John Fitzpatrick among panellists who are discussing the implications of deflation for trustees, the future of the longevity market, their attitude to quoting for smaller schemes, and the affect of annuity Costs of Solvency II.
The panel
Chairman: David Stewart, partner, Lane Clark & Peacock
Stewart is a member of LCP’s specialist buyout advisory team and since joining LCP he has managed the buyout of over £400m of liabilities including full buyouts and partial buyouts of pensioners.
Andy Reed, director, defined benefit solutions, Prudential
Reed is responsible for innovation within Prudential’s Defined Benefit Solutions, developing new routes to market. Reed led the transaction to secure the first insured £1bn pensioner buy-in (with Cable and Wireless) in September 2008.
John Smitherman-Cairns, corporate development director, Lucida
Smitherman-Cairns is a member of the executive team responsible for the development and delivery of Lucida’s pension de-risking offering to the UK market. He is a qualified accountant and joined Lucida from Prudential where he was head of corporate finance.
John Fitzpatrick, partner, Pension Corporation
Fitzpatrick joined Pension Corporation in 2006. Prior to this, he was a member of Swiss Re Group’s executive board and executive board committee. He served Swiss Re as the company’s chief financial officer, head of life & health business group and head of financial services.
Hugo James, sales development director, bulk annuities, Legal & General
James has overall responsibility for Legal & General’s sales in the bulk annuity market. He is focused on helping develop solutions and structures to support larger schemes seeking to de-risk.
Nick Johnson, head of defined benefit risk, Aviva
A qualified actuary, Johnson has headed up Aviva’s bulk annuity proposition since January 2006. He is currently working with a number of trustees bodies to develop innovative solutions to manage the transition to insured benefits.
Myles Pink, business development director, Paternoster
Pink is responsible for new business generation, negotiation of commercial terms, devising product structures and trustee/adviser relationships at Paternoster. Pink advised on the initial fundraising for Paternoster in early 2006.
STEWART: The UK has just moved into the first period of deflation for many years. What are the practical implications of deflation for trustees preparing for a buyout?
REED: While the increases to most occupational DB pension benefits are linked to inflation, this link is broken when inflation turns negative (becomes deflation). Many schemes who covered these benefits by investing in assets whose payments and value were themselves linked to inflation, will find that in 2009, while these assets have decreased with deflation, the benefits they are covering remain level, leading to a decrease in the level of funding. Some buyout providers may not offer a floor of 0% (leaving trustees with an uncovered liability), or may charge a premium for the extra risk they are taking on. Trustees therefore need to be aware of the type of assets they hold, whether or not they contain a hedge against the deflationary risk (usually options/swaps are required to provide the appropriate hedge) and whether these assets may be transferred across to the insurer via in-specie asset transfer. Schemes looking to undertake a buy-in should consider whether or not to insure the deflation risk with the insurer, or purchase appropriate assets within the market (note the inflation swap market is quite illiquid at this current time).
SMITHER MAN-CAIRNS: Most pension scheme benefits do not deflate. Benefits can only increase with inflation. Hence insurers taking on pension scheme liabilities need to hedge inflation with a floor of zero (and often with a cap of 3% or 5%). In today’s low inflation/deflation environment, the cost of hedging this risk increases. There is also limited availability.
Trustees of schemes having inflation linked benefits will need to work with insurers to address this lack of availability of hedges, for example by purchasing LPI swaps over a period of time so that by the time the trustees are ready to buyout, the scheme has a portfolio of swaps which can be passed to the insurer.
FITZPATRICK: Insurers will insure pension scheme benefits as agreed in the contract of insurance and this includes a floor of zero on RPI. Costing this is complex as insurers will consider inflation expectations over the full 20-50 years, not just over the next few years. It is better if trustees have some protection against inflation, even if this is not perfect protection, because over the long term we will see inflation – not deflation.
JAMES: Negative inflation is particularly relevant for LPI increasing pension benefits with a 0% floor, where deflation has resulted in this floor biting. Deflationary fears have resulted in liquidity in the LPI swap market drying up and prices increasing significantly. Insurers are therefore currently not able to pass significant amounts of LPI risk on to the capital markets and as a result their appetite for pension schemes with unhedged LPI exposure has decreased.
Where a scheme has existing LPI swaps in place, we are able to novate these swaps over to Legal & General to ensure the buyout can proceed. Where a scheme does not have the required LPI swaps in place, trustees may see better “value for money” securing benefits on a zero, or fixed increase basis with the ability to add indexation at a future date.
JOHNSON: A key consideration for trustees for all buyout transactions is to ensure that the benefits they think they are securing actually reflect the benefits provided by the policy. Inflation linked pension increases is an obvious area where a previously unthought of/unlikely set of circumstances and unclear policy documentation could lead trustees to be ‘under insured’.
PINK: When pension benefits are linked to inflation, the scheme rules refer to pension “increases” or “escalations”. In practice, trustees of UK pension schemes will not reduce pension payments in times of deflation and there is therefore an implicit floor in the inflation-linkage. When trustees insure the benefits of a pension scheme any ambiguity or subjectivity in the benefit structure needs to be clarified before codifying it in the insurance policy. Trustees preparing for buyout should ensure their scheme rules are clear on the application of a floor to inflation-linkage and ensure that insurers are including the cost of providing this floor in the premiums they charge.
STEWART: Babcock recently announced the first longevity swap by a UK pension scheme. In response, some commentators are predicting that the longevity market will grow rapidly while others are more sceptical. How do you think the longevity market will develop for the rest of the year and what are the main obstacles to its development?
REED: There is clear interest in longevity only insurance and we expect further deals to follow the Babcock announcement. However, longevity swaps are less likely to be a high volume solution compared with buy-ins, due to the costs and complexities involved in these swap deals. We therefore expect to see a few, larger schemes with high proportions of pensioner liabilities to be most interested.
There are two key considerations that may provide obstacles to this new market. The first is that longevity swaps only hedge against longevity risk, whereas buy-in solutions also mitigate investment risk and inflation risk as well. The second is that there is potential to become locked in to a swaps solution, which may prove restrictive when schemes ultimately look to secure a buy-in or full buyout at a later date. Trustees should carefully assess the structure of any longevity swap before transacting.
SMITHER MAN-CAIRNS: Longevity risk is a key risk facing the UK and for selected schemes, longevity swaps may represent a sensible step along the path to ultimate pension fund de-risking.
However, we would caution against over playing the potential role of this product as a solution for all schemes at present given uncertainties over the ultimate market capacity and the complex nature of this product. We would also highlight there is a cost for longevity risk transfer which is significantly subsidised by asset spread in buyout or buy-in structures. This subsidy is not available in a straight longevity swap transaction.
FITZPATRICK: With funding levels having taken a hit, many schemes are looking to protect against increasing longevity while retaining investment exposure in the hope of recouping losses. In this environment, longevity insurance has increased in popularity. Different forms of longevity protection are available. Protection through an insurance contract has advantages. It operates in an FSA regulated environment, is covered by the Financial Services Compensation Scheme, protects the specific members of the scheme and is unlimited in duration. The main obstacle to date has been “portability” – can the trustee switch cover or cancel the cover. This has now been addressed and demand will grow quickly.
JAMES: The longevity market is still in its infancy and while a large liquid market in longevity will benefit both pension schemes and insurers in the long term, it is unlikely that this market will be quick to develop. Individual transactions are bespoke and require significant negotiation between longevity providers, sponsors, trustees and their advisers before they can be completed. This complexity and the currently limited number of market providers mean that the longevity risk market is unlikely to grow rapidly in the short term.
It is likely the longevity market will grow to compliment the buyout market rather than being a competitor, as longevity only products do not protect schemes against investment risks which have proved to be far more volatile within schemes.
JOHNSON: The first longevity swap has been on the horizon for a number of years, and it was only a matter of time before a group of trustees took the ‘leap of faith’ and undertook a transaction. While the intellectual argument for such swaps is relatively easy to be made as part of an ongoing risk management strategy, there are a number of practical considerations which significantly complicate the use of longevity swaps.
As with any synthetic investment, I’d consider there are two main causes for concern, apart from the obvious counterparty risk: the first being sheer complication of how they operate in practice, and ensuring that they do hedge the risk effectively; the second, being what value (if any) the contract would have should the trustees need to realise assets.
PINK: A pension scheme can insure against principally two risks: longevity and investment. Current uncertainty about the extent to which investment strategies might perform in the future has led to increases in the cost of this component. Demand from pension schemes for a product that strips out investment risk insurance and focuses more on longevity is a logical reaction to the impact that widening corporate credit spreads has had on annuity providers’ reserving policies. Longevity swaps that are tailored to a defined group of members of a specific pension scheme are developing in sophistication.
There are two main obstacles: longevity risk is long-dated and the impact of that risk today appears small, so a swap may often appear expensive and longevity-only insurance is only a partial solution in the de-risking of a defined benefit pension scheme.
STEWART: With fewer schemes requesting buyout quotations in 2009 than last year, are you currently more willing to quote on smaller schemes? What is the minimum transaction size you will quote upon?
REED: We do not have a specific minimum transaction value and will assess each case on its own merits. With many large schemes struggling to afford large one-off transactions, there may well be an opportunity for smaller schemes to take action now. It’s important to note that for quotation purposes, a scheme’s ability to transact is more relevant than the size of the deal. Trustees that have made shrewd preparations (such as completing a data cleansing exercise and moving into appropriate assets), will find themselves in a stronger position and better able to secure the insured solutions that help them reduce their risk exposure.
SMITHER MAN-CAIRNS: We evaluate each new potential opportunity on a case by case basis looking at a range of factors including corporate and trustee buy-in to the affordability, process and scale. For all serious enquiries that meet our selection criteria, we will attempt to provide a quote on a timely basis. However, given the on-going interest in this area and our focus on developing customised risk transfer solutions, we need to manage the number of opportunities we take on and tend to focus on the larger end of the market.
FITZPATRICK: Pension Corporation has completed transactions varying in size from £10m to over £1bn. We have seen an increase in serious demand across the board – large schemes and small schemes. The economic situation has delayed completion of some buyouts and buy-ins but sponsors and trustees are more engaged than ever before. Companies want to remove legacy hurdles to developing their businesses, overseas investors want to restructure their UK operations, and trustees want to bring security and stability to member benefits.
JAMES: Legal & General remains committed to quoting on the broadest spectrum of buyout business, ranging from schemes with less than £1m of liabilities up to schemes with in excess of £1bn of liabilities. One of our key strengths is providing buyouts to smaller schemes. In 2008 we wrote close to 200 policies with the average buyout premium being approximately £10m.
JOHNSON: We have seen the number of quotation requests reduce, but I think it’s yet untested as to whether this results from a reduction in speculative requests that were unlikely to transact in the short term. As for transaction size, Aviva has always considered scheme size as only one of a number of factors that effect the decision to quote. Last year for example we transacted around 30 ‘small transactions’ and fully intend to continue this strategy going forward. It’s fair to say that we wouldn’t rule any scheme out on premium size alone.
PINK: No, we are tending to focus on complex solutions that require flexibility and innovation; these solutions are often being sought by large schemes, typically in excess of £25m.
STEWART: There has been speculation that annuity costs might increase by up to 20% due to the impact of stronger reserving requirements for insurers under Solvency II . Do you agree with this view? How else will the introduction of Solvency II affect pension schemes in the UK?
REED: The outcome of Solvency II is still uncertain as we are still in the consultation period for the implementing measures for this directive, but there are approaches being discussed that would have this type of negative impact. Pension schemes are not covered by the legislation but it is feasible that there would be some kind of future harmonisation which could have significant implications.
SMITHER MAN-CAIRNS: Although the Solvency II Directive was officially adopted on May 5, 2009, this is a “framework” Directive, which confines itself to the principles to which the new system would be subject. More detailed implementing measures will then need to be set down by the Commission which will be done following consultation with key stakeholders. A considerable level of uncertainty remains as to how Solvency II will affect bulk annuity writers in the UK.
In a recent speech, the Chairman of the FSA, Adair Turner, said: “The new Solvency II capital regime needs explicitly to recognize that there is an illiquidity premium in bond yields...”
Given the importance of this issue, we remain optimistic that the final regulation will recognise Lord Turner’s comments and we continue to work with the Association of British Insurers to that end.
FITZPATRICK: Solvency II will put in place a comprehensive and consistent risk framework for all insurers across Europe and this has to be welcomed. Pension Insurance Corporation has an existing strong and comprehensive risk-based approach to capital management, an approach we have been following since we started the business. This is reflected especially in conservative investment portfolios and credit default assumptions. While higher capital may be required under Solvency II, it is also likely that new means of risk transference will develop to the benefit of pension insurers, such that capital requirements are controlled and annuity costs do not rise as significantly as some market commentators predict today.
JAMES: If the recent EU directive on Solvency II is implemented in its current form, it is likely to significantly increase the cost of annuities. We believe that the one-size fits all approach of Solvency II is not appropriate to the UK’s annuity market and that a more appropriate solution will be found before Solvency II is implemented. However, the risk of regulatory change cannot be hedged so trustees who are in a position to enter into a buyout now should consider acting sooner rather than later, as should regulatory uncertainty continue then prices may increase as the implementation date for Solvency II approaches.
JOHNSON: It goes without saying that any additional costs for insurers will at some point be reflected in increased annuity prices, and increased capital is a significant factor in the pricing of annuities. That said, it is early days yet, and the extent to which Solvency II actually increases capital costs for a given insurer will undoubtedly be something that emerges over time.
PINK: Current proposals mean that the implementation of Solvency II will result in a marked increase in annuity costs. The level of the increase is difficult to gauge as insurers are yet to obtain approvals for the models they intend to use to evaluate their capital requirements, but increases of 20% are possible. The model approval process is something which could take several years and the likely increase in cost will become clearer over this timeframe.
Although defined benefit pension schemes share many of the same risks as insurers, they are exempt from Solvency II requirements. Therefore the most likely impact on UK pension schemes will be a restriction in their ability to de-risk the scheme through the use of insurance due to the increased cost of doing so.
