08 September 2023
In the UK, the market for insurance buyouts of defined benefit (DB) pension plans is booming. Affordability for these deals is improving, client demand is rising, and profits for insurers are also increasing. This year, the total value of pension assets and liabilities transferred to insurers is expected to beat 2022’s estimated £45bn (US$58bn).
The US buyout market is experiencing similar dynamics, although improved pricing is being driven primarily by intense competition among the country’s 21 insurers – far more than provide buy-in and buyout transactions in the UK. The rising cost of running a DB plan is also a factor behind transactions designed to de-risk pension funds. To the north, Canada’s market is smaller but has experienced similar growth.
With such momentum behind the move toward pension plan endgames, it is important for plan sponsors to evaluate de-risking strategies and to understand the risks and alternative approaches available to them, to avoid being overly influenced by the force of a market trend.
As Mercer's Global Pension Buyout Index shows, the relative cost of annuitization varies considerably from one country to another. For example, as of April 2023, the cost of buyout in the US was less than 100% of accounting liabilities. In Germany, however, the cost was 147% of liabilities. Financial market movements can change pricing dynamics quickly, whether at a global or national level.
This is an important consideration for multinational companies looking to reduce pension costs. We believe it can be beneficial to prioritize markets where pricing is attractive and wait for dynamics to change in other jurisdictions.
Security versus costs
Pension risk transfer to an insurance company is often seen as offering greater security for pension plan members, but the transfer of risk from many company plans into a small number of insurers is itself leading to a concentration of risk, and in many markets the cost of pension risk transfer is very high compared to the best-estimate assumptions used for company accounting.
At our recent Global Investment Forum in London, John O’Brien, European Strategic Risk Management Leader at Mercer, explained that European institutions have often chosen consolidation to mitigate the costs rather than risk transfers to insurance companies because consolidation enables them to retain flexibility around investments and their funding objectives.
“European pension schemes gain scale economies that help them manage their costs, they avoid crystalizing margins paid to insurance companies, and they can retain a much healthier risk appetite,” he explained.
European plans tend to be subject to more conditional indexation or have more discretion in granting pension increases, and there is likely a bigger culture of risk sharing in Europe than in the UK, he added. This gives pension leaders a decision to make over whether to prioritize insuring existing core benefits or investing in a way that potentially helps member purchasing power over the long term.
Pension leaders must ensure they can afford the premium paid to insurers to complete a transaction, and current funding levels mean most plans are at or near this level in markets such as the UK and US. In addition, the demand for transfers on the plan side is proving more than a match for supply to meet, with the potential profits for insurers from such deals attractive.
As Leanne Johnston, a senior actuary at Mercer, explains: “The primary duty of a UK trustee is to take all reasonable action to make sure they can pay out all benefits for every single member for the rest of their lives. Member security is ultimately what is driving trustees to go to buyout – they are not necessarily focusing on whether this is cost effective especially if they can already afford to do it.”
Across the Atlantic in the US, meanwhile, expense is a major factor in the rising interest in pension risk transfer deals. Premiums paid to the Pension Benefit Guaranty Corporation (PBGC) – the government-run insurer for DB plans – are calculated on a per-member basis and have increased substantially in recent years. For plans with large numbers of people with small benefits, it can make running DB plans costly.
Matt McDaniel, US Pension Strategy and Solutions Leader at Mercer, explains: “The cost of holding liabilities, particularly underfunded liabilities, is very expensive for US plan sponsors right now. Pension risk transfer is not just about reducing risk – in many cases it is about reducing costs.”
This means that so-called “lift-out” transactions are common in the US, whereby plan sponsors transfer portions of their retiree membership (often those receiving small payments) to an insurer to improve their overall cost efficiency.
Alternatives to buyout
Insurance buyouts are not suitable for every pension plan. Those with high allocations to illiquid assets may not be able to easily access transactions as insurers are often unable to take on these assets due to regulatory constraints. This means it is important for plan decision makers to also consider the alternative options for de-risking.
Pension risk transfer can take many forms. As noted by John, consolidation is seen as an attractive option for regulators and policymakers in Europe because pension plans have the freedom to invest in the local economy and in private markets with more flexibility than insurers. European regulatory requirements related to governance, investment and liquidity have raised the bar for many plans and prompted some to consider forms of consolidation.
Panelists at the European Global Investment Forum also posited that UK regulation does little to encourage trustees toward exploring alternatives to traditional buyouts and buy-ins, for example consolidation via superfunds or master trusts. The Pensions Regulator’s work on the nascent superfund sector has indicated that insurance is still seen as the ‘gold standard’, as it has pushed for insurance-like regulations for the new vehicles.
Monica Dragut, US Annuity Solutions Leader at Mercer, says buy-ins may become more prevalent in the US as the market continues to mature and providers innovate. Accounting rules in the US mean traditional buy-ins are not as common in the current market environment, but she explains that they may start to be used as a way of locking in pricing ahead of a full buyout in future, as often happens in the UK.
“Insurers are trying to be creative in how they structure deals,” says Monica. One good example is with plan terminations. In these situations, active and deferred members get the option to either take a lump sum payment or keep their benefit to be paid as a pension later.
Monica adds: “Plan termination is a 12- to 18-month process, and at the onset it is not known who will be electing a lump sum, making it difficult for plan sponsors to secure pricing and capacity early by engaging the insurers with a buyout. Alternatively, they can do a buy-in, and a year later, once the elections are known, they can convert to a buyout. That’s where insurers can be creative – they can take on the lump sum risk, or they can share it.”
As the pension insurance market continues to grow in multiple jurisdictions, insurers’ ability to innovate is increasing. Transactions are being priced and locked in earlier, and more complex pension arrangements are being secured through buy-ins, buyouts or similar deals.
This innovation creates challenges for pension plan leaders as they work to understand the options available. However, with the right advice, there is an attractive array of ways to ensure that pension costs are managed and members’ retirement benefits are secure.
Buyouts in other markets
The UK and US are the largest and most mature DB pension markets in the world, meaning this is where much of the DB-related insurance activity takes place. However, there are other jurisdictions with DB plans and insurance can play a role here, too.
In Canada, the pension risk transfer market grew from US$2.7bn to US$7.7bn between 2016 and 2021, according to the Society of Actuaries, mostly through lift-outs similar to the trend in the US. With the Bank of Canada raising interest rates in a similar fashion to the Federal Reserve, Canadian plans’ funded status has been improving, leading to a significant uptick in pension risk transfer activity in the first quarter of 2022 compared to recent years.
There are small pockets of activity in the Netherlands and Ireland, for example. Traditional DB plans are rare in the Netherlands, with the country having long ago transitioned to a risk-sharing structure known broadly as collective defined contribution (DC). The Dutch system is set to change again in the next few years to be closer to a ‘pure’ DC format, which could prompt those companies still sponsoring legacy DB plans to seek to offload this cost.
Ireland’s recent adoption of the IORP Directive [and its imminent introduction of auto-enrolment into DC plans] could potentially encourage companies to consider addressing legacy DB arrangements. Historically, corporate plans have struggled to reach fully funded status due to the high cost of contributions to the sponsors, but recent interest rate rises and other market movements have pushed Ireland’s DB plans into an aggregate surplus position. However, the relatively small number of insurers willing to bid on deals, the lack of a deferred annuity market and the prevalence of discretionary benefits has kept the pace of risk transfer in check.
Buyout transactions have taken place in Germany, but the size of the market and specific regulations have limited appetite for insurance deals. Pricing is currently less attractive in Germany compared to other buyout markets, according to the Mercer Global Pension Buyout Index. In addition, a sponsor remains ultimately liable for the plan even if it is transferred to an insurer, reducing the attractiveness of such deals.