspective the idea of longevity hedging and buy-ins may stillrather than a buy-in. Over the second half getting rid of those risks is fantastic, but represent good value, depending on theof 2011 there was a noticeable pick-up in in practical terms, it is going to be very asset and liability profile of the pensioninterest in bulk annuity, with a number difficult given uncertainties in the European scheme. As more pension schemes look toof those schemes invested largely in gilts, economies. Therefore, innovative solutions de-risk, providers of de-risking products willsitting on good investment performance, are required from providers to persuade be faced with the challenge of increasingconsidering switch up from gilts to bulk trustees to spend time and resources on capacity and finding new sources ofannuities. To put this into perspective we a cash requirement from the sponsoring capital. They will also need to develophave looked at yields at the 20 year point employer. products that are accessible for schemeson the curve. Assessing the drop from the of varying sizes and who are at different31st December 2010 to 31st December STEPHEN: From our perspective, the stages on their de-risking journey plans.2011; interest rate swaps went down 1.1% longevity market is still in its infancy and Scheme sponsors and trustees will needper annum, conventional gilts went down it is not something that we have looked at to think about having a good governance1.3% per annum, the iBoxx corporate in much detail. We are more interested in framework to deliver any de-risking endbond over 15 years index was negative buy-ins and buy-outs. In terms of the actual game that they may have. They will also1.1% per annum. If you then look at market position at the moment, we feel need to need to think about evolving theirinflation statistics, the inflation swap that when capital is available to enter the investment strategy to take account of theirrate at 20 years went down just 0.2% per market and there is a market mechanism existing funding position. There will beannum whereas break evens from gilts that is offering significant value, then that the added complication of understandingwent down 1.3% per annum. How does will make it a more attractive proposition. In how a schemes asset and liability profileall this fit into pension funding levels? terms of buy-outs and buy-ins, it is scheme will evolve over time such that the trusteeWe estimate that International Financial specific and most companies would want and the employer are able to put in placeReporting Standards (IFRS) levels went to take away legacy defined benefit plan action based de-risking triggers. Trusteesdown approximately 5% over the year but liabilities if they could, especially if they and employers will need to ensure that anybulk annuities or buy-out funding levels consider the cost of running the scheme de-risking strategy they embark on bringwent down about 20%. If you think within which will probably be comparable to the value for money. Most de-risking solutionsthose figures, especially regarding the margin added on by insurers. will have a cash cost associated with them.CLEAR PATH ANALYSIS: PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012 5
  6. 6. What are the Anticipated Effects of the Recent Market Volatility on Longevity Swaps & Buy-Outs?It is important that an analysis is done on the market. Depending on how you larger schemes it will depend on capacitythe solution to ensure that the cash cost of value it, there might be £1-1.5 trillion and that is limited.removing the risk(s) is at least lower than worth of liabilities in UK private sectorthe cost of running the risk. defined benefit pension funds. There KELVIN: I would echo Stephen’s points. isn’t enough provider capital, or even One additional point I would make is, if weANDREW: There is one point Kelvin close, currently to take on that quantity are going to address the funding shortfallsmentioned which has been key to this of risk. It’s been spoken about before that many schemes have with de-riskingmarket developing. That is the cost, or the but it seems as though we are getting solutions, then the real emphasis has to beadditional cash cost, of longevity hedges. closer to meaningful involvement from on innovative structures. Structures thatBecause many schemes are reserving non-insurers and re-insurer based capital, take account of deficits in schemes andprudently, a bit above best estimate, it bringing in what we might broadly call provide a path over time to de-risk, notmeans the prudential reserve can be used ‘capital markets’ If we can bring that . necessarily immediately. Providers need toto meet some, or in a few cases all, of the capital in then that’s going to bring huge come up with a type of mechanism thatcost of the hedge. From a cash funding pricing tension advantages. allows pension schemes to engage butperspective, the pitch from us has been which doesn’t necessarily involve locking‘you have this reserve, why not replace STEPHEN: That does assume the demand into low yields. Alternatively, if they do lockit with a hedge?’ That certainly has . will increase. What some of us are hoping into low yields, then allow flexibility in theresonated on the company or treasury for are higher interest rates or higher real structure of the transaction. It’s all aboutside. yield. When we have 10% interest rates and innovation for me. the yield curve is a bit higher then we won’t’KELVIN: It is important that scheme have to worry about longevity hedges, JOHN: This type of activity will becometrustees and sponsors understand their buy-outs and buy-ins. It is no coincidence less unusual and more mainstream inobjective(s) and how they are going to that there is a lot more interest in providing the future. I would echo the views thatreach their objectives. Whether you are and buying these types of solutions but it innovation would be ideal. The reality ishedging pension scheme risks through is coloured by the environment we are in. that for the larger plans, we would prefer touse of a longevity swap or a buy-in, it is In the pensions industry this is just a blink close the funding gap before we take theimportant that trustees and sponsors of an eye. You have to learn from history financial decisions necessary.understand the key aspects of the and take a long term perspective and beprocess - what assets are the scheme prepared to wait and see, which doesn’t DEREK: I agree with John. The reality isinvested in, have they undertaken scheme sound very proactive but sometimes you those schemes who can afford to transactdata cleansing and do the schemes can be overly proactive. are not going to do so in the next 12-stakeholders need to create a sub- 24 months, at a point where they arecommittee and have a sub-governance ANDREW: What is your view, Stephen, of effectively locking in losses they havestructure in place to allow quick and the future outlook for longevity hedging made over the last 18 months. They willdecisive decisions to be taken? A better and swaps markets? What can and should be looking to put their funds to work,understanding of the process and how the market do to evolve? where they can afford to take that risk orthe solutions work means an easier and where the employer convent is strongsmoother process to transaction. Perhaps STEPHEN: My outlook does depend on enough. Then over the next year or two,some of the onus here is on the providers if we carry on in a low yield environment, they will move towards the longevity swapand the consultants to better educate their which is not going to happen. We are going opportunities and buy-out markets. Longclient base. to get continued stubborn inflation and term they will become more prevalent. printing of money to inflate deficits awayProviders need to be innovative. They need in the developing world. In that situation, ANDREW: This echoes our experienceto recognise that not all pension schemes I don’t foresee longevity swaps and the to a large extent. Although the betterare the same. They need to appreciate that buy-out market proceeding at pace. For funded schemes are looking at bulkdifferent schemes have different funding the time being, anybody that can afford annuity solutions, there is quite a lot oflevels and have differing liability profiles. to buy-out and has experienced burnt interest in longevity hedging because itProviders need to structure their solutions fingers in recent years should proceed. It is an unfunded solution. There is no cashin a way that considers the funding position does depend on sponsoring employers up front and if it can be traded at a levelof the scheme, the cash constraints of as well as the trustees, and what their whereby there is no increase in technicalemployers and which focus on de-risking view of the world is. There will be more provisions or cash contributions froma pension scheme over time and not opportunities for smaller schemes to the sponsor, then it is seen as quite annecessarily requiring immediate cash de-risk, as we’ve seen with the advent of attractive proposition.funding. fiduciary management and integrated trustee solutions providing a more rounded I’d like to conclude the debate there andANDREW: A point that Kelvin picked up service. That model will include managing thank the panel for their time.on is one of bringing new capital into buy-outs and de risking strategies. ForCLEAR PATH ANALYSIS: PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012 6
  7. 7. Bridgingthe gap.At Grant Thornton, we help remove or reduce therisk of financial losses associated with running adefined benefit pension scheme.Our Pensions Advisory team provides independentde-risking advice on structured solutions andtransactions that will either transfer out or mitigatethe risks you face. To secure and protect yourposition, now is the time to act.For further information, please contact:Kelvin Wilson Darren MasonT 020 7865 2402 T 020 7728 2433M 07879 667208 M 07971 434964E E© 2012 Grant Thornton UK LLP. All rights reserved.‘Grant Thornton’ means Grant Thornton UK LLP, a limited liability partnership. Grant Thornton UK LLP is a member firm within Grant Thornton International Ltd (‘Grant Thornton International’).Grant Thornton International and the member firms are not a worldwide partnership. Services are delivered by the member firms independently.
  8. 8. INTERVIEWAnalysing the Drivers behind the Continued Interest inPension Buy-OutsINTERVIEWER: INTERVIEWEE: IAN SMITH MARK BOWER Deputy Editor Finance Director Arnold Laver and CoIAN SMITH: What are the key factors transactions to hedge movement in you need a fixed price i.e. what will theyou would attribute for the continued both inflation and bond yields, luckily buy-out actually cost. If you haven’t gotinterest in pension buy-outs perhaps we got our timing virtually spot on. We a fixed price, you can’t fund the buy-outover the other de-risking options? got our hedging in place before the transaction and that is particularly so credit crunch and once you’ve got that in today’s banking environment whereMARK BOWER: There are a growing matching in place, it gives a reasonable funding is very difficult as banks arenumber of final salary schemes that are expectation that the movement and very risk averse. However, when youclosed to both new entrants and future the cost of buying out won’t alter approach the world of pensions it is aaccrual. Once the final salary scheme dramatically from what you have polar opposite because what you areis in that position, from a company’s entered into. quickly told is that the traditional pathperspective, it is just a liability. That for a buy-out is that you give a buy-outliability becomes a growing concern IAN: Regarding your buy-out with provider your data, they give you anin terms of the value of the scheme Pension Insurance Corporation (PIC), indicative price, you sign up for that,liabilities in relation to the overall size of what were some of the key challenges then in 6 months’ time the buy-outthe company itself. Given that scenario, that you experienced during the completes and that indicative priceit makes sense for a company to plan process? moves for any changes in data, marketover a fairly sizeable period of time to conditions or the value of schemebuy-out the liability and get that risk off MARK: That is a very good question investments. Therefore, from thethe balance sheet. I do accept that there because initially I went into the buy-out company’s point of view, that traditionalis a price to be paid for the buy-out and with it being just another corporate approach gives you an uncertain pricethat is what stops most people doing it. transaction, which I had done many and that is not fundable. We were luckyBut there is also a price for not doing a of over the years so didn’t see why with our choice of PIC because theybuy-out e.g. cash contributions to fund the buy-out would be any different. understood this dilemma so they knewthe deficit, high administration costs However, it quickly became apparent that they had to somehow come upand ever increasing compliance costs that it did need to be treated as a with this fixed price solution. We made itwith The Pensions Regulators, etc. unique challenge because it was a bit more interesting for them because different. My thinking was that the we said during the buy-out process weIAN: How would you say the current company wants the buy-out to remove want to put in an ETV exercise as well,conditions are given the historic low the risk off its balance sheet and but they were very flexible and togetherbond yields? How are they affecting trustees want it as it is in the members’ we arrived at a solution.this continued interest? Also, in best interests, so surely everybodyregards to your deal do you think wants it. However, that is not necessarily IAN: Had you already started the ETVthat you de-risked at the right time in the case because to do the buy-out you or had you said we want an ETV at theterms of the markets and the impact need a lawyer, a scheme administrator, same time as doing the buy-out?of various issues such as quantitative an investment manager and othereasing? advisors who are absolutely attuned to MARK: We told them that we were achieving this buy-out. You quickly learn definitely going to do a buy-out, butMARK: The point you made about the as you go through the buy-out process on that route to the buy-out, we werelow bond yields and therefore bond that there are many obstacles along the going to do an ETV exercise as well.yields being very expensive now is route, and it is very easy for problems We knew that we were in a fortunateabsolutely spot on. We were fortunate to come up or be created that put position with our matching makingas we decided to start planning doubt into somebody’s mind. The first funding near to buy-out and so theour exercise a number of years ago. challenge is to get everybody involved transfer values we could offer ourFundamentally, we were in a situation with the buy-out genuinely aiming for members were very high. There werewhere we could move quickly if the the same result and having a positive certain categories of members whobond yields got to a point where we incentive to achieve that result. For us were better off with a transfer outthought it was the right time to start one of the biggest problems was from a through an ETV exercise than frommatching and entering into swap type company’s perspective, to do a buy-out staying in the scheme. For instance,CLEAR PATH ANALYSIS: PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012 8
  9. 9. Analysing the Drivers behind the Continued Interest in Pension Buy-Outspeople who just wanted a pension for open for a few days. we’re taking out £45 million worth ofthemselves and didn’t have a spouse liabilities, which would be significantlyyet would get a better deal this way IAN: That is the challenge that a lot of more now bearing in mind the waythan if they stayed in the scheme which pension schemes have. If they don’t bond yields have gone, the differencewas funded on them plus spouse. There have that speed, it is quite hard to lock in price was £70K which is nothingwere some significant categories of in at good rates. compared to what it could have been. Ifpeople who genuinely wanted to buy- that figure had been significantly biggerout so that exercise had to be captured MARK: We had to put that in place and it would have put the whole funding ofwithin the process. We had a take up of that is part of what you need to work the buy-out into question so you couldroughly 50%. towards. Another bit of advice is that have actually scuppered the whole deal I was very confident with our records and all the costs that go with that.IAN: Do you feel that the transaction and members’ entitlements goingfulfilled your objectives as we are now into this process, but I didn’t bargain IAN: Is there anything that you wouldroughly one year on? on absolutely everything being taken have done differently looking back at apart and reworked. For instance, all the entire process?MARK: In terms of achieving our of our members’ entitlements wereobjectives, the buy-out we picked recalculated from base and the accuracy MARK: No, we were lucky. There werehas gone to plan and provided all of the data really does reflect the price. one or two other things that I am reallythe benefits we expected. All of our So when working out your plan to move pleased we did. When the buy-outmembers have been very happy. PIC towards buy-out, it’s really a good idea became a real possibility, we lookedhave delivered on all of their promises to make sure that you have bottomed all at whether we had the right actuary,and the company has managed to of your scheme records and data as this lawyer and advisors on board to takeget rid of a historic liability so we can will save you a lot of heartache down us through a buy-out process. I wasjust focus on the business. It is well the line. surprised that there are not manyknown that banks view final salary advisors that have done a buy-out,pension schemes as a black hole, so by IAN: Did you work through the data but we took the hard decision inpassing off the risk of our deferred and in-house or is that something that you conjunction with the pension schemepensioner members, it enabled us to put out to a data provider? trustees to bring in a specialist actuarystate that we had a capped liability. who was experienced in buying out and MARK: We had the data in-house but we made sure that the investment managerIAN: Based on your experience, what put it to experts because it was beyond was experienced too. It meant that asadvice would you offer to schemes us how you actually work all of these issues cropped up, they knew that thesecurrently going down the same route things out. We just had the raw data and issues were solvable as opposed to dealthat you have gone? then we had it checked externally. breakers. Having the right team in place before we started that final push was aMARK: The first thing is that the IAN: Do you think that had an impact tough decision to make, but the rightcompany and the trustees have to work on the price you were given for the one to make.incredibly closely together, and you buy-out, because the quality of thehave to genuinely trust each other. The data was better? IAN: Lastly, I was interested to knowsecond, based on our experience, is whether at all you considered doing athat you need to plan as far in advance MARK: Definitely. It gives a buy-out pension increase exchange at the sameas you can and you have to move provider confidence that there is more time as the ETV?the scheme into a position where of a chance of this deal happeningultimately a buy-out is fundable which because the data is good and they have MARK: The company and companydoes involve many difficult decisions done all this work on it. They will still do advisers did but the pension trustees,on things such as asset allocation, risk their audit on it, but it tees the thing up while they were happy with the ETVhedging strategies, etc. It also means to happen right. It also stops you having because they could clearly see thethat the pension scheme has to get used a nasty shock after the pension provider categories of people that would benefit,to making decisions quickly and not in 3 has done the work on it and comes back they did not want to worry their retiredmonths’ time when they next have their to tell you that the data is all wrong and members or give them any difficulties.trustee meeting because you can miss the price is going up. So the trustees requested that we didn’topportunities. We did our initial hedging do it and as we worked with the trusteesback in 2007 and when we pressed the IAN: Is there any quantification you quite closely, we didn’t want to upsetbutton on the right day for us to start can put in terms of how much you them so we withdrew the proposal forbuying swaps and hedging off interest think this process cost and how much the pension increase offer.and inflation exposure, that was done do you think it could have saved you?because we had hit a target point IAN: I suppose that comes back toso we had in place a quick decision MARK: After all of the exercises and what you said at the beginning aboutmaking procedure. Although it was the adjustments that had taken place making everyone comfortable withpre-credit crunch, the same principals bearing in mind that we had negotiated the process. We’ve come to the end ofapply. We could have easily missed that as fixed a price as we could, the final the interview. Thank you very much foropportunity as that window only stayed adjustment to the buy-out price and you time.CLEAR PATH ANALYSIS: PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012 9
  10. 10. WHITE PAPERThe Practical Side of Reducing Longevity Risk ISABEL FRANCE MADHU JAIN ANNA TAYLOR Partner Counsel Managing Associate Linklaters Linklaters LinklatersA s the longevity market develops, trustees and sponsors are thinking seriously about the option of some form oflongevity hedge – whether a longevity swap, a buy-in or a the trustees to assess their priorities in any risk reduction strategy – which will be of benefit to the trustees even if they do not enter into a longevity transaction. Understandingbuy-out. the extent of the risks involved will also help trustees assess the acceptability of the price and the terms available for anyVery often, the circumstances which make such a transaction longevity transaction.appropriate come together at the last minute – and the partiesthen need to move quickly. But, as lawyers within Linklaters’ How it worksnew Longevity Solutions Initiative explain below, there is a There are now a number of different products in the market.lot that trustees can do even before a transaction is on the These include traditional buy-outs, buy-ins & bespokehorizon. longevity insurance or derivatives. Other variations are also available e.g. synthetic buy-ins or index linked longevity swaps.Proper preparation will help smooth any transaction whichdoes happen – and could even potentially reduce the costs of All these transactions work differently. Trustees need tothe transaction. In many cases these actions will also be helpful understand their different characteristics and, in particular, toto the trustees going forward in managing their scheme. understand the risks associated with each kind of transaction. Trustees also need to understand the roles and concerns ofUNDERSTANDING THE OPTIONS the different stakeholders (including the reinsurers who will,As with any major transaction, it is critical that before deciding in many cases, ultimately carry the economic risks). Particularto enter into any form of longevity hedge, the trustees issues to consider might include the following:understand: • How do the different kinds of transaction actually work?• how the transaction “fits” with overall investment & risk What are the obligations of each party? strategy • How do the different kinds of transactions work• how it works – legally and practically economically? How are prices reached? What is the• what are the risks upfront cost and/or the on-going cost? • What risks are being transferred? Does the transactionThis is common sense – but also reflects the requirements of primarily transfer longevity risk (e.g. a longevity swap)?the “trustee knowledge and understanding” legislation, that Or is investment risk also transferred (e.g. a buy-in)? Whatthe trustees have a good understanding of any major contracts about the risk on the sponsor covenant – how is thisrelevant to their scheme. affected? • How long will it take to enter into a transaction?Clearly some of the detailed analysis will depend on theterms of any particular transaction which is proposed, but The risks of the transactionmuch of the thinking can be done in general terms even Linked to the process of understanding how the transactionbefore a transaction is on the table. Trustee advisers should works, is the issue of understanding the risks which thebe able to help trustees with this process. One of the practical trustees will bear. For example:considerations at the outset may be for the trustees to ask • The trustees will be taking on counterparty risk in anywhether they have suitably experienced advisers in place. transaction. They will want to understand what kind of entity is the counterparty? What safeguards exist if thatInvestment and risk strategy counterparty becomes insolvent? Are there optionsTrustees will already be reviewing their investment strategy which can improve that position? Longevity swaps willand risk tolerance regularly. As part of this process, trustees generally be collateralised, which should reduce theshould start thinking about the materiality of longevity risk. insolvency exposure. On buy-ins, in the past, there hadSuch an exercise will help to provide a more concrete idea of been a move towards structured buy-ins which includedthe scale of longevity risk relative to other risks carried by the a measure of protection against insurer insolvency. Thosescheme (e.g. interest rate risk, equity risk). It will also enable structures currently appear less popular.CLEAR PATH ANALYSIS: PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012 10
  11. 11. The Practical Side of Reducing Longevity Risk• The detailed documentation for any transaction will set transaction. For example, it may be appropriate to exclude out the risks which are being transferred and retained. them until the data is improved. Although the detail will be transaction specific, trustees can start to think about the following key areas: Data protection - Given the Government’s recent announcement on It is a legal requirement to ensure that scheme members have Guaranteed Minimum Pension (GMP) equalisation, been told about the purposes for which their data may be will the trustees look to transfer liability for equalised used. Often the disclosures made are in narrow terms – and in GMPs? some cases will not have been issued to all members. - Are there any benefits under the scheme which are unusual and which providers may be unwilling to Trustees should review their data protection disclosures from take on? time to time – and if necessary update them. As part of this, - Are any changes to the scheme likely which may they should consider whether the disclosures are wide enough affect the transaction? For example, if there is a plan to encompass disclosure of data to a longevity hedge provider to carry out a pension increase exchange exercise, it (and to reinsurers). will be necessary to consider carefully how the two projects “fit” together (and in particular, how pension Of course, once a shortlist of prospective counterparties increases will be dealt with in the longevity hedge). has been identified, there will be a need for non-disclosure - The issue of discretionary practices is always one agreements and any transaction timetable needs to factor in which will require discussion. Providers generally sufficient time for negotiating these. However, disclosure to require that their commitment is fixed, and not members is a separate requirement. linked to the way in which trustees actually exercise discretion. Sponsors, by contrast, will generally not Administration wish to convert discretionary benefits to guarantees. Trustees should identify any additional administration Some work can usefully be done to identify the requirements associated with particular transactions. For key areas of discretion, identify trustee practice example, if there is to be a collateralised longevity swap, there and think about how it might be translated into a will be a need for the administrator to monitor actual longevity provider obligation. This analysis will also be useful experience against the agreed longevity assumptions – a to trustees more generally in terms of identifying wholly new process. Putting appropriate processes in place and reviewing any discretionary practices. can take some time – and will involve some cost – which needs - Trustees may also want to think about the pros and to be factored in. cons of “all risks” deals, a new form of buy-in contract where – for a price – the provider takes on all risks It is also important to understand who will be responsible for (including the risk of unidentified beneficiaries administering benefits after the transaction – and whether coming forward) rather than a specified set of risks. the trustees have any particular requirements. Normally the trustees would continue to administer benefits on a buy-in. IfMAKING THE TRANSACTION HAPPEN the trustees want the provider to take this on at this stage (itThere are also a number of areas where trustees can prepare will usually be a pre-requisite on moving to a buy-out), thispractically for any proposal. needs to be factored in at an early stage in discussions (and may limit the available providers).Data cleansingIt is well known that, the better the data, the keener the pricing Deed and Rulesthat is available – and in some cases this can make a significant Clearly, trustees need to ensure they have power under theirdifference. Additionally, other than in “all risks” transactions, Deed and Rules to enter into the proposed transaction. Intrustees will generally remain responsible for data errors. most up-to-date documentation, this should not cause any difficulty. However, if there is any question mark, the mostThe Pensions Regulator has issued guidance on record straightforward approach will be to amend the documentationkeeping, including targets for trustees to achieve – and so to put the matter beyond doubt.most trustees will already have projects in hand to review andimprove the quality of the data they hold. It will be helpful to Conclusiondiscuss with advisers whether there are any additional checks Putting in place preparatory work now will help to ensure athat can usefully be done which would assist specifically with smooth longevity transaction and should also help to managelongevity transactions. the costs of such a transaction.A review of data may show that there are particular groups of Isabel France, Madhu Jain & Anna Taylor are all lawyers in Linklaters’members for whom data issues are most acute. If so – as well as Longevity Solutions Initiative. Linklaters lawyers have acted on theconsidering any special projects to improve this – trustees can leading longevity transactions in recent months including the ground-also consider how to factor such members into any longevity breaking Uniq deal.CLEAR PATH ANALYSIS: PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012 11
  12. 12. TO READ MORE FREE REPORTS VISIT: www.clearpathanalysis.comInformation in this report is based on current understanding of legislation at the time of print. © Clear Path Analysis 2012