Busting buy-in myths

In this short myth-buster we look to address some commonly held misconceptions about buy-ins and why for the majority of schemes a buy-in would make it harder to achieve a buy-out.


Overview: Buy-ins can make it harder to achieve buy-out funding

It is important to take a holistic view when assessing the suitability of a buy-in. When doing so, in the majority of cases, a buy-in will be detrimental to the trustees’ ability to achieve a buy-out, requiring re-risking or pushing out the timeframe.

In particular, a buy-in may not be in your best interests if:

  • The implied yield of the buy-in is lower than the required return on your total assets to meet your long-term funding objective
  • You are concerned about the sponsor covenant
  • You are expecting meaningful transfers out or cash commutations
  • You want to get to buy-out sooner rather than later

Below, we examine commonly held misconceptions about buy-ins which could distract investors from considering the more fundamental question of whether a buy-in would make it harder or easier to achieve a buy-out.

Myth 1: Our LDI manager says we have enough collateral, so we can afford a buy-in

REALITY: Excess collateral has no direct link with the affordability of a buy-in; any excess collateral can be redeployed to be more effective.


The vast majority of LDI portfolios have excess collateral due to interest rates falling to historical lows. However, being able to release collateral from the LDI portfolio does not mean a scheme can ‘afford’ a buy-in.

To answer the question on affordability, the scheme needs to assess the impact of a buy-in on the probability of it achieving its long-term objective, such as a buy-out in 10 years, and whether there are more optimal ways of achieving them.

When schemes consider their whole strategy (rather than narrowly looking at only the LDI portfolio and collateral levels), the likely conclusion will be that the existing strategy is inefficient and can be improved rather than that buy-ins are affordable.

Myth 2: Buy-ins yield more than gilts, so doing a buy-in is a no-brainer

REALITY: Comparing the buy-in yield to your required return to meet your long-term funding objective is a more relevant basis for decision making. If the buy-in is priced at a lower yield, the required return from the rest of your portfolio will have to increase after the buy-in.


Pensioner buy-ins are typically priced at gilts plus a margin (the margin varies depending on a number of factors, including the prevailing level of credit spreads).

However, this in itself does not suggest a scheme should swap its gilts for a buy-in policy. Gilts are the bedrock for many pension schemes’ investment strategies and serve multiple purposes. They may be used as collateral for the liability hedge or used to collateralise a repo agreement to raise cash, perhaps to pay pensions or settle other cashflow requirements, such as currency hedges. By way of contrast, buy-ins are illiquid and cannot be used as collateral or to raise cash via a repo.

A pension scheme must therefore look beyond the buy-in yield relative to gilts. Exchanging gilts for a buy-in is likely to create more strain on the rest of the portfolio, as assets may have to be sold to replace the gilts previously used as collateral. If gilts are deemed excess collateral, a pension scheme may consider exchanging those gilts for other assets generating a higher yield than a buy-in, to reduce the strain on other growth assets. In other words, the price relative to gilts alone is not the only factor to consider.

Myth 3: Buy-ins are cheaper than the pensioner discount rate of gilts flat; it improves our funding position

REALITY: Comparing the buy-in yield to your required return to meet your long-term funding objective is a more relevant basis for decision making. If the buy-in is priced at a lower yield, the required return from the rest of your portfolio will have to increase after the buy-in.


The value of pensioner liabilities is often calculated using a gilts-flat discount rate, which is lower than a buy-in yield. This results in the thinking that conducting a buy-in will allow a scheme to discount the pensioner liability at a higher discount rate, thereby reducing the present value of those liabilities and improving the funding position.

However, using gilts-flat to value pensioner liabilities is not an exact science. It is merely a proxy in the same way that a gilts-plus rate for deferred and active members is a proxy. In the consultation on a revised defined benefit funding code, The Pensions Regulator hinted at using a discount rate of gilts plus 0.25%-0.5% for all liabilities for long-term funding targets. As a result, doing a buy-in at gilts plus 0.2% now might well reduce a scheme’s funding level relative to its long-term funding target.

Myth 4: Insurer capacity for buy-ins might run out

REALITY: Insurers active in this market have shown no sign of capacity shortage and have shown that they can raise additional capital to be able to write more business.


We often hear that pension schemes should do buy-ins now due to a concern that buy-in ‘stock’ will run out. This has been the consistent message since buy-in sales took off about five years ago.

However, every year has seen record buy-in volumes and some estimate that this year’s volumes could be twice the size of last year’s transactions. To us there are no signs of stocks running out, which makes sense in efficient markets where demand results in higher profits, which in turn attract additional capital and capacity. We have also seen new entrants in the insurance market increasing capacity further.

We would encourage pension schemes to conduct a buy-in only if, based on in-depth analysis, they deem it appropriate for their scheme and that it will help them achieve their long-term objectives.

Myth 5: Buy-ins are cheap

REALITY: Historical buy-in pricing comparisons do not help in any way if a buy-in decreases your ability to achieve buy-out.


Credit spreads increased significantly at the peak of the COVID crisis. This resulted in many headlines that buy-ins are cheap.

However, we believe it is instructive to consider buy-in pricing on a relative rather than an absolute basis. Buy-in pricing is linked in part to credit spreads. Investment grade credit spreads widened by 100-200bp at the peak of the 2020 crisis, while buy-in pricing seemed to increase by around 25-50bp at the same time.

Therefore, while buy-in pricing became more attractive relative to history, it was much less so when compared to replicating the characteristics of a buy-in policy yourself. When viewed in this way, the conclusion during the COVID crisis would have been the opposite: that buy-ins have become more expensive.

Myth 6: Buy-in takes us a step closer to buy-out

REALITY: Don’t automatically assume a buy-in makes a buy-out more certain without analysing the overall impact on your required returns and liquidity position.


Doing a buy-in makes it feel like you are chipping away at the pension problem. It therefore naturally also leads one to conclude that it takes you closer to buy-out.

But when assessing the impact of a buy-in on a scheme’s chances of reaching buy-out, as we have already explained, in most cases this will lead a pension scheme to either increase the risk in its residual portfolio to stay on track for buy-out, or to delay the time to buy-out. Also, conducting a buy-in ties up capital, leaving a pension scheme with less flexibility to deal with future unpredictability. All things considered, the quickest route to buy-out is unlikely to involve a buy-in for most schemes.

Myth 7: Buy-ins reduce our reliance on the sponsor

REALITY: The reliance on the sponsor increases if a buy-in delays a buy-out or makes it less certain.


Many people believe that a buy-in will reduce reliance on the sponsor as it ‘insures’ some of the risk with an insurance company.

This is not true. A buy-in does not remove liabilities from the sponsor’s balance sheet and does not reduce reliance on the sponsor. A buy-in is an asset of the scheme (like all other assets, but very illiquid) and all the liabilities remain on the sponsor’s balance sheet. We consider some of these issues in this article.

If the sponsor gets into trouble and the scheme has a deficit, all members end up in the PPF or have benefits cut should they be better funded than PPF levels.


For an alternative approach to conducting a buy-in, you may wish to consider a self-managed buy-in solution. A more technical perspective on these issues has been published in The Actuary by Insight’s Ren Lin and Callum Duffy, available here. To discuss these issues in greater depth, please contact your Insight representative.

 

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