To buy-out or not to buy- out? That is the question...
12th October, 2022
This has been a very turbulent month for UK pension schemes, a tragedy of Shakespearian magnitude – hence the title. However, for many it may have been transformational in terms of their funding against a gilts-based funding lens.
Those invested in balanced non-gilt strategies, will have likely had a significant funding increase. The losses on the growth portfolio heavily outweighed by the reduction in gilt-based liabilities. Those with lower liability driven investment (LDI) hedging and a well-collateralised strategy (with the right LDI manager) will also have had a massive improvement in funding.
Therefore, as I look at my buy-out tracker telling me I am almost there, should I dive in? Like many things that appear too good to be true, I think you must proceed with caution.
The first issue is basis volatility. Whilst you have reached a great position on paper, how do you lock this in other than doubling down into a dysfunctional gilts market and/or selling growth assets, if still invested in those, at a market loss alongside schemes who must sell to meet collateral calls.
The second issue is preparedness. When you approach buy-out you would normally do so having prepared months or even years in advance. You need to understand your data, benefits and any legal issues that may be lingering around. If buy-out has not been on your radar, it would be risky to assume you can just walk to the market without having addressed these issues. Even if you were to have any takers, the price could increase substantially when you address these issues, which leaves you with a problem of how to close the new gap.
The third and crucial issue is the insurer appetite. The struggles faced by the pension industry are certainly not a trade secret. The market ripples will have been felt by insurer portfolios and also watched by the risk officer at the pricing desk. I think it is wrong to assume in this new environment that pricing will simply continue on a consistent basis. The insurer makes money on an asset basis, and not via deal volume. This means they may have to write more deals to hit their budgets in a higher-yield environment. The cost of this may impact both their appetite at the small end, and their pricing margins with every aborted deal having a heavy labour cost.
The fourth, and slightly ‘out there’, consideration is what other options may be available in a higher yield environment? The drive to risk transfer has primarily been driven by record low gilt yields. If this becomes a new norm, is buy-out actually the right step for a well-resourced and secure sponsor? I would imagine alternative long-term low dependency options could thrive in a higher-yield environment. It is always helpful to look one step ahead.
My view is that trustees’ number one priority right now should be managing their scheme through these turbulent times, and ensuring they protect member benefits and manage cash flow risks carefully (which is a bigger issue in a higher yield environment). Trustees should focus on aligning strategies sensibly working through the market turbulence. Following this the buy-out market is not going away, and approaching market in an orderly manner when the world has calmed down seems a more prudent step, and prudence is the name of the game.