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Targeting buy-out

An insurance solution is a desirable endgame for many sponsors. However, for some, an insurance buy-in may be closer than they think.

This article was first published in our Leading the Way report.

In recent years buy-in and buy-out volumes have increased substantively, and it is a sign of the resilience of the market that even during the pandemic buy-in and buy-out volumes have reached £30bn a year. We expect this trend to continue in the coming years.

Source: LCP analysis

For schemes targeting full buy-out, the market will be busy and schemes will be competing for capacity. Therefore having an effective strategy for insurance transactions is essential.

In the past, the decision to buy out a scheme was usually dominated by funding level, with schemes often looking to remove risk via pensioner buy-ins (funded through scheme assets), as a step towards a full risk transfer to an insurer. For smaller and very well-funded larger schemes (and where comfort was achieved around the company accounting treatment) buying-out in full was also a common route.

However, in light of the Pension Schemes Act 2021, for some companies, the associated risk of pensions disrupting wider strategic decision making (eg around dividends or M&A activity), could now be sufficient for these companies to consider their options to remove pensions risk, even if this requires a significant upfront contribution. We describe this in more detail here.

Where the required contribution is low (or zero), the “business case” for a strategic buy-in is likely to be especially compelling.

The 'business case' for a full buy-out

Driven by concerns around growing regulatory risk, increasingly we are seeing companies consider making very significant contributions to their pension schemes to fund an insurance transaction that will transfer all future financial, demographic and regulatory risks to the insurer, and remove pensions from the corporate balance sheet in its entirety.

For some of these companies this has been possible largely thanks to significantly improved funding levels. Additionally, a formal market assessment of the buy-out funding level can itself often show an improved position compared to historical informal estimates.

For sponsors of well funded schemes, a key question then becomes “What is the right price?” to justify a (potentially very significant) final payment to remove pension risk.

One approach to answering this question is to examine “Pre committed” costs and to compare these to realistic insurer pricing:

“Pre-committed” costs:

  • What contributions has the business already committed to paying into the pension scheme?
  • What are the ongoing running costs?
  • How much extra money and time might be needed if the pension scheme runs on indefinitely?

“Realistic insurer pricing”:

  • What is an accurate estimate of the buy-out cost likely to be? Business as usual solvency estimates can be cautious, with improvements of 5-10% often being achievable from a competitive process.

In the example above, the initial observation could be that at a cost of £100m buy-out was not worth pursuing. However, slightly more in depth analysis, allowing for the expected contribution and running costs, and an updated view of actual buy-out costs could feasibly halve this cost to around £50m, making the option worth considering.

If the additional contribution required after allowing for pre-committed costs is palatable, consideration should be given to whether now is a good time to fund the additional cost required to achieve buy-out and remove pension scheme risk and balance sheet volatility. Future plans for the business, including restructuring, corporate tax (and forthcoming changes), M&A activity, and even financing considerations could all be very relevant in determining whether the additional cost is worthwhile.

For sponsors of schemes where a full insurance solution is not preferred, or is not currently possible, they may still wish to target buy-out over the longer term. This provides the opportunity for sponsors to take an active role in setting the plan to buy-out and so ensure the buy-out is achieved in a cost-efficient manner, whilst focusing appropriately on risk reduction.

The plan might include sponsor focused objectives such as preserving free cashflow, managing key accounting metrics and balance sheet volatility and controlling the timescales. It should also allow flexibility to respond opportunistically to market shocks, such as we saw with the emergence of Covid-19, when asset market dislocations initially created significant short term pricing opportunities for well-prepared schemes.

LCP’s five point buy-out planning framework helps guide sponsors and trustees through the approach to buy-out. The key steps are:

  1. Understand how close you are Get a realistic understanding of the current costs of buy-out. In our experience these may be less than trustees and sponsors think, meaning insurance solutions are achievable more quickly. Relying on the latest estimate you received as part of a triennial valuation could mean your estimate is out of date.
  2. Establish your journey Armed with this knowledge, develop a robust, flexible and practical plan, that allows for expected investment returns, member options activity and changes in buy-out pricing as the membership matures. Keeping an eye on how the funding level is evolving can enable you to take advantage of periods of favourable pricing and reach your end goal sooner. Capturing favourable insurer pricing (such as emerged in April to July 2020) can be the biggest contributor to bridging the gap to buy-out for many schemes.
  3. Understand what risks could blow you off course As well as having a clear idea of when you expect to get to your long-term funding target, it is important to understand the sensitivity around that date. Member option exercises, such as Pension Increase Exchanges and Flexible Retirement Options can accelerate buy-out timescales, as can the natural flow of member movements. Ensuring that the investment strategy hedges buy-out pricing appropriately, but potentially retains some return seeking assets to improve affordability is likely to be key. Scenario analysis can give a better understanding of the sensitivities for your scheme.
  4. Consider phased buy-ins to lock-down pricing risk A series of buy-in transactions, perhaps focusing on pensioner liabilities, could form part of the strategy particularly for sizeable schemes as their funding levels improve. This would reduce exposure to risks such as longevity, inflation changes and adverse insurer pricing to smooth out price fluctuations, but needs careful planning to avoid delaying the full buy-out.
  5. Manage transition to buy-out Finally, the transition of benefits to an insurer. Good quality data is a pre-requisite and needs to be prepared in advance. Running a competitive process with insurers helps ensure optimal pricing and only by approaching the market can the actual costs be known for certain.

More detail is included in our de-risking report.

Setting buy-out as a long term funding target will require careful consideration, particularly if it is formalised in a journey plan. For example, sponsors will be rightly wary of creating unexpected contribution obligations or potentially risking a “trapped surplus”.

But, done well, proactively planning for a buy-out can result in significant cost-savings, acceleration of the time to buy-out, aid business planning and improve relationships with the Trustees.

Other blogs in this series:

Managing regulatory risk on route to your long-term target

Contingent funding