Lucy Barron, investment partner, Aon
Many schemes choose buyout as their ultimate endgame, driven by the certainty that payments will be made to members as they fall due. However, any number of risks can blow schemes off course on their journey.
One of the biggest obstacles for schemes to navigate is the investment risk posed by assets not matching movements in the scheme's liabilities. Schemes have generally tried to reduce this risk using Liability Driven Investment and gradual asset de-risking. Going further than this - setting a course early on that aims for your ultimate target can help reduce potential gale force headwinds to a gentle breeze.
For schemes with a longer time to buyout, generating high returns to outperform the liabilities may seem like the only option to combat fluctuating funding levels. Nevertheless, there may be options available in the insurance market to help stabilise the funding position, even at a relatively early stage, through a phased buy-in approach - a strategy favoured by a growing number of schemes. This involves investing in an asset which exactly matches the risk profile and cashflows of a pre-determined slice of your liabilities (usually pensioners). Using a strategic buy-in as an astute investment decision can pay dividends in dampening funding volatility. Recent market experience also shows that repeat buyers (schemes who have already done buy-in transaction) are often favoured by insurance companies - it demonstrates good preparation and a commitment to transact which can ultimately lead to being offered better pricing.
While achieving a buy-in or buyout may require a contribution from the sponsor, this can be reduced, or even removed, through diligent preparation of data and benefits, but more critically by positioning assets in a prime position for any upcoming transaction.
As your scheme comes closer to buyout, structuring your portfolio so that it more closely matches the risk profile of your liabilities can be done in various ways. Gradually reducing your allocation to growth assets and replacing them with less risky and better matching assets will help to stabilise your funding level. Also, investing in assets which hedge interest rate or inflation risks allows your assets to move in line with the corresponding hedged liabilities.
For some schemes, the investment strategy may be anchored by an illiquid asset, for example in the form of physical property holding. Being a forced seller of this asset to make room for a transaction could mean having to accept a lower price than expected, ultimately creating a shortfall from the premium payable. Thinking in advance about the exit strategy from assets such as these can help to maximise the return achievable and avoid delays when transacting.
In the years and months leading up to a potential transaction, aside from looking at your investment strategy purely from a liability matching viewpoint, it is useful to consider which assets may be attractive to insurers as part of a transaction. Many insurers will provide what is known as a price-lock portfolio, meaning that during the negotiation phase of a transaction the price payable will move in line with an agreed basket of assets until the deal is done. Being invested in the typical types of assets included in these price-locks will mean that good preparation will not be undone in the final few weeks before a transaction is completed.
Investment strategies at insurance companies are designed to be safe havens, and shelter schemes from the storms. As such, they hold much of their assets in government bonds and investment grade credit. Holding an element of credit can help your assets move in line with the price-lock offered by an insurer - the most efficient, and cheapest, way to do this is through synthetic credit. This provides an exposure to credit that is more flexible and quicker to adjust to match a specific insurer's pricing basis than physical credit and incurs lower transaction costs in the process.
Aon has vast experience of successfully preparing scheme assets for buyout. One recent example of our success was leading a long-standing client to achieve its target much sooner than anticipated. Originally anticipating an insurance transaction in about 2025, our investment team structured the portfolio accordingly, with outperformance accelerating the scheme to full funding on a solvency basis by 2020.
Mindful of the impending transaction, and because of excellent asset preparation, within one day of the trustee selecting the insurer, the assets were able to be moved to precisely match the specific insurers' price-lock. This preparation instantly translated into significant savings for the client, with market movements at the time meaning that if it had taken one week rather than one day to match the selected insurer's pricing, the mismatch would have added £1.2m to the cost of the transaction (c.£400m transaction). In addition, if this had happened in the most volatile week of 2021, it would have added more than £4m to the cost.
It is never too early to plot your course to your buyout - a key part of which will be aligning your investment strategy. By knowing the waters, identifying hazards, checking your position and monitoring the conditions regularly, you can set yourself up for a safe journey to settlement.
This post is funded by Aon
