The world without buyout: An alternative pension’s history 

I’ve always found alternative histories fascinating. What would the world look like if the Industrial revolution had happened in China rather than Europe, or if the printing press had been invented in a different century? Not only can alternative histories make interesting reads, but they can also be enlightening in terms how the things we take for granted today, could so easily have been very different.

Defined Benefit (DB) pension schemes have been on a long developmental journey since their inception. Few things in this sphere have weighed so heavily on the industry as the concept of the buyout. However, what might the industry look like had buyouts (and similar products) never been created? And how might the industry react, were buyouts only brought to market today?

In truth, many things would still have happened. Liabilities would still have ballooned during the period of low interest rates, and most schemes would ultimately have ended up closing to new members. As schemes then matured — and faced greater needs to meet immediate cashflows — a transition out of equity-like investments and into more income-producing assets would very likely still have occurred. However, what has since become viewed as the “gold standard” of pension de-risking would no longer be available. As a result, trustees and sponsors would have had to develop alternative ways of de-risking their pension schemes.

In this alternative world, the “gold standard” of de-risking might well look something like:

• A portfolio of matching gilts (and possibly interest rate/inflation swaps)
• A longevity swap
• A reserve for expenses
• A reserve for any remaining member option risks, etc.

Under such a strategy, investment risk and longevity risk would, essentially, have all been fully removed. However, this approach would also be very expensive. It is therefore likely that the goal of reaching this shiniest of gold standards would have a very extended timeframe.

Alternatively, without the option of full risk transfer to a third party, sponsors and trustees might be more open to surplus sharing options. Investment and longevity risk would still be removed to a significant degree, however, all parties may be comfortable stopping someway short of the full de-risking outlined above. Surpluses generated above a certain level could then be split between:

Finally, with the need to run pension schemes on until the last member died, operational efficiencies would need to receive a greater focus. This might involve the greater use of master trusts or other cost-saving initiatives.

In our alternate history, let’s fast forward to 2023. Some smart cookie at one of the insurers has developed a solution for the pension market … the buyout. The insurer will take on the obligation to pay members’ pensions in return for the pension scheme making an upfront lump-sum payment to the insurer. The buyout is priced materially below the gold standard set out above, but still offers to fully remove the risk from the sponsor and pension scheme (albeit not from the member).

Some sponsors are very keen, seeing this new buyout idea as a way of removing pension risk at below the cost they had previously budgeted for (albeit significantly above the level it had been accounted for). Sponsors with well-funded schemes that have enacted surplus sharing are possibly less keen — their pension schemes haven’t been a problem for a while, and the steady streams of returned surpluses have been helpful in subsidising their businesses.

How would trustees react to such a proposal? With a fair degree of suspicion! This is because, compared to the status quo the trustee has been used to, the following would hold true:

• The trustee would lose all control over ensuring investments are made in the best interest of their members. They would be concerned that the insurer will need to balance member protection against its profitability targets when making investment decisions. Similarly, both the trustee and the sponsor would lose the ability to express their ESG views in how the assets are invested.

• The trustee would worry that the insurer is going to increase investment risk versus what the trustee had been targeting and that the insurer might also invest in assets the trustee doesn’t really understand.

• With the buyout not being collateralised, the trustees/members would be entirely reliant on The Regulator for any protection. Given what happened in the 2008 financial crisis, the trustee may want to retain more control over how member benefits are protected.

• Although the trustee would be told that the insurer holds a 1-in-200 risk buffer, they might be suspicious as to how this has been calibrated, especially as so-called “tail risks” keep happening in financial markets.

• The members would lose any ongoing support from the sponsor covenant.

• Members would gain access to the Financial Services Compensation Scheme (FSCS), which currently covers member benefits to a higher level than the Pension Protection Fund (PPF). However, having looked into this a bit further, the trustee would see that government backing of the FSCS does not seem anywhere near as assured as the government support for gilts.

In short, it would be difficult to convince trustees that opting for a cheaper but less secure option for meeting member benefits would be the right thing to do, especially given how complicated it all would seem. 

So is buyout actually a bad option then? No! Our world has been relatively open to the idea of the buyout, perhaps due to bulk annuities emerging as a concept long before many schemes started properly considering de-risking. And in practice, buyouts have served many useful purposes. For those schemes that reach buyout funding, in most cases a buyout has provided a boost in member security versus running on as usual (at least where no additional security is provided to support running on). While this precludes the trustee targeting an even stronger position, many trustees view the security provided by a buyout as sufficient.

At the current time, superfunds, capital-backed funding arrangements and scheme run-on options take the place of buyouts as products that are “under suspicion”. Meanwhile, buyouts are held up as the “gold standard” of de-risking. However, as demonstrated, a buyout involves the trustee getting comfortable with some level of risk, and these risks need to be considered when comparing buyouts to the other options available to trustees. These options include cheaper but less secure options, such as superfunds. They also include options that seek a comparable level of security to a buyout but in a different form. For example, in return for being able to benefit from scheme surpluses, sponsors could make security available to a pension scheme that is comparable to (or even exceeds) that which an insurer is required to hold to support a buyout.

The public interest considerations over how to manage DB pension liabilities are clearly very topical. There is currently an open debate on the extent to which it is reasonable for trustees and sponsors to take account of these considerations. However, an ideal outcome would be if the public interest was better aligned with those of decision makers.

Under the current direction of travel, it is quite possible that almost all of the £1 trillion of private sector DB liabilities will eventually end up sitting with a relatively small group of insurance companies. With insurance regulation in its current form, these life insurers are also encouraged to adopt relatively similar strategies to each other. As financially strong as these insurers may currently be, such levels of concentration creates the risk that a single oversight in regulation or risk management quickly develops into a systemic risk. A more diversified pool of pension solutions, of which buyout will almost certainly remain a material element, should help improve the industry’s overall resilience to such shocks.

There is then the hot topic of “productive assets” and how/if more pension assets should be invested in them. Depending on the definition of productive assets, insurers arguably already support this objective to some extent through holdings in corporate bonds, support for infrastructure assets, etc. Compared to an alternative world of assets being held exclusively in gilts, this already represents a step up. However, assets must meet quite narrow criteria in order for insurers to hold them efficiently. One option, of course, is to relax the investment restrictions on insurers. However, a buyout requires trustees to relinquish ongoing control over investment strategy. It may therefore be inappropriate to materially broaden the investment freedom of insurers unless this is accompanied by an increase in the capital requirements against those investments. In contrast, in the occupational pensions regime, trustees are able to judge whether an investment in productive assets makes sense on a case-by-case basis, creating flexibility to consider a broader range of productive assets.

Finally, there is the enormous practical task of on-boarding the remaining DB pension schemes (of which there are over 5,000) with insurers. In future, this could well lead to instances where schemes that have sufficient assets to buyout must still join a long waiting list to actually transact. Other solutions may need to be supported in order to minimise the risk for schemes sitting on this “buyout waiting list” (even if buyout remained the ultimate end-state for most schemes). The developing area of Capital Backed Funding Arrangements (CBFAs) could become more prevalent in this scenario.

To date, buyouts have brought enormous benefits to a number of schemes and sponsors. However, in order to take advantage of these benefits, trustees have to get comfortable accepting the risks associated with a buyout. The question we should all be asking ourselves is this: just like the trustees in our alternative history, who risked missing out on the benefits of a buyout, are we in danger of missing out on the benefits of these other de-risking solutions? Does the fixation on the “gold standard” option distract the industry from giving proper consideration to the range of options available, judging each on its own merits?