Expanding the investment toolkit: Buy-ins

Large funding deficits and low yields have meant that, for many trustees, annuities haven’t been considered a suitable asset over the last decade. However, that picture is changing slowly. Today, competitive pricing in the bulk annuity market, together with improved funding positions and more mature schemes, means that annuities should be considered. 

Buy-outs may be more achievable than you think

For many pension schemes, the reported buy-out deficit is significant and seems an unachievable target. However, there are a number of reasons why this may not reflect the real cost of buying out in the long term.  For example, as members retire the cost of buy-out will come down considerably, as pensioner members are typically cheaper to insure. 

In addition to the above, liability management exercises – such as transfer value exercises or pension increase exchanges, can be used to reduce the buy-out shortfall. 

Therefore, we would encourage trustees and employers to consider how the ‘headline’ buy-out deficit is to be dealt with rather than just dismiss it out of hand.  It’s not all employer contributions. 

Buy-ins – When might they form part of your strategy?

Whether or not your scheme is working towards buy-out, annuities can be viable investment options. 

However, there may be good reasons why a buy-in does not make sense for your scheme at the moment. In particular:

• Firstly, is a buy-in the most effective way of reducing risks in the scheme?  For many schemes, interest rates and inflation remain the most significant risks to the funding position, with the size of longevity risk being materially smaller.  If this is the case, then using leveraged liability-driven investment (LDI), is a more effective way to reduce risk.

• Secondly, is the scheme sufficiently well-funded to consider buy-ins?  Using return-seeking assets that are needed to help close the deficit to buy annuities is likely to lock into a lower expected return, and it may unduly limit otherwise sensible investment strategies for the residual assets.  Purchasing annuities when poorly funded may reduce the chance of being able to reach full buy-out in the planned timescales.

Getting ready for buy-in – What you need to know

Finally, if buy-in is right for your scheme, you may want to take some action to protect against significant increases in the price of the annuities. In the past, some schemes have attempted to do this by aiming to mirror the investments held by insurers in the scheme’s investment portfolio. 

Our view is that, rather than trying to mirror the insurer’s portfolio, the important thing is to gain exposure to the key drivers of changes in insurer’s prices: interest rates, inflation and credit spreads. This can be done through liquid derivatives and assets that are easily converted to cash when needed. 

In summary, we suggest that trustees:

1. Don’t discount buy-out as a feasible medium-term objective.
2. Keep partial buy-ins in mind when considering investment strategy. These are more likely to be suitable when the scheme is relatively well funded and has largely hedged the interest rate and inflation risk. Undertaking partial buy-ins ‘too-early’ can mean that it takes longer to reach the ultimate aim of full buy-out.
3. Finally, if you are aiming to insure liabilities in the short term, focus on matching the key drivers of changes in insurers’ pricing, rather than trying to mirror their investment portfolios.