A large global distribution company’s UK entity had a significant defined benefit pension scheme position on its balance sheet. Positive incremental investment returns, combined with sizable recovery contributions, had helped correct much of the scheme’s deficit over a number of years.
As the funding level improved to 92% on a self-sufficient basis, the investment strategy was derisked as laid out in the scheme’s pre-agreed journey plan. Liability matching investments were implemented as the market’s interest rate and inflation expectations changed. However, longevity risk remained, and it was becoming a larger proportion of the scheme’s overall risk in the midst of a de-risking strategy.
The trustees investigated a buy-in arrangement with an insurer that looked to match the risk of pensioners living longer than expected.
For them, this presented a number of issues:
- Whilst the security of delivering benefits to the pensioners would improve, the risk of funding the scheme would be spread across the remaining non-pensioners as a result
- Matching assets in the form of gilts would need to be transferred to an insurer to fund the buy-in. This would leave the scheme with significantly less assets to match the remaining non-pensioners
- The non-pension members were younger in age and their pension benefits were longer dated; consequently, their liabilities were more sensitive to changes in interest rate and inflation expectations. In short, more liability matching assets would need to be held to match the members who hadn’t retired yet
- Growth assets would need to be reallocated to the matching portfolio to match the non-pensioners. The expected return of the overall investment strategy would then be reduced
- Even for a scheme in a strong funding position, the deficit recovery plan would be put at risk. This would potentially mean the sponsor having to make additional contributions
- Because the buy-in was a one way transaction, it would mean a loss of flexibility should the trustees want to reallocate to growth assets in the future
Given these concerns, the trustees understandably wanted to investigate more flexible ways to address longevity risk.
Why DIY buy-in?
A do-it-yourself buy-in is an end-game solution that takes the position of principally holding income generating, low-risk assets and longevity hedging in order to meet the pension scheme’s commitments. Bypassing the need to pay an insurance premium, this approach looks to achieve similar outcomes to a buy-in whilst using fewer assets.
Cost saving is an obvious benefit, but is taken in hand with a small risk of additional funding requirements should the experience underperform against the careful assumptions made.
We recognised that the interest rate and inflation risks of the liabilities could easily be addressed with liability matching investments. Furthermore, credit investments could provide a matching and return enhancing function by generating an extra yield in excess of the liabilities over the long term.
For the remaining longevity risk, a longevity swap could be entered into with a large global reinsurer. If the actual scheme members lived longer than expected, the reinsurer would post assets to the scheme to match their increasing liabilities. Likewise, if pensioner mortality was heavier than expected, assets would be posted from the scheme to the reinsurer, reflecting the fall in liabilities.
The assets could be managed so self-sufficiently that in effect a ‘do-it-yourself’ buy-in could be built.
A scalable solution
The DIY buy-in is an easily scalable solution that can accomplish the following:
- Match longevity risk as with a buy-in, whilst the scheme’s trustees retained control of the underlying assets
- The investment strategy did not have to be changed to differentiate between matching pensioners and non-pensioners
- No subsequent side-effects whereby reallocations had to be made between growth and matching assets
- Significant cost saving; transacting directly with the reinsurer removed the incursion of additional premiums
What end-game solution is right for you?
We put end-game solutions under the microscope to bring you real case studies demonstrating how other pension schemes mapped their route.
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