Grant Thornton - UK Pension De-risking: Longevity Hedging & Buying Out 2012

PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012

MARCH 2012

THE THIRD ANNUAL REPORT WHEREBY EUROPEAN PENSION PLAN TRUSTEES, CORPORATE SPONSORS, ADVISORS, BROKERS, REGULATORS AND THIRD PARTY GROUPS COME TOGETHER TO SHARE THEIR VIEWS ON RELIEVING LIABILITY RISKS, ENGAGING IN LONGEVITY HEDGING AND BUYING OUT AS WELL AS OTHER OPPORTUNITIES WITHIN THE VOLATILE MARKET.

SPONSORS

PUBL

ISH

ED B

Y

CLEAR PATH ANALYSIS: PENSION DE-RISKING: LONGEVITY HEDGING & BUYING OUT 2012 2

WHITE PAPERMaking Buy-Outs & Buy-Ins More A�ordable

KELVIN WILSONHead of Pension Risk SolutionsGrant Thornton UK LLP

The transfer of all pension liability risks to an insurance company through a buy-out transaction, is a goal that

many trustees and employers of a defined benefit (DB) pension scheme have. However, it is also a goal that many of them consider to be prohibitively expensive to achieve. Over recent years, many pension schemes have used the more affordable "buy-in" structure as a means to reach their buy-out (de-risking) objective. A buy-in involves insuring a portion of the scheme's liabilities (usually pensioners in payment) and requires lower level of immediate funding than a buy-out). However, a perfect storm combination of low interest rates, volatile investment markets, high inflation and rising longevity expectations have seen the liabilities and deficits of many schemes rise to levels such that even the buy-in model is now in danger of becoming unaffordable.

During the financial crisis of 2009, the de-risking market responded to the unaffordability of buy-ins and buy-outs by developing the pensioner longevity swap. This solution required little, if any, additional scheme funding, which made it a viable solution even for relatively poorly funded pension schemes. However, a longevity swap is not a comprehensive de-risking solution and it is not favoured by, or suitable to many schemes. Buy-out and buy-in solutions will need to be restructured such that their implementation does not deteriorate the funding position of schemes which are already underfunded. Additionally, the structure should make it possible for the sponsoring employer to fund the buy-out/buy-in without having to provide prohibitive, immediate additional funding.

BUY-OUTS AND BUY-INS, WHILST COMPREHENSIVE RISK TRANSFER SOLUTIONS, NEED TO EVOLVEIn terms of complete risk coverage and executional simplicity, buy-outs and buy-ins remain attractive to trustees and sponsoring employers. However, the large single premiums associated with these transactions have deterred many pension scheme sponsors and trustees from completing such deals. Providers need to address these challenges by developing structures that take account of three key issues facing scheme trustees and scheme sponsors:

a. Deteriorations in funding levelsb. Affordability - large upfront cash outlay for buy-ins and buy-outs is not an option for many scheme sponsors c. Weak equity markets deter trustees from liquidating equity portfolios to execute buy-outs/ buy-ins

For poorly funded pension schemes, a pensioner buy-in that transfers large assets out of the scheme to an insurance company can leave the scheme in a worse funding position, unless accompanied by significant capital injections from the scheme sponsor. Therefore, it is important that providers consider how buy-in pricing can be made more attractive and/or how they can better structure the timing of premium payments.

The main reason why buy-ins and buy-outs are not pursued by pension schemes is due to unaffordability. That is, the sponsoring employer, after allowing for assets in the scheme, cannot afford the funds needed to make up the deficit between the on-going valuation of the liabilities and the insurance premium – "the premium gap". Pension schemes have on-going funding deficits which, following agreement between the trustee and the sponsor, is paid down over a recovery period. A similar approach could be taken on funding the premium gap, whereby insurers and trustees/sponsors execute a buy-in/buy-out but agree to fund its cost over a longer timeframe. This is an option that would be attractive to scheme trustees and sponsors.

The past eighteen months have seen significant volatility in investment markets. Corporate bond yields have fallen, government bonds yields are at record lows and the behaviour of equity markets continues to be finance's best illustration of particle theory. Depending on the investment strategy of buy-out providers, falling bond yields can lead to an increase in buy-in and buy-out premiums. If the premium is then financed by liquidating pension plan equity assets during an equity bear market, this would crystallise the loss on the scheme's equity portfolio. This situation deters many employers and trustees from using buy-out/buy-in to de-risk pension schemes.

DEFERRED PREMIUM PENSION ANNUITY (DPPA) ALLOWS BUY-INS AND BUY-OUTS TO BE PAID FOR OVER A NUMBER OF YEARSIn response to some of the above issues, we have started to see insurance companies offering buy-in and buy-out solutions where the premium is structured into two components – an initial premium, followed by a series of deferred premium payments. The solution is known as a DPPA. The diagram below illustrates how the solution and a transaction would work.


Making Buy-Outs & Buy-Ins More A�ordable

The structure would see the insurer calculate the buy-in or buy-out premium on a commercial basis, say £200m. Rather than make a single premium payment for the full amount, the pension plan would make an initial payment of, say, £160m (80% of the total premium). The outstanding or deferred premium of £40m would then be paid over an agreed schedule, e.g. between 5 to 10 years, to suit the cash flow requirements of the pension scheme and the sponsoring employer. If the agreed schedule is not met then the default position is that the insured benefits would be scaled back. The insurer would charge interest on the deferred premium – partly for the cost of capital that it would need to hold against the transaction.

The structure addresses many of the concerns that we raised about buy-in and buy-out for underfunded pension plans. The lower initial premium would result in:

a. Reduction in the risk of further deterioration of funding position, post a transactionb. Lower (or even zero) capital injectionc. Deferred premium can be funded in same way as on- going funding deficitd. Lower crystallisation of potential losses on equity portfolio, if payment of the premium necessitates liquidating these assets during an equity bear market, as not all scheme assets are transferred to the insurer on day one

PENSION SCHEME VALUATIONS ASSUMES INVESTMENT OUTPERFORMANCEBuy-out and buy-in premiums are higher than most pension scheme liabilities, due to insurers using lower discount rates to value the scheme’s liabilities than the rates used by the scheme. This "valuation gap" is a result of the pension plan allowing for an element of equity outperformance in the applied discount rate, which the insurance company does not allow for. Where there are strong commercial grounds to do so, it may be possible to negotiate with insurers to structure a buy-in deal that allows an element of equity out performance in the buy-in pricing basis. A high level description of this "risk and profit-share" structure might be as follows:

a. The insurer calculates a risk transfer premium, £300m, based on its standard commercial pricing basisb. The insurer calculates another risk transfer premium, £250m, that incorporates an element of investment outperformance, zc. The pension scheme/employer earmarks assets to the value, £50m, which is the difference between the commercial and outperformance pricing basis - perhaps as collaterald. The risk transfer transaction is entered into, for £250me. To the extent that a pre-agreed market index (or a combination of indices) does not perform better than z, the pension scheme/employer makes payments to the insurer out of the £50m earmarked assets

The above structure would need to consider a number of issues, including how the £50m is invested, who has legal ownership, and under what circumstances (if any) would the £50m be retained by the employer/pension scheme.

CONCLUSION The turbulent economic conditions of the last few years have caused many pension schemes, their sponsoring employers and investors in the sponsoring employers, to experience a lot of pain! Whilst many pension plans now understand the importance of good risk management and want to better manage their risks, poor and deteriorating funding levels leave many of them believing that the option of buy-out and buy-in remain out of their reach. However, the de-risking market is responding to trustee and employer concerns regarding the cost and financing of de-risking solutions. Solutions are now being offered that are bespoke to the profile of pension scheme liabilities, level of funding and the strength of the employer's covenant. Pension scheme trustees and sponsors should recognise that opportunities to transfer risk still exist and the cost of transfer might not be as onerous as previously perceived.

Company Scheme Insurer

Deferred premium + [LIBOR + %]

Deferred premium + [LIBOR + %]

Insurer premium

Pension payments

FIGURE 1


ANDREW REID: Thank you everyone for joining me today. I’d like to begin by asking the panel, do you believe that recent micro and macro events including low interest rates, inflation uncertainty and difficulties within the Euro zone have had a significant impact on the longevity swap and buy-out market? What have you noticed, John?

JOHN CHILMAN: I’m going to start on the other side of that equation with, ‘What does it really mean for the underlying pension fund?’ Obviously the low interest rate environment has meant we’ve seen an escalation in liabilities. I’m sitting here thinking, ‘does it matter for buy-outs because I’m so far away now from being able to afford a buy-out, it’s inconsequential to me’. I’m also not sure that capital is going to be available in the markets for transacting longevity swaps, meaning the market can’t continue to proceed at the pace it has in recent months. Looking at the position my trustees are sitting in, their primary focus is on how to get back to a reasonable funding position, as opposed to trying to lock down any of the liabilities and risks at this point in time. The focus has changed from one of good funding positions into how do we recover from where we are.

KELVIN WILSON: I understand John’s points and feel they are all very valid.

However, in terms of the impact the issues being discussed have on the longevity and buy-out market, that really depends on the individual pension schemes concerned. For clients with fairly mature liabilities below £100 million, we have found that deterioration in their funding positions has not been so significant to make a pensioner buy-in or, in some cases, a buy-out completely unaffordable. Typically, this has been due to the shorter duration of these schemes' liabilities. There are schemes out there who have a mature liability profile and who are still able to consider de-risking using transaction structures such as buy-ins and buy-outs because whilst buy-out pricing may have increased, the increase hasn't been to a level that makes it completely unaffordable. Schemes with asset duration that matches their liabilities and/or who have sponsors generating a cash windfall, are quite happy to engage in a buy-out right now.

ANDREW: The relative price increase depends upon what assets the scheme has been holding. Those that have been largely in gilts have fared quite well over the last few months.

DEREK RUSHTON: Interesting to this discussion is that we have been looking at de-risking the two defined benefit schemes we have within Virgin Media. I agree with John that the appetite for interest rate

swaps and full buy-outs at this time is curtailed by the cost involved. However, that does not mean that we are taking no de-risking action, especially in terms of buy-ins. As was just mentioned, it all depends on a scheme's investment strategy and liability profile and certainly the trustees have been looking very closely at utilising buy-ins as a function to offset the liabilities of their more mature pensioners. We are in the early days of looking at that, bearing in mind that one of our schemes is funded to buy-out anyway. My view is that although full buy-outs and swaps may have lost a little of their lustre over the last 12-18 months, I feel there is still a market for buy-ins which is likely to expand given current market conditions and gilt returns.

STEPHEN TILEY: It’s very much a case of looking at each scheme on its merits and the appetite of the sponsoring employer to de-risk, whether it can afford to buy-out, buy-in or put in other mechanisms to reduce volatility. There have been recent cases where schemes holding gilts over the last year have taken advantage of the arbitrage between those and corporate bonds. The spreads over gilts have certainly been at a level where schemes have wanted to look at buying out if the insurer was prepared to meet the target price due to the arbitrage between the gilt yields and corporate bond yields. Similarly, it depends on what assets you are holding as a scheme

ROUNDTABLE DEBATEWhat are the Anticipated E�ects of the Recent Market Volatility on Longevity Swaps & Buy-Outs?

ANDREW REIDManaging Director, European Head of Pensions Origination, CMTSDeutsche Bank

MODERATOR:

JOHN CHILMANGroup Pensions DirectorFirst Group PLC

PANELLISTS:

STEPHEN TILEYGroup Pensions ManagerWincanton

KELVIN WILSONHead of Pension Risk SolutionsGrant Thornton UK LLP

DEREK RUSHTONGroup Pensions ManagerVirgin Media Pensions


What are the Anticipated E�ects of the Recent Market Volatility on Longevity Swaps & Buy-Outs?

and whether you can afford various forms of de-risking. In respect to Wincanton, we have gilts in our portfolio which has helped us but we are some way off buy-out. But a buy-out isn’t the only target in the market. Self-sufficiency is another form of target that we would want to follow first. On the longevity side it does depend on the demographics of the scheme because we’ve always over estimated our longevity rates. Certainly we wouldn’t want to enter into anything where we felt we were over paying. Obviously, if you have the money and you want to take risk off the table and you can afford to de-risk then most companies would have the appetite to do so.

ANDREW: From a provider’s perspective, I would echo the comment that it varies between schemes, and the solution investigated from one to another varies significantly. Many of the better funded schemes are investigating bulk annuities. In the large to medium end of the pension scheme scale, there is more interest in unfunded longevity only hedges, where longevity plus a few ancillary risks like the proportion married and the age difference between members and dependents are hedged, rather than a buy-in. Over the second half of 2011 there was a noticeable pick-up in interest in bulk annuity, with a number of those schemes invested largely in gilts, sitting on good investment performance, considering switch up from gilts to bulk annuities. To put this into perspective we have looked at yields at the 20 year point on the curve. Assessing the drop from the 31st December 2010 to 31st December 2011; interest rate swaps went down 1.1% per annum, conventional gilts went down 1.3% per annum, the iBoxx corporate bond over 15 years index was negative 1.1% per annum. If you then look at inflation statistics, the inflation swap rate at 20 years went down just 0.2% per annum whereas break evens from gilts went down 1.3% per annum. How does all this fit into pension funding levels? We estimate that International Financial Reporting Standards (IFRS) levels went down approximately 5% over the year but bulk annuities or buy-out funding levels went down about 20%. If you think within those figures, especially regarding the

20% drop, that there are some plans that are experiencing zero or even positive returns, then there must be a few that are substantially lower or have a bigger fall to get back to that average. Hence the wide variety of solutions being considered.

Moving to the next question, assuming there is a demand for these products if the price and terms are right, what challenges will possible future increases in demand hold from both the pension scheme perspective and the provider’s perspective

DEREK: This goes back to the employer covenant and how secure the trustees are with that, along with what cash flows are available from the employer in the first place. It is going to be a challenge for the trustees to persuade sponsors to part with any significant cash flows beyond a basic minimum requirement. Certainly if they are not at valuation in the next 12-18 months, then the likelihood of them trying to persuade the release of cash from their current employer is slim unless you happen to have an extremely cash rich sponsoring employer. That cash has no better usage within a commercial environment, so from the plan’s perspective the idea of getting rid of those risks is fantastic, but in practical terms, it is going to be very difficult given uncertainties in the European economies. Therefore, innovative solutions are required from providers to persuade trustees to spend time and resources on a cash requirement from the sponsoring employer.

STEPHEN: From our perspective, the longevity market is still in its infancy and it is not something that we have looked at in much detail. We are more interested in buy-ins and buy-outs. In terms of the actual market position at the moment, we feel that when capital is available to enter the market and there is a market mechanism that is offering significant value, then that will make it a more attractive proposition. In terms of buy-outs and buy-ins, it is scheme specific and most companies would want to take away legacy defined benefit plan liabilities if they could, especially if they consider the cost of running the scheme which will probably be comparable to the margin added on by insurers.

DEREK: I agree with Stephen's point. There is an issue around trustee understanding of longevity swaps. They are, by their nature, quite complex and trustees tend not to have the enthusiasm to pursue a longevity swap because they don’t necessarily find it as easy to understand as a buy-in or a buy-out.

KELVIN: What you tend to see is the corporate becoming interested in longevity swaps. They are often the ones taking the idea to the trustees and, together with the advisers, helping the trustees to understand some of the more complicated structures. Most pension schemes now have a flight path or journey to some goal. They are closed to new members so it is all about managing the liabilities to that end goal, whether that be through buy-out or self-sufficiency. That will require good risk management of the pertinent risks in the pension scheme (interest rate, longevity or inflation). Longevity swaps, buy-ins or liability reduction exercises are simply tools ‘that are in the locker’ of trustees and scheme sponsors. The tools need to be explored as the cost of running off scheme liabilities can prove very expensive. Whilst the price for buy-out is not right as of now, longevity hedging and buy-ins may still represent good value, depending on the asset and liability profile of the pension scheme. As more pension schemes look to de-risk, providers of de-risking products will be faced with the challenge of increasing capacity and finding new sources of capital. They will also need to develop products that are accessible for schemes of varying sizes and who are at different stages on their de-risking journey plans. Scheme sponsors and trustees will need to think about having a good governance framework to deliver any de-risking end game that they may have. They will also need to need to think about evolving their investment strategy to take account of their existing funding position. There will be the added complication of understanding how a scheme's asset and liability profile will evolve over time such that the trustee and the employer are able to put in place action based de-risking triggers. Trustees and employers will need to ensure that any de-risking strategy they embark on bring value for money. Most de-risking solutions will have a cash cost associated with them.


What are the Anticipated E�ects of the Recent Market Volatility on Longevity Swaps & Buy-Outs?

It is important that an analysis is done on the solution to ensure that the cash cost of removing the risk(s) is at least lower than the cost of running the risk.

ANDREW: There is one point Kelvin mentioned which has been key to this market developing. That is the cost, or the additional cash cost, of longevity hedges. Because many schemes are reserving prudently, a bit above best estimate, it means the prudential reserve can be used to meet some, or in a few cases all, of the cost of the hedge. From a cash funding perspective, the pitch from us has been ‘you have this reserve, why not replace it with a hedge?’. That certainly has resonated on the company or treasury side.

KELVIN: It is important that scheme trustees and sponsors understand their objective(s) and how they are going to reach their objectives. Whether you are hedging pension scheme risks through use of a longevity swap or a buy-in, it is important that trustees and sponsors understand the key aspects of the process - what assets are the scheme invested in, have they undertaken scheme data cleansing and do the scheme's stakeholders need to create a sub-committee and have a sub-governance structure in place to allow quick and decisive decisions to be taken? A better understanding of the process and how the solutions work means an easier and smoother process to transaction. Perhaps some of the onus here is on the providers and the consultants to better educate their client base.

Providers need to be innovative. They need to recognise that not all pension schemes are the same. They need to appreciate that different schemes have different funding levels and have differing liability profiles. Providers need to structure their solutions in a way that considers the funding position of the scheme, the cash constraints of employers and which focus on de-risking a pension scheme over time and not necessarily requiring immediate cash funding.

ANDREW: A point that Kelvin picked up on is one of bringing new capital into

the market. Depending on how you value it, there might be £1-1.5 trillion worth of liabilities in UK private sector defined benefit pension funds. There isn’t enough provider capital, or even close, currently to take on that quantity of risk. It’s been spoken about before but it seems as though we are getting closer to meaningful involvement from non-insurers and re-insurer based capital, bringing in what we might broadly call ‘capital markets’. If we can bring that capital in then that’s going to bring huge pricing tension advantages.

STEPHEN: That does assume the demand will increase. What some of us are hoping for are higher interest rates or higher real yield. When we have 10% interest rates and the yield curve is a bit higher then we won’t’ have to worry about longevity hedges, buy-outs and buy-ins. It is no coincidence that there is a lot more interest in providing and buying these types of solutions but it is coloured by the environment we are in. In the pensions industry this is just a blink of an eye. You have to learn from history and take a long term perspective and be prepared to wait and see, which doesn’t sound very proactive but sometimes you can be overly proactive.

ANDREW: What is your view, Stephen, of the future outlook for longevity hedging and swaps markets? What can and should the market do to evolve?

STEPHEN: My outlook does depend on if we carry on in a low yield environment, which is not going to happen. We are going to get continued stubborn inflation and printing of money to inflate deficits away in the developing world. In that situation, I don’t foresee longevity swaps and the buy-out market proceeding at pace. For the time being, anybody that can afford to buy-out and has experienced burnt fingers in recent years should proceed. It does depend on sponsoring employers as well as the trustees, and what their view of the world is. There will be more opportunities for smaller schemes to de-risk, as we’ve seen with the advent of fiduciary management and integrated trustee solutions providing a more rounded service. That model will include managing buy-outs and de risking strategies. For

larger schemes it will depend on capacity and that is limited.

KELVIN: I would echo Stephen’s points. One additional point I would make is, if we are going to address the funding shortfalls that many schemes have with de-risking solutions, then the real emphasis has to be on innovative structures. Structures that take account of deficits in schemes and provide a path over time to de-risk, not necessarily immediately. Providers need to come up with a type of mechanism that allows pension schemes to engage but which doesn’t necessarily involve locking into low yields. Alternatively, if they do lock into low yields, then allow flexibility in the structure of the transaction. It’s all about innovation for me.

JOHN: This type of activity will become less unusual and more mainstream in the future. I would echo the views that innovation would be ideal. The reality is that for the larger plans, we would prefer to close the funding gap before we take the financial decisions necessary.

DEREK: I agree with John. The reality is those schemes who can afford to transact are not going to do so in the next 12-24 months, at a point where they are effectively locking in losses they have made over the last 18 months. They will be looking to put their funds to work, where they can afford to take that risk or where the employer convent is strong enough. Then over the next year or two, they will move towards the longevity swap opportunities and buy-out markets. Long term they will become more prevalent.

ANDREW: This echoes our experience to a large extent. Although the better funded schemes are looking at bulk annuity solutions, there is quite a lot of interest in longevity hedging because it is an unfunded solution. There is no cash up front and if it can be traded at a level whereby there is no increase in technical provisions or cash contributions from the sponsor, then it is seen as quite an attractive proposition.

I’d like to conclude the debate there and thank the panel for their time.

Bridgingthe gap.At Grant Thornton, we help remove or reduce the risk of financial losses associated with running a defined benefit pension scheme.

Our Pensions Advisory team provides independent de-risking advice on structured solutions and transactions that will either transfer out or mitigate the risks you face. To secure and protect your position, now is the time to act.

For further information, please contact:

© 2012 Grant Thornton UK LLP. All rights reserved. ‘Grant Thornton’ means Grant Thornton UK LLP, a limited liability partnership. Grant Thornton UK LLP is a member firm within Grant Thornton International Ltd (‘Grant Thornton International’). Grant Thornton International and the member firms are not a worldwide partnership. Services are delivered by the member firms independently.

grant-thornton.co.uk

Kelvin Wilson T 020 7865 2402 M 07879 667208 E [email protected]

Darren Mason T 020 7728 2433 M 07971 434964 E [email protected]


INTERVIEWAnalysing the Drivers behind the Continued Interest in Pension Buy-Outs

IAN SMITHDeputy EditorschemeXpert.com

INTERVIEWER: INTERVIEWEE:

MARK BOWERFinance DirectorArnold Laver and Co

transactions to hedge movement in both inflation and bond yields, luckily we got our timing virtually spot on. We got our hedging in place before the credit crunch and once you’ve got that matching in place, it gives a reasonable expectation that the movement and the cost of buying out won’t alter dramatically from what you have entered into.

IAN: Regarding your buy-out with Pension Insurance Corporation (PIC), what were some of the key challenges that you experienced during the process?

MARK: That is a very good question because initially I went into the buy-out with it being just another corporate transaction, which I had done many of over the years so didn’t see why the buy-out would be any different. However, it quickly became apparent that it did need to be treated as a unique challenge because it was different. My thinking was that the company wants the buy-out to remove the risk off its balance sheet and trustees want it as it is in the members’ best interests, so surely everybody wants it. However, that is not necessarily the case because to do the buy-out you need a lawyer, a scheme administrator, an investment manager and other advisors who are absolutely attuned to achieving this buy-out. You quickly learn as you go through the buy-out process that there are many obstacles along the route, and it is very easy for problems to come up or be created that put doubt into somebody’s mind. The first challenge is to get everybody involved with the buy-out genuinely aiming for the same result and having a positive incentive to achieve that result. For us one of the biggest problems was from a company’s perspective, to do a buy-out

you need a fixed price i.e. what will the buy-out actually cost. If you haven’t got a fixed price, you can’t fund the buy-out transaction and that is particularly so in today’s banking environment where funding is very difficult as banks are very risk averse. However, when you approach the world of pensions it is a polar opposite because what you are quickly told is that the traditional path for a buy-out is that you give a buy-out provider your data, they give you an indicative price, you sign up for that, then in 6 months’ time the buy-out completes and that indicative price moves for any changes in data, market conditions or the value of scheme investments. Therefore, from the company’s point of view, that traditional approach gives you an uncertain price and that is not fundable. We were lucky with our choice of PIC because they understood this dilemma so they knew that they had to somehow come up with this fixed price solution. We made it a bit more interesting for them because we said during the buy-out process we want to put in an ETV exercise as well, but they were very flexible and together we arrived at a solution.

IAN: Had you already started the ETV or had you said we want an ETV at the same time as doing the buy-out?

MARK: We told them that we were definitely going to do a buy-out, but on that route to the buy-out, we were going to do an ETV exercise as well. We knew that we were in a fortunate position with our matching making funding near to buy-out and so the transfer values we could offer our members were very high. There were certain categories of members who were better off with a transfer out through an ETV exercise than from staying in the scheme. For instance,

IAN SMITH: What are the key factors you would attribute for the continued interest in pension buy-outs perhaps over the other de-risking options?

MARK BOWER: There are a growing number of final salary schemes that are closed to both new entrants and future accrual. Once the final salary scheme is in that position, from a company’s perspective, it is just a liability. That liability becomes a growing concern in terms of the value of the scheme liabilities in relation to the overall size of the company itself. Given that scenario, it makes sense for a company to plan over a fairly sizeable period of time to buy-out the liability and get that risk off the balance sheet. I do accept that there is a price to be paid for the buy-out and that is what stops most people doing it. But there is also a price for not doing a buy-out e.g. cash contributions to fund the deficit, high administration costs and ever increasing compliance costs with The Pensions Regulators, etc.

IAN: How would you say the current conditions are given the historic low bond yields? How are they affecting this continued interest? Also, in regards to your deal do you think that you de-risked at the right time in terms of the markets and the impact of various issues such as quantitative easing?

MARK: The point you made about the low bond yields and therefore bond yields being very expensive now is absolutely spot on. We were fortunate as we decided to start planning our exercise a number of years ago. Fundamentally, we were in a situation where we could move quickly if the bond yields got to a point where we thought it was the right time to start matching and entering into swap type


Analysing the Drivers behind the Continued Interest in Pension Buy-Outs

people who just wanted a pension for themselves and didn’t have a spouse yet would get a better deal this way than if they stayed in the scheme which was funded on them plus spouse. There were some significant categories of people who genuinely wanted to buy-out so that exercise had to be captured within the process. We had a take up of roughly 50%.

IAN: Do you feel that the transaction fulfilled your objectives as we are now roughly one year on?

MARK: In terms of achieving our objectives, the buy-out we picked has gone to plan and provided all the benefits we expected. All of our members have been very happy. PIC have delivered on all of their promises and the company has managed to get rid of a historic liability so we can just focus on the business. It is well known that banks view final salary pension schemes as a black hole, so by passing off the risk of our deferred and pensioner members, it enabled us to state that we had a capped liability.

IAN: Based on your experience, what advice would you offer to schemes currently going down the same route that you have gone?

MARK: The first thing is that the company and the trustees have to work incredibly closely together, and you have to genuinely trust each other. The second, based on our experience, is that you need to plan as far in advance as you can and you have to move the scheme into a position where ultimately a buy-out is fundable which does involve many difficult decisions on things such as asset allocation, risk hedging strategies, etc. It also means that the pension scheme has to get used to making decisions quickly and not in 3 months’ time when they next have their trustee meeting because you can miss opportunities. We did our initial hedging back in 2007 and when we pressed the button on the right day for us to start buying swaps and hedging off interest and inflation exposure, that was done because we had hit a target point so we had in place a quick decision making procedure. Although it was pre-credit crunch, the same principals apply. We could have easily missed that opportunity as that window only stayed

open for a few days.

IAN: That is the challenge that a lot of pension schemes have. If they don’t have that speed, it is quite hard to lock in at good rates.

MARK: We had to put that in place and that is part of what you need to work towards. Another bit of advice is that I was very confident with our records and members’ entitlements going into this process, but I didn’t bargain on absolutely everything being taken apart and reworked. For instance, all of our members’ entitlements were recalculated from base and the accuracy of the data really does reflect the price. So when working out your plan to move towards buy-out, it’s really a good idea to make sure that you have bottomed all of your scheme records and data as this will save you a lot of heartache down the line.

IAN: Did you work through the data in-house or is that something that you put out to a data provider?

MARK: We had the data in-house but we put it to experts because it was beyond us how you actually work all of these things out. We just had the raw data and then we had it checked externally.

IAN: Do you think that had an impact on the price you were given for the buy-out, because the quality of the data was better?

MARK: Definitely. It gives a buy-out provider confidence that there is more of a chance of this deal happening because the data is good and they have done all this work on it. They will still do their audit on it, but it tees the thing up to happen right. It also stops you having a nasty shock after the pension provider has done the work on it and comes back to tell you that the data is all wrong and the price is going up.

IAN: Is there any quantification you can put in terms of how much you think this process cost and how much do you think it could have saved you?

MARK: After all of the exercises and the adjustments that had taken place bearing in mind that we had negotiated as fixed a price as we could, the final adjustment to the buy-out price and

we’re taking out £45 million worth of liabilities, which would be significantly more now bearing in mind the way bond yields have gone, the difference in price was £70K which is nothing compared to what it could have been. If that figure had been significantly bigger it would have put the whole funding of the buy-out into question so you could have actually scuppered the whole deal and all the costs that go with that.

IAN: Is there anything that you would have done differently looking back at the entire process?

MARK: No, we were lucky. There were one or two other things that I am really pleased we did. When the buy-out became a real possibility, we looked at whether we had the right actuary, lawyer and advisors on board to take us through a buy-out process. I was surprised that there are not many advisors that have done a buy-out, but we took the hard decision in conjunction with the pension scheme trustees to bring in a specialist actuary who was experienced in buying out and made sure that the investment manager was experienced too. It meant that as issues cropped up, they knew that these issues were solvable as opposed to deal breakers. Having the right team in place before we started that final push was a tough decision to make, but the right one to make.

IAN: Lastly, I was interested to know whether at all you considered doing a pension increase exchange at the same time as the ETV?

MARK: The company and company advisers did but the pension trustees, while they were happy with the ETV because they could clearly see the categories of people that would benefit, they did not want to worry their retired members or give them any difficulties. So the trustees requested that we didn’t do it and as we worked with the trustees quite closely, we didn’t want to upset them so we withdrew the proposal for the pension increase offer.

IAN: I suppose that comes back to what you said at the beginning about making everyone comfortable with the process. We’ve come to the end of the interview. Thank you very much for you time.


As the longevity market develops, trustees and sponsors are thinking seriously about the option of some form of

longevity hedge – whether a longevity swap, a buy-in or a buy-out.

Very often, the circumstances which make such a transaction appropriate come together at the last minute – and the parties then need to move quickly. But, as lawyers within Linklaters’ new Longevity Solutions Initiative explain below, there is a lot that trustees can do even before a transaction is on the horizon.

Proper preparation will help smooth any transaction which does happen – and could even potentially reduce the costs of the transaction. In many cases these actions will also be helpful to the trustees going forward in managing their scheme.

UNDERSTANDING THE OPTIONSAs with any major transaction, it is critical that before deciding to enter into any form of longevity hedge, the trustees understand:• how the transaction “fits” with overall investment & risk

strategy• how it works – legally and practically• what are the risks

This is common sense – but also reflects the requirements of the “trustee knowledge and understanding” legislation, that the trustees have a good understanding of any major contracts relevant to their scheme.

Clearly some of the detailed analysis will depend on the terms of any particular transaction which is proposed, but much of the thinking can be done in general terms even before a transaction is on the table. Trustee advisers should be able to help trustees with this process. One of the practical considerations at the outset may be for the trustees to ask whether they have suitably experienced advisers in place.

Investment and risk strategyTrustees will already be reviewing their investment strategy and risk tolerance regularly. As part of this process, trustees should start thinking about the materiality of longevity risk. Such an exercise will help to provide a more concrete idea of the scale of longevity risk relative to other risks carried by the scheme (e.g. interest rate risk, equity risk). It will also enable

the trustees to assess their priorities in any risk reduction strategy – which will be of benefit to the trustees even if they do not enter into a longevity transaction. Understanding the extent of the risks involved will also help trustees assess the acceptability of the price and the terms available for any longevity transaction.

How it worksThere are now a number of different products in the market. These include traditional buy-outs, buy-ins & bespoke longevity insurance or derivatives. Other variations are also available e.g. synthetic buy-ins or index linked longevity swaps.

All these transactions work differently. Trustees need to understand their different characteristics and, in particular, to understand the risks associated with each kind of transaction. Trustees also need to understand the roles and concerns of the different stakeholders (including the reinsurers who will, in many cases, ultimately carry the economic risks). Particular issues to consider might include the following:• How do the different kinds of transaction actually work?

What are the obligations of each party?• How do the different kinds of transactions work

economically? How are prices reached? What is the upfront cost and/or the on-going cost?

• What risks are being transferred? Does the transaction primarily transfer longevity risk (e.g. a longevity swap)? Or is investment risk also transferred (e.g. a buy-in)? What about the risk on the sponsor covenant – how is this affected?

• How long will it take to enter into a transaction?

The risks of the transactionLinked to the process of understanding how the transaction works, is the issue of understanding the risks which the trustees will bear. For example:• The trustees will be taking on counterparty risk in any

transaction. They will want to understand what kind of entity is the counterparty? What safeguards exist if that counterparty becomes insolvent? Are there options which can improve that position? Longevity swaps will generally be collateralised, which should reduce the insolvency exposure. On buy-ins, in the past, there had been a move towards structured buy-ins which included a measure of protection against insurer insolvency. Those structures currently appear less popular.

WHITE PAPERThe Practical Side of Reducing Longevity Risk

ISABEL FRANCE PartnerLinklaters

ANNA TAYLOR Managing AssociateLinklaters

MADHU JAINCounsel Linklaters


• The detailed documentation for any transaction will set out the risks which are being transferred and retained. Although the detail will be transaction specific, trustees can start to think about the following key areas:

- Given the Government’s recent announcement on Guaranteed Minimum Pension (GMP) equalisation, will the trustees look to transfer liability for equalised GMPs?

- Are there any benefits under the scheme which are unusual and which providers may be unwilling to take on?

- Are any changes to the scheme likely which may affect the transaction? For example, if there is a plan to carry out a pension increase exchange exercise, it will be necessary to consider carefully how the two projects “fit” together (and in particular, how pension increases will be dealt with in the longevity hedge).

- The issue of discretionary practices is always one which will require discussion. Providers generally require that their commitment is fixed, and not linked to the way in which trustees actually exercise discretion. Sponsors, by contrast, will generally not wish to convert discretionary benefits to guarantees. Some work can usefully be done to identify the key areas of discretion, identify trustee practice and think about how it might be translated into a provider obligation. This analysis will also be useful to trustees more generally in terms of identifying and reviewing any discretionary practices.

- Trustees may also want to think about the pros and cons of “all risks” deals, a new form of buy-in contract where – for a price – the provider takes on all risks (including the risk of unidentified beneficiaries coming forward) rather than a specified set of risks.

MAKING THE TRANSACTION HAPPENThere are also a number of areas where trustees can prepare practically for any proposal.

Data cleansingIt is well known that, the better the data, the keener the pricing that is available – and in some cases this can make a significant difference. Additionally, other than in “all risks” transactions, trustees will generally remain responsible for data errors.

The Pensions Regulator has issued guidance on record keeping, including targets for trustees to achieve – and so most trustees will already have projects in hand to review and improve the quality of the data they hold. It will be helpful to discuss with advisers whether there are any additional checks that can usefully be done which would assist specifically with longevity transactions.

A review of data may show that there are particular groups of members for whom data issues are most acute. If so – as well as considering any special projects to improve this – trustees can also consider how to factor such members into any longevity

transaction. For example, it may be appropriate to exclude them until the data is improved.

Data protectionIt is a legal requirement to ensure that scheme members have been told about the purposes for which their data may be used. Often the disclosures made are in narrow terms – and in some cases will not have been issued to all members.

Trustees should review their data protection disclosures from time to time – and if necessary update them. As part of this, they should consider whether the disclosures are wide enough to encompass disclosure of data to a longevity hedge provider (and to reinsurers).

Of course, once a shortlist of prospective counterparties has been identified, there will be a need for non-disclosure agreements and any transaction timetable needs to factor in sufficient time for negotiating these. However, disclosure to members is a separate requirement.

AdministrationTrustees should identify any additional administration requirements associated with particular transactions. For example, if there is to be a collateralised longevity swap, there will be a need for the administrator to monitor actual longevity experience against the agreed longevity assumptions – a wholly new process. Putting appropriate processes in place can take some time – and will involve some cost – which needs to be factored in.

It is also important to understand who will be responsible for administering benefits after the transaction – and whether the trustees have any particular requirements. Normally the trustees would continue to administer benefits on a buy-in. If the trustees want the provider to take this on at this stage (it will usually be a pre-requisite on moving to a buy-out), this needs to be factored in at an early stage in discussions (and may limit the available providers).

Deed and RulesClearly, trustees need to ensure they have power under their Deed and Rules to enter into the proposed transaction. In most up-to-date documentation, this should not cause any difficulty. However, if there is any question mark, the most straightforward approach will be to amend the documentation to put the matter beyond doubt.

ConclusionPutting in place preparatory work now will help to ensure a smooth longevity transaction and should also help to manage the costs of such a transaction.

Isabel France, Madhu Jain & Anna Taylor are all lawyers in Linklaters’ Longevity Solutions Initiative. Linklaters lawyers have acted on the leading longevity transactions in recent months including the ground-breaking Uniq deal.

The Practical Side of Reducing Longevity Risk

TO READ MORE FREE REPORTS VISIT:

www.clearpathanalysis.com

© Clear Path Analysis 2012 Information in this report is based on current understanding of legislation at the time of print.

Grant Thornton - UK Pension De-risking: Longevity Hedging & Buying Out 2012

Economy & Finance

Transcript of Grant Thornton - UK Pension De-risking: Longevity Hedging & Buying Out 2012