In the majority of cases, a buy-in will be detrimental to the trustees’ ability to achieve a buy-out, requiring re-risking a pension scheme’s portfolio of assets or pushing out the timeframe. We explain why, providing a case study to illustrate the practical implications for a pension scheme.
A buy-in increases the uncertainty of achieving a buy-out
As private defined benefit 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. They therefore 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. Click here to read about the fundamental differences between a buy-out and buy-in.
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:
- Higher required return from the residual asset portfolio or delay to the target date for buy-out
- Higher proportion of assets allocated to support the rate/inflation hedging strategy in the residual portfolio
- Reduced liquidity and flexibility to deal with future unpredictability
These implications often result in a greater reliance on the sponsor covenant post the buy-in, while the original objective may have been to reduce reliance. We discuss each of these risk factors in turn.
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 investment 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.
This ultimately increases the potential reliance on the sponsor covenant, as the scheme is still responsible for the same amount of liabilities.
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.
Again, such measures will ultimately increase the potential reliance on the sponsor covenant.
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 less 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 timeframe.
Case study: how a buy-in can increase the uncertainty of achieving a buy-out
|The analysis below indicates that for this scheme, a buy-in would increase the uncertainty of attaining a buy-out by almost doubling the required return to achieve the buy-out within 10 years, or more than doubling the time to achieve a buy-out if the investment returns remained the same.|
Background and objective
The trustees of a medium-sized scheme were considering whether to conduct a buy-in to cover all pensioner liabilities. The buy-in would account for 50% of the overall liabilities and we assume would be executed on a liability discounting basis of gilts plus 0.4% (the estimated implied yield is gilts + 0.9% when making an allowance for longevity protection provided by the buy-in). The trustees’ ultimate objective is to conduct a full insurance buy-out, for which they are assuming a gilts-flat discounting basis, ideally in 10 years’ time.
In Table 1 we show the current funding position for the scheme and the funding position of the residual portfolio following the proposed buy-in.
Table 1: Funding position pre and post a buy-in
|Original portfolio||Residual portfolio||Change|
|Liabilities (gilts flat discounting basis, £m)||1,000||498||-50%|
|‘Free’ Assets (£m)||831||350||-58%|
|Deficit as % of ‘free’ assets||20%||42%|
The required returns would increase after a buy-in
Following a buy-in, the size of the deficit in nominal term ‘falls’, but the size as a proportion of ‘free’ assets would rise materially from 20% to 42%. Consequently, to conduct a buy-out in 10 years’ time, the required returns from the scheme’s ’Free’ investment portfolio would rise substantially after conducting a buy-in:
- Original portfolio required return2: Gilts + 2.6% pa
- Residual portfolio required return: Gilts + 3.4% pa
This would result in the scheme having to rely on more uncertain growth assets to meet the desired return target.
The longer duration of the residual liabilities would exacerbate the challenge
After insuring the pensioner liabilities using a buy-in, the scheme’s residual liabilities would have a longer duration and be more sensitive to changes in interest rates.
To ensure enough collateral is held to maintain its hedge against interest rate rises, the pension scheme would have to allocate a higher proportion of its assets as liability-hedging collateral. This would lead to an even higher required return from the portfolio’s non-collateral assets (see Table 2).
Table 2: Maintaining a scheme’s liability hedge after a buy-in can put even more pressure on its investment portfolio
|Collateral allocation3||Non-collateral allocation||Required return on non-collateral assets (pa)|
|Original portfolio||30%||70%||Gilts + 3.7%|
|Residual ‘Free’ portfolio (post-buy-in)||52%||48%||Gilts + 7.0%|
Less ‘free’ assets to deal with future unpredictability
The buy-in would match the payments to pensioners but would leave materially fewer liquid assets (58% less) available to help deal with unanticipated cashflow requirements, amplifying the impact on the certainty of achieving a buy-out. This potential risk would be increased by any other allocation to illiquid assets in the residual portfolio.
The alternative consequence would be to delay a buy-out
If after a pensioner buy-in, the trustees refuse to increase the investment risk in the residual portfolio and maintain a gilts plus 3.2% pa return objective for the non-collateral assets, the time to buy-out would be extended significantly:
- The original portfolio would take 10 years to reach buy-out
- The residual portfolio would take 21 years to reach buy-out
While delaying the timeframe to buy-out does not result in additional investment risk being taken in any one year, it is easy to see why this also increases the potential reliance on the sponsor covenant.
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 would increase the uncertainty of achieving full buy-out in a given timeframe. It would also increase the reliance on the sponsor covenant.
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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1According to the Hymans Robertson Pension scheme funding: benchmarking analysis, October 2020, covering 1,730 valuations, the median funding level on a buy-out basis is 67%.
2Pensioner liabilities have been scaled upwards by 5% to make a reserving allowance for the cost of longevity protection.
3Assumes a liability hedge of 90% of the non-bought-in liabilities and that the collateral allocation is set to withstand a 2% rise in interest rates.
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