In the second of a two-part series, Russell Lee (left) and Tom MacAulay (right) from Legal & General's Pension Risk Transfer business look at pension consolidation vehicles (PCVs) from an insurance perspective
Since our first article there have been a number of publications and comments on PCVs. Indeed the battle lines seem to be drawn: pension advisors declare, "pensions is not insurance" (even though the pension promises are the same) and insurers shout, "regulatory arbitrage" (even though lower cost for lower protection is not).
Can we improve the quality of the debate?
The sponsor insolvency risk for scheme members is very real: a sponsor insolvency would lead to a reduction in benefits for virtually all UK pension schemes, because of their funding levels compared to current buyout pricing.
PCVs could, in some circumstances, allow schemes to run on safely after sponsor insolvency, until they can afford buyout, but only if the risk framework and level of capital support are well set. Otherwise, trustees will be exchanging one weak sponsor for another. As we discussed in our first article, even a small one-year risk of failure can compound over the lifetime of pension liabilities to something large.
So, in order to develop a safe regulatory framework, the question is: do we start with a pensions' framework and add things, or start with the insurance framework and take things away?
To have a proper debate on this, we need to: (i) acknowledge the shortcomings in the current pension framework; and (ii) understand the build-up of insurer pricing under Solvency II - and what could be revised in order to provide a price improvement.
We also need to critique PCV pricing and compare it against buyout, noting that buyout becomes cheaper as duration shortens. Then we can assess whether schemes might be better to adopt a very low-risk strategy and wait, rather than increase the level of investment risk for the benefit of the PCV capital providers.
The problem with the current pensions' valuation framework is that it is built on the presupposition that there is a sponsor with independent sources of revenue. Trustees and their advisors assess the sponsor covenant and factor this into the amount of prudence they adopt for longevity, inflation, and discounting. It is a highly subjective process, and for PCVs it doesn't work! A PCV's financial strength (covenant) is based on how much greater than scheme liabilities the scheme assets plus capital buffer are. But you can't: (i) assume a strong financial covenant, (ii) set prudence accordingly, (iii) value the liabilities, (iv) produce a large surplus, and demonstrate that you have a strong covenant! This would be entirely circular.
Insurance, on the other hand, is fundamentally about the ability to withstand losses of a certain severity - and a 1-in-200-year event is standard. This might sound extreme, but in fact only equates broadly to a BBB rating.
Insurers typically hold more capital than this minimum level so are higher rated, but the important point is that capital to cover a 1-in-200-years loss is not extreme, it is just safe: nobody wants to buy insurance from a junk-rated insurer. Many proponents of PCVs have claimed that while insurance is a Gold standard, PCVs are Bronze - cheaper but still safe. However, unless they are able to withstand a 1-in-200-year event, we struggle to see how they can be described as such.
PCV Pricing
One aspect of PCVs that is poorly understood is how little difference there is between their pricing and buyout. Originally billed as 15% cheaper, it is now clear that the real difference is more likely to be mid-single digits. If the pricing of a PCV that co-mingles assets and liabilities is gilts + 25bps, plus 5% to break the sponsor link - an assumption that is reasonable on the basis of publically available information - then for a scheme with a 17-year duration this equates to gilts - 5bps. The equivalent buyout pricing is likely to be in the order of c. gilts - 25bps. That is a difference of c. 3%.
A scheme this well-funded could invest solely in gilts and still expect to buyout in five or six years. Alternatively it could enter a co-mingled PCV where asset risk is taken for the benefit of capital providers, putting members permanently in the position where they retain the risk of a cut to benefits - long after capital providers have made a healthy return. This seems manifestly unfair. The concept of sharing profits with members sounds great until you remember that, in a co-mingled fund, funding levels are continuously diluted by adding additional schemes.
An alternative approach
It is helpful to illustrate what can be achieved under an insurance-like framework. At L&G we have developed a solution that is based on insurance principles with respect to both governance and ability to withstand loss, and has a strong price improvement compared to buyout (more than 10%). It is not a PCV because it does not break the sponsor link, but it:
- Protects against sponsor insolvency;
- Delivers a safe route to buyout;
- Provides a 1-in-200 year level of financial strength at inception; and
- Aligns interests between the scheme, the investment manager and the insurance provider.
We do not advocate breaking the sponsor link - it seems unnecessary - but if schemes wanted to do so then L&G's Insured Self Sufficiency framework would work fine. It provides insurance-like protection and is cheaper than the commercial PCVs currently available.
Summary
To date, the public debate on PCVs has focused too often on point scoring, and a number of the points do not stand up to closer analysis. As Nobel Laureate Richard Feynmann said, "you need to be careful not to fool yourself, and you are the easiest person to fool". The critical principle that should guide the debate is simple: members' interests first!
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