The only game in town?

Over the past few years, discussions around endgame planning for UK defined benefit (DB) pension schemes have gathered pace, thanks in part to a rising yield environment that has brought forward scheme time horizons. The insurance market for pension liabilities has subsequently been buoyant as sponsors consider the costs and benefits associated with undertaking these transactions. The Pensions Regulator (TPR) is also taking a keen interest in the topic.

Should buyout really be considered the ‘gold standard’ for DB schemes?

One reason many consider insurance buyins and buyouts the ‘gold standard’ for DB schemes has to do with the security of member benefits, which are considered to be further solidified through such an arrangement. 

Whilst of course attractive, it’s possible that this ‘security’ is overstated. It’s not uncommon for insurers to reduce their own capital requirements by undertaking funded reinsurance deals with reinsurers, many of them offshore. There are therefore risks associated¹ not just with offloading sizeable institutional liabilities onto a handful of insurers (i.e. through the initial insurance policies), but also with the subsequent reinsurance transactions undertaken by those same firms on the secondary market. With offshore entities, the risks are not typically well understood, given offshore reinsurers may be subject to different, and potentially less stringent, regulatory oversight.²

Does running a scheme on generate more value over the long run? 

Leaving aside issues of potential systemic risks, there’s the question of value foregone by undertaking a buyout—by nature, an irreversible decision—which remains a key consideration for trustees and sponsors. This extends beyond solely the premium paid to the insurer, given a scheme passes up on the possibility of future surpluses, but also better buyout pricing as the membership matures.³

To add some illustrative numbers, and aid the conversation, we considered an example scheme and underlying investment strategy with the following characteristics:

Scheme profile

• £100M, fully funded on a low dependency basis (gilts plus 0.4% here)
• Reasonably mature, with a c.60% pensioner population 
• Targeting gilts plus 1.5% (c.1.1% above the assumed low dependency discount rate)
• Unrewarded risks relating to rates and inflation locked down by allocating c.75% to a matching portfolio
• Additional returns through allocating to equities and illiquid investments with short-to-medium-lockup periods

Source: SEI. For illustrative purposes only. 

In the charts above, our illustrative scheme is expected to reach full funding on a buyout basis—including a loading for transaction expenses —in five years. 

Buyout or run-on: What’s right for my scheme?

Importantly, the strategies adopted above (or versions thereof) would not negate the possibility of a buyout being executed along the way, at any point the sponsor and trustees deemed advantageous (for example, in response to improved pricing or a change in sponsor). A critical element of acting nimbly, in this case, would entail the oversight and daily monitoring of overall assets, something we routinely carry out for clients as part of our fiduciary management and journey planning offering. In a similar fashion, mechanisms could be put in place whereby a decision to de-risk further—prior to entering into a buyout—could be automatically triggered should the scheme’s funding level or surplus fall below a minimum threshold.

In practice, the benefits and viability of run-on would depend on the unique specifics of the scheme. However, rather than whether or not to buyout, perhaps the more pertinent question for trustees is when to buyout. In many cases, buying out as soon as possible might indeed be the correct answer, whereas for other schemes there is a benefit to running on, given the surplus upside and governance support. What’s clear, we believe, is that in preparing for the endgame, sponsors and trustees should weigh up their options, and be mindful of the associated risks and costs. 

Interested in finding out more?

SEI can help. Having successfully led several clients to their endgame positions—whether buyout or run-on—our client strategy directors would be happy to have a conversation about the unique challenges and opportunities facing your scheme.

¹ We deem these risks to be, primarily, concentration risk, and the risk of less stringent regulatory oversight, as explained later in this paragraph.

² To quote the Prudential Regulation Authority (PRA), increased deal-making has raised concerns around ‘concentrated exposure to correlated, credit-focused reinsurers’. In direct response, the Bank of England now plans to stress test insurers on their reinsurance exposures. 

³ For schemes buying out any non-pensioner liabilities which generally cost more to insure. 

⁴ Above 100% on buyout, including expenses.

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