Bulk logjam – breaking the mould in bulk annuities

The financial crisis may have made defined benefit schemes’ deficits rocket but many companies trying to offload their liabilities are finding their hands are tied by a pensions buyout market that has all but ground to a halt.

Pension Insurance Corporation’s record-breaking £1.1bn Thorn deal in December may have created a veneer of activity but it was also the only significant transaction of the quarter. Despite a bright start to 2008, just £7.5bn of buyout deals were ultimately completed, someway below the £10-12bn many had predicted at the start of the year.

Jarrod Parker, employee benefits director at Alexander Forbes, says demand is stronger than ever but a combination of falling asset values and hardening pricing has served to effectively close down the market for most sponsoring employers.

“The volatility we have seen in the markets over the past quarter has served to highlight the attractions of buyouts but the widening of liabilities means that for many companies it is now just out of reach,” he says. “Some companies will never have the money to fund it and will just have to run the scheme off until the last member dies.”

The extent of this pent-up demand is clear. Paternoster reports that it is quoting on £1bn of business a week, while both Prudential and Legal & General say that they have seen a significant increase in both the number and size of deals they have been asked to quote on.

Corporate advisers note that clients are largely falling into three camps. The most common of these groupings are firms that are committed to a buy-in of pensioner liabilities, if not a full buyout, but are finding the gap between what they are willing to pay and what insurers are charging difficult to bridge. Intermediaries say there are also a significantly smaller number of clients that are close to being in a position to transact but are trying to time the market and a growing minority of companies, typically in a restructuring phase, which want rid of their liabilities at any cost.

However, deal flow has been so low because pricing in the current market climate is so difficult. Some of the pension schemes’ investment grade corporate bond holdings that are typically used to fund the transaction through an in specie transfer have fallen by as much as 40 per cent over the past year, while there are also concerns that the flight from risk assets has resulted in gilts becoming hugely overpriced.

Andy Reed, director of DB solutions at Prudential, says: “Spreads on corporate bonds have moved out significantly and the question is how much of this is down to default risk and how much to illiquidity.”

Clive Wellsteed, a partner at Lane Clark & Peacock, says that either way this is making discussions between sponsoring employers and insurance companies about pricing all the more complex as the two parties try to find common ground.

“The key challenge is to value the bond portfolio and if you cannot agree then it is a great source of uncertainty. The illiquidity of the corporate bond market at the moment is exacerbating the problem because if a particular corporate bond has not been traded for some time it is difficult to get a valuation that both the trustees and the insurer agree on,” he says.

The insurers are also less keen than ever on taking on equities and property as payment and even cash has lost its appeal due to low deposit rates and the need to match liabilities. Where options are held, there are also legal issues to be resolved around whether they can be novated over.

The insurers themselves have been hit by their large exposure to falling asset values, which has led to many revising their pricing as their capital adequacy ratios have come under pressure.

Reed admits that Prudential may have appeared to have dipped in and out of the buyout market last year, but stresses that this was because it was being selective and did not want to get dragged into a land grab bidding war as new entrants came in. (See box below)

“The market was very busy this time last year and it was all about price as we saw with the online auctions. There was some very aggressive pricing in the first quarter in particular but now the focus is on quality and exposure,” he says.

This may well be music to the ears of shareholders of the insurers but it undoubtedly makes the trustees’ and their corporate advisers’ decision about whether to proceed with a buyout all the more difficult.

Looking at buy-ins, Wellsteed says that in the first three quarters of 2008 the decision was often fairly straightforward as the prices insurers were charging to take on this risk was often lower than the level of liabilities the trustee was already funding.

However, in the last quarter as gilt yields moved down sharply and insurers became more risk averse this discount moved to a premium of around 2 per cent in many cases, pushing it out of the reach of a lot of companies.

“It was a bit of a no-brainer. Clients got a substantial risk reduction and no increase in liabilities on their next actuarial valuation. Now this will increase the overall deficit in the scheme at a time when companies can least afford it,” Wellsteed adds.

Mark Wood, chief executive at Paternoster, says that the £1bn of business transacted in the fourth quarter was against around £6bn of quotations proposed, underlining the fact that some firms are putting back the decision in the hope of a market recovery.

He does expect the market to improve this year but admits volumes will take some time to reach the levels seen in the first three quarters of 2008.

“There is a definite pause going on and a number of companies have deferred deals but there is still substantial demand and we could see something of a logjam in the second half of the year,” Wood notes.

In the meantime, a lot of companies are considering alternative solutions. Many intermediaries, such as Alexander Forbes Financial Services, have developed strategies that aim to get clients into a position to wind-up their scheme within five to 10 years. Buy-ins of pensioner liabilities rather than full buyouts accounted for most of the transactions in 2008 and experts expect this to remain the case in 2009. Lower cost measures, such as offering enhanced pension transfers are also widely touted to grow in popularity.

However, there are tentative signs that insurers are looking at different ways of structuring deals to make them more affordable.

James Staveley-Wadham, a senior consultant at Towers Perrin, says: “This year we need more innovation over how to close the gap in pricing and we would like to see a collaborative approach.”

He says using a form of asset recapturing is one possibility where if assets deliver performance above a certain level, this is used to fund the difference where a buy-in is priced at a premium.

Wood points to the phased buy-out his company agreed with Scottish drinks firm Morrison Bowmore Distillers last year as a further alternative.

Under the arrangement, Paternoster transferred the scheme’s assets over and secured members’ benefits but payment is to be phased with the deal structured in such a way as to protect the insurer in the event of the company’s failure.

“We did the deal with payments deferred over four years effectively and this may be a model that others will follow,” he says.

Another area where innovation is needed is around the provision of buyout options for both the very smallest and the very largest schemes. The vast majority of the business transacted last year was in the £100m-£1bn range.

Staveley-Wadham says companies with schemes with £5-10m schemes are currently not well-served and many of these are the types of firms that are restructuring and desperate to get their liabilities off the books at no matter what cost.

On the flipside, multi-billion pound schemes are also struggling to find insurers with sufficient capital or the appetite to take on liabilities of this size.

Opinions vary on the viability of a syndicate approach, similar to the Lloyd’s of London model.

Staveley-Wadham says: “The whole idea of syndication feels quite difficult because the companies have to be comfortable working alongside each other and you feel someone has to take the lead. There are a lot of barriers, such as brand, group compliance and how flexible they are willing to be as providers need to be able to act quickly.”

Reed is a little more optimistic, confirming discussions have taken place and a lot of research is being carried out on possible models.

However, he adds: “I can see it happening and there is no reason why it couldn’t operate like the Lloyd’s market in theory, but it is very hard to transact with two or three other companies and get the contracts aligned.”

The only concern if this were to become a reality is that the smaller end of the market could be squeezed even more as insurer’s capital is tied up in the big-ticket deals. Demand for buyouts already vastly outstrips the capital available, which means that clients with DB liabilities will need the help of their corporate advisers more than ever over the coming year.

SPOTLIGHT:Who is left in the market?

Despite the impact of the market turmoil on many providers’ balance sheets, the number of players in the pension buyout market has remained more or less constant.

The volumes of business they are pursuing and their ability to fund it is altogether less clear.

Consultants report that Paternoster, which accounted for the lion’s share of business last year, and insurance giants Prudential and Legal & General have been the most consistently active providers in the pitching process. UBS and Aegon’s tie-up has only operated on the periphery and Goldman Sachs has completed just one transaction, albeit a large one with the £700m Rank Group partial buyout back in February. Similarly, Norwich Union has done little business since its £350m deal with Friends Provident last May, while Synesis Life was taken out of the equation when it was taken over by rivals Pension Insurance Corporation in November.

However, Zurich Life surprised many by entering the market in December and AIG is still quoting for business, contrary to many reports.

Paternoster chief executive Mark Wood says: “By transaction volume the market has thinned out a bit but this is not a huge problem for trustees as the core are still very active.”

That said, Lane Clark & Peacock partner Clive Wellsteed warns that insurers face ongoing issues around the availability of capital and regulatory pressure to increase reserves.

“Going forward we expect the number of players to reduce over the medium-term,” he says.

Pension transfers to come to the fore

The lack of affordability of both full buyouts and buy-ins for many companies is expected to result in an upsurge of pension transfer business.

After a sponsoring employer that is keen to manage its defined benefit liabilities has taken the obvious steps of closing the scheme to future accrual and adopted a more sophisticated liability-matching investment strategy, offering deferred members enhanced transfer values can be used as the next stage of a managed wind-up plan.

Parker stresses that enhanced transfers must also offer fair value to the member. “Enhancements must be individually calculated and must be sufficient to put the member in a position where an IFA could advise that they are well positioned to match or exceed the DB benefits they are giving up.”

Ideally, the employee will receive independent advice from an intermediary unconnected to the consultants acting for the employer to remove any conflicts of interest.

The Institute of Actuaries has been at the forefront of the arguments against the use of cash ‘sweeteners’ and the FSA is expected to focus on this contentious area in the next phase of its thematic review into pensions transfers next year.

For many high earners, however, the attraction of pension transfers is likely to grow with the deepening recession set to result in more companies failing. John Lawson, head of pensions policy at Standard Life, points out that with the Pensions Protection Fund capping compensation at £27,700 a year, executives at firms such as Lehman Brothers risk losing out massively.

“This is likely to grow as an advice area next year. Many high earners that will not have their full benefits protected by the PPF may feel that transferring out is the lower risk option,” he says.