A company with a long presence in the UK mining sector supported a defined benefit pension scheme with a significant proportion of retired pensioners. The pension scheme had a strong funding position that had already benefited from matching most of its assets to its liabilities. This matching strategy, coupled with steady low volatility growth investments, had gradually improved the funding level over time, resulting in a large amount of physical bonds backing much of the liabilities, as the scheme investments had been de-risked.
It became apparent from insurance pricing that a buy-in asset could be sought to match some of the pensioners at a price that was cheaper than the scheme had reserved for. Although the longevity risk associated with some of the elder pensioners was not that high – especially compared to the scheme’s younger members who hadn’t yet retired – the trustees thought that it would nevertheless be helpful to insure this longevity risk.
When trustees target buy-in as an end-game solution, they purchase an insurance policy to cover the liabilities of a group of their members, for example, current pensioners in payment. It is considered a ‘match’ to the covered liabilities, with the trustees holding the insurance policy as an asset, whilst retaining responsibility for paying the pensions. This is in contrast to a buyout, where the liabilities of the entire scheme are transferred to the insurer.
Before undertaking a buy-in, it is essential that the fiduciary manager carries out essential checks. In this case, SEI investigated whether there would still be sufficient assets left to match remaining non-pensioners in the event of transferring the pensioner matching assets to an insurer.
Given that this scheme was so well funded, it was in the rare position of being able to transfer physical matching assets to an insurer and still have enough reserve assets to match the remaining liabilities.
The scheme would be locking up assets over the future life of the pensioners by investing in the buy-in, and for the non-pensioner liabilities, sensitivity to changes in interest rate and inflation expectations remained. In order to match these factors, a greater number of derivatives were required and the scheme still needed all of its growth assets to generate the returns to meet its liabilities.
The trustees satisfied themselves that the derivatives exposures in the liability matching assets would become more levered. They were also comfortable that more assets would need to be paid away to match any future decrease in value of the liabilities.
Entering into a buy-in can mean that liability matching assets become increasingly levered, as illustrated here.
As a result of this approach, there was a moderate increase in the scheme’s ongoing funding level, given that the buy-in was slightly more economical than originally forecast. The insurer also offered the pensioners a level of security that was similar to or potentially better than that presented by the strong backing sponsor.
Nevertheless, these advantages were counterbalanced with some disadvantages:
- If the scheme wished to pursue a full buyout at a later date it may be tied to the provider of the buy-in: It is common for buy-in providers to stipulate periods of no competition when it comes to subsequent pricing of full buyout or further buy-ins
- The scheme had been left with the more irregular pension benefits. The easier benefits to match had been taken on by the insurer: This made the remaining liabilities harder to insure and full buyout at a later date potentially harder to transact.
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