In an increasingly busy market for bulk purchase annuities, schemes are reaching buyout funding earlier than planned.
As a result, a growing theme is the need for pension schemes to manage illiquid asset holdings as they look to secure a buyout.
Standard Life senior business development manager Kieran Mistry and Van Lanschot Kempen Investment Management head of client solutions Nikesh Patel discuss how illiquids will be a key focus in 2023, the challenge they present buyout processes, and give their perspectives on how schemes can manage their illiquid assets.
How did last year set up the pensions risk transfer market heading into 2023?
Kieran: 2022 was an unprecedented year in the pensions industry. After a period of rising interest rate and inflation expectations, the Autumn saw short, sharp spikes in interest rates putting a significant strain on the liquidity of schemes employing liability-driven investment strategies.
For some schemes, the increase in interest rates and high inflation improved buy-out funding levels and reduced headline buyout deficits.
As a result, there has been a ramp up in demand for bulk purchase annuities, and a big shift towards schemes looking to complete full scheme buyouts rather than sectionalised buy-ins. This is because many schemes are now ahead of schedule on their journey plans, potentially with sponsors willing to fund the remaining deficit to remove pensions risk after the economic volatility of 2022.
Some of the largest schemes in the UK have also found affordability coming within reach. While some of these schemes have traditionally considered themselves run-off vehicles, they are increasingly entering the buyout conversation as insurance appears more viable.
Nikesh: It is worth noting that it was schemes with low hedge ratios to begin with that saw the greatest shift in funding levels, as those that were well hedged were largely protected against the market volatility. Well-hedged schemes with buy-out firmly in their sights saw more modest changes in funding levels.
We typically see low levels of hedging in schemes that are less well funded. That's because schemes most impacted were those that may have felt that a buyout was a long way off, but yields rising by nearly 3% over the year brought the end goal of insurance into their immediate future.
Ultimately, the result of these shifts in market conditions is that a smaller cheque is now needed from sponsors to remove pension scheme risk from their balance sheets. What might have been previously unaffordable or unpalatable to sponsors has become more feasible, and so buyout is firmly on the agenda.
Unfortunately, not all schemes fared well over 2022. There were many schemes that saw their funding levels fall during the gilt market crisis, and now are much further from buy-out than they expected to be.
What are trustees focusing on to be ready for a 2023 risk transfer transaction?
Kieran: The focus remains unchanged in many areas; data cleanliness, understanding and clearly articulating scheme benefits and ensuring that they have robust governance in place to navigate a transaction.
One growing theme for many is a need to manage illiquid assets as schemes approach buy-out sooner than anticipated. Their investment strategies have been designed to run over a longer period, with illiquid assets providing diversification and valuable returns if allowed to run to term. Trustees of these schemes are now having to find ways to deal with these assets ahead of schedule, against a challenging economic backdrop.
Nikesh: We're definitely seeing the need to manage illiquid assets and move into an insurer friendly portfolio - where sensible to do so - becoming a key consideration for many schemes, impacting their readiness for a risk transfer transaction.
While some trustees are considering traditional risk transfer products (buy-in, buyout or longevity swap), where illiquid assets present a challenge, they may also be considering one of the alternative risk transfer options, or stepping stones, that have emerged in the market.
Why are illiquid assets a challenge for risk transfer?
Kieran: Insurers are subject to stringent and strict requirements under Solvency II, the insurance regulatory regime, which dictates which assets can be used to back insurance liabilities. These include requirements regarding the type and nature of assets, the capital that must be held against them, and the close matching of asset and liability cashflows.
Insurers also have limits on exposure to asset classes, sectors, and specific counterparties, and self-imposed sustainability overlays on their investment strategies. The result is that assets which are suitable for pension schemes may not be beneficial for an insurer.
Schemes looking to buy-out while holding illiquid assets that insurers are unable to accept as premium payment creates a liquidity kink that must be addressed before completion of a transaction.
Nikesh: One of the most frustrating aspects of Solvency II is that insurers have challenges "looking through" pooled funds to exposures that they might otherwise accept.
A great example is that insurers are prolific investors in infrastructure assets, just like pension funds. However, insurers need individual infrastructure assets and would struggle to accept a pooled vehicle. This challenge is value destructive from an overall capital markets perspective - pension funds have to sell something that insurers would be quite happy to buy.
What can schemes who want to buy-out do with their illiquids?
Kieran: There are several avenues for schemes to explore. For example, insurers can work with trustees to identify whether any directly held assets can be accepted towards premium payment.
The insurer may be able to support the scheme by deferring a proportion of the buy-in premium for a limited time, allowing a scheme to realise its illiquid assets in a more measured manner and maximising value from redemptions or sales. However, schemes will require some comfort regarding the cost of deferral, the remedies for non-payment of the residual premium and that they have sufficient time to realise their assets.
The market is continuing to look for ways to innovate and support schemes looking to buy-out with illiquid assets. Given the volume of requests seeking a solution, this will be an important nut to crack!
Nikesh: From a scheme's point of view, trustees can help themselves in many ways. They may consider actively managing down the illiquid assets, which can reduce the period to full liquidation by a number of years. There are several possible approaches here, which are very much dependant on having substantial relationships with underlying managers.
They may also consider a secondary market sale. This approach would normally incur a haircut (a discount to the fair value of the holding) but, when combined with active management of liquidity as described above, can be a valuable option.
Alternatively, there is also the options of a sponsor-funded liquidity facility, though this carries significant risks of its own and may not be straightforward (or attractive to sponsors).
What advice would you give to schemes with illiquid assets and a buy-out endgame?
Kieran: Have a plan. Schemes will get the best outcome when they have pre-tested the market through exploratory conversations and agreed an approach to managing their illiquid assets before issuing their formal quotation request. Formal commitments aren't needed, but an understanding in principle of how the illiquid asset holdings will be realised is crucial. Schemes that come to market well-prepared are more likely to attract the attention of insurers and achieve an optimal outcome.
Nikesh: Having a plan is really the key; that's hard to argue with. But I wouldn't shy away from making a new plan, if the existing one leaves you unable to overcome the illiquids hurdle.
Ultimately, trustees may simply make the decision to delay the buy-out until the costs become tenable. This is likely the most sensible route for schemes that lack the governance or investment expertise to facilitate the alternative options.
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