Published: April 01, 2012
In recent years, full scale pension buyouts have been rare despite an increasing corporate focus on the pensions ‘endgame’. Yet innovative new approaches to buyout may prove more tempting for treasurers and CFOs.
Over the past decade there has been a substantial increase in the cost of defined benefit (DB) pension schemes as a result of rising longevity, a more demanding regulatory environment, and the combination of falling equity prices and lower interest rates. The result is that DB schemes are now entering their own phase of retirement and, although the death of DB may not be upon us quite yet, it is clear that the end-game has fast risen to the top of the agendas of many treasurers and CFOs of companies with significant pension obligations.
In search of a solution, some sponsoring companies have turned towards benefit re-design, while an increasing number are closing their schemes completely. Recently, Shell – one of the last bastions of DB provision within the FTSE 100 – announced that it too was to close its scheme to new members. Yet closing a scheme does not end a company’s obligation to pay its previously accrued liabilities – which means that the risk management burden remains. Certainly, there are serious implications of unmanaged DB pension risk, which can impact the sponsoring company’s core business – affecting its credit rating, share-price, ability to attract capital and even its contracts with clients — with significant knock-on effects for shareholders and scheme members.
In the worst case, DB pension liabilities may be so large and volatile that they endanger the entire financial viability of sponsoring companies. One only needs to look at the FTSE 100, where no fewer than 10 companies now have pension liabilities greater than their market capitalisation, to realise that this is a very real threat.
It is here that pension buyouts — which enable sponsoring companies to pass their pension risk over to an insurance company, at a cost — could potentially offer a way out. Yet, despite the theoretical benefits of a buyout, very few have been completed in the market to date, as insurance companies struggle to persuade treasurers and CFOs of their value. In this respect, the emergence of a new approach to pension buyouts – aimed at making transactions more affordable for sponsoring companies – may help.
Given treasurers and CFOs’ anxiety about the impact that DB pension risk may have upon the financial viability of their company, the actual number of buyout transactions since 2007 (when they seemed to be taking off) has been minimal. Indeed, since then, the market has witnessed only £25bn of business — the equivalent of roughly 2.5% of the total value of DB liabilities sitting alongside the balance sheets of private UK companies — and that figure includes buy-ins (bulk annuities).[[[PAGE]]]
To explain the reluctance among treasurers and CFOs to move this volatile risk off their businesses’ balance sheets, I would suggest that there are five key barriers to buyout:
1) The cost barrier
For those treasurers and CFOs considering transacting, a major obstacle to date has been the absence of economically attractive solutions. On an IAS19 basis, buyouts have commonly been priced at about 140% of the valuation of a scheme’s liabilities. Even where a pension scheme is fully funded to IAS19, it is understandable that most CFOs have been reluctant to pay a 40% premium to an insurance company to remove their pension risk, especially as this cost will be an immediate hit to the sponsor’s P&L.
2) Cash flow issues
In recent years, schemes have experienced significant investment losses as a result of the volatile economic environment. The prospect of funnelling significant amounts of cash into a pension scheme to enable a buyout has therefore become less appealing – with projects offering a more obvious short-term return on investment taking precedence. In trying economic times, justifying an investment in more efficient technology, for instance, is often easier than justifying a transaction to remove a long-term, uncertain obligation.
3) Not the time to transact
The cost of a buyout is intrinsically linked to the pension scheme’s current funding measure, as well as the position of the scheme with respect to the markets. In 2008 and early last year, pension schemes failed to exploit opportunities to lock in improvements in funding levels by removing risk. Many have slipped back into deficit or seen their deficit increase since, as economic volatility — including a struggling FTSE and low AA bond yields — reduced pension scheme assets and increased already substantial pension liabilities. In such an environment, there is naturally caution and a reluctance to transact.
4) A lack of board-level incentive to transact
Pension liabilities are a complex and long-term obligation and too many boards of sponsoring companies have not completely understood the problem. This has not been helped by a lack of corporate disclosure on the exact nature of the risk at hand. While 95% of the FTSE 100 detail their key enterprise risk exposures within their annual accounts, only a handful of companies do the same with DB pension risk, despite the fact that it may constitute one of the largest risks faced by the business. And this lack of disclosure means that pension risk management still struggles to make it on to board-level agendas.
5) A lack of understanding about the exact nature of the risk posed by schemes
Undeniably, scrutiny and management of scheme risk has improved in recent years. But there is still a way to go. Analysis is often out of date and presented in a way that is hard to get to grips with, particularly since board members of even large companies may have had little exposure to the issues presented by pensions. And without an understanding of the true nature of the risk they face, analysing and engaging in effective de-risking transactions is almost impossible.
For buyouts to fulfil their potential to offer a genuine solution to the DB problem, it is clear that the issue of price must be addressed. And, in order to do this, untangling the economics of an insurance buyout is essential. [[[PAGE]]]
Typically, buyout costs are around 140% of the IAS19 value of a pension scheme’s liabilities (see Figure 1) — combining the insurer’s best estimate of the value of the liability and, about, a further 20% which represents the insurer’s profit. Insurance companies treat this 20% profit as part of their regulatory capital. Additionally, the insurer must put up around another 20% of capital as equity, totalling 40% of capital to back the 120% liability. In other words, the scheme and sponsor provide around half of the insurer’s regulatory capital, with the insurance company itself putting up the rest.
For CFOs, this raises an important question — if the buyout premium contributes half of the insurer’s regulatory capital, why not consider making an equity investment to recapture all of the insurance profit? After all, this approach mirrors the captive solutions used by many large companies to manage other risks (such as property and casualty). This approach would potentially reduce the cost of buyout by allowing the sponsor to capture some, or all, of the profit that would otherwise be paid to an insurance company.
However, on closer inspection, using a stand-alone captive would mean consolidating the pension liability on the sponsor’s balance sheet which is not an ideal solution. There would also, at least at the beginning, be no transfer of risk.
Long Acre Life – a new insurance initiative focused on delivering buy-in and buyout solutions – has been created to allow companies to secure the economics of a captive without the disadvantages that come from consolidating the risk. The framework is highly flexible but the essence is a mutual solution, giving a more affordable route to buy-in and buyout – with the potential to reduce the cost from 140% to around 120% of the value of IAS19 liabilities.
There is no alchemy in this. While it does reduce the long-term cash cost of buyout, as well as minimise the immediate P&L impact, companies must still find the cash to invest upfront to enable their participation in the profit-sharing element. That said, sourcing this cash may now be less of a barrier than it was previously. Indeed, companies’ cash flow has grown 40% since the depths of the financial crisis [1], which means CFOs are seeking out opportunities to put shareholders’ funds to good use. And the opportunity to remove a volatile risk in return for an asset on the balance sheet offering a stable annuity-based income appears to tick this box.
Long Acre Life also tackles the problem of transparency. With this approach all assumptions, transactions, risks and rewards are visible and shared among stakeholders (the sponsor, the scheme and any outside investors). Crucially, there are no black boxes. And with the right technology (Long Acre Life uses PensionsFirst’s PFaroe, for instance), CFOs and trustees have easy access to up-to-date and accurate information about scheme liabilities, assets and risks, at the click of a button. The result is that all parties can make timely and more efficient decisions about when to transact.[[[PAGE]]]
And this leads us to the final hurdle – timing. It is fair to say that buyout and buy-in prices have increased, yes, but innovative solutions offered by new entrants into the market now put buyouts within reach for many schemes. Of course, on the flipside, it is clear that there are also schemes that are some way away from being in a position to conduct a full buyout – yet this does not mean that they should simply sit back and do nothing.
Indeed, preparing for a major transaction itself takes many months and to delay the start of this journey may mean missing a window of opportunity when it opens. Schemes must therefore engage with buyout experts as soon as possible, who will be able to advise them on the potential routes to buyout – longevity swaps, synthetic buy-ins or deferred buy-in/buyouts are all legitimate precursors to a full buyout, for instance. The journey to buyout may be a long one for some schemes – which means that now is the time to begin.
[1] http://www.ft.com/cms/s/0/7b391364-2715-11e1-b9ec-00144feabdc0.html#axzz1keoSCdJu
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