Breaking Down the Barriers to Buyout

Rising longevity, poor investment returns and, some would argue, increased regulation have seen the costs of providing defined benefit (DB) pension schemes increase significantly over the past 10 years. While the death of DB – which has been predicted from as far back as 2004, when I joined the Pensions Regulator – may not be upon us quite yet, it is clear that more and more pension scheme sponsors are looking towards the end-game.

Some scheme sponsors have gone down the road of benefit re-design in search of a solution, but an increasing number are opting to close their schemes completely. And with typical labour turnover of about 15%, it does not take long for a closed scheme to become purely a legacy issue. Yet, as most chief financial officers (CFOs) are well aware, this does not make the scheme an irrelevance to the sponsoring company. Closing a scheme does not remove a company’s obligation to pay its previously accrued liabilities, which means the need to fund and to manage risk remains.

Left unmanaged, DB pension risk can seriously impact the core business with implications for both shareholders and scheme members. Changes in regulatory and accounting rules in 2004 made this impact more acute and apparent to the markets. There can be damage to a company’s credit rating, its share-price, its ability to attract capital and even its contracts with clients. And in some cases, DB pension liabilities are so large and volatile that they pose a serious threat to the financial viability of sponsoring companies – 10 of the FTSE 100 now have pension liabilities greater than their market capitalisation, for instance.

It is therefore little wonder CFOs have begun to take a growing interest in pension buyouts, which, in essence, enable the company to pass the problem on to an insurance company. Yet despite the substantial attractions of a buyout, very few have been completed. That said, a new approach to pension buyouts may now be altering the balance, making buyouts more affordable for sponsoring companies.

Substantial Interest, Little Action

Given sponsors’ anxiety about the impact that DB pension risk may have upon the financial viability of their company, the actual number of buyout transactions has been paltry. Since 2007 – when buyouts seemed to be taking off – the market has witnessed merely £25bn of business, and that figure includes buy-ins (bulk annuities). While a large number in isolation, £25bn is only the equivalent of roughly 2.5% of the total value of DB liabilities sitting alongside the balance sheets of private UK companies.

There are five core reasons why CFOs have been so reticent to move this volatile risk off their balance sheet:

1. Prohibitive cost

A large part of the problem lies with the nature of the insurance industry, which has so far failed to deliver solutions that are economically attractive for those considering transacting. Undoubtedly, this is not helped by the need to move between different regulatory environments and, in particular, move into the solvency capital regime required within the regulated insurance sector. Buyouts have commonly been priced at about 140% of the valuation of a scheme’s liabilities on an IAS19 basis – a price greater than most CFOs are willing to pay.

Indeed, a survey conducted by Punter Southall back in 2008 suggested that at buyout prices of around 140% of IAS19 liabilities, only about 0.5% of CFOs would be willing to transact. In many respects this is understandable. Even where a pension scheme is fully funded to IAS19, it seems improbable that many will be reaching for their chequebooks to pay a 40% premium to an insurance company to take the risk away – especially given that the premium will be an immediate hit to the sponsor’s profit and loss (P&L).

2. Cash flow problems and return on investment concerns

Investment losses over the past few years have reduced the funding levels of many schemes and, until the economic climate really begins to improve, few CFOs appear willing to pour more cash into the pension scheme to allow a buyout to take place.

With a whole host of other corporate opportunities vying for funds, many CFOs favour channelling cash into projects offering a more obvious short-term return on investment. In trying economic times, justifying an investment in more efficient technology, for instance, is often easier than justifying a transaction to remove a long-term, uncertain obligation.

3. Poor timing

The cost of implementing a buyout strategy is intrinsically linked to the scheme’s current funding measure as well as the position of the scheme with respect to volatile investment markets. Recently, opportunities have existed to transfer components of risk from pension funds to insurance companies for a small premium over their Technical Provisions or IAS19 liability. For instance, many pension schemes were in a favourable funding position back in 2008 and similarly early last year when the combined deficit of the schemes of the FTSE 100 fell to £80bn (from a high of £134bn in August 2010).

Yet the vast majority of schemes failed to take the opportunity to lock in improvements in funding levels by removing risk, resulting in them slipping back into deficit when markets took a turn for the worse. Currently, global long-term economic uncertainty has meant a struggling FTSE (reducing pension scheme assets) while AA bond yields remain low (meaning large pension liabilities). Given this, there is a sense that it may be preferable to wait for favourable conditions to return before transacting.

4. A lack of board-level incentive to transact

Pension liabilities are a complex and long-term obligation and too many boards of sponsoring companies have not completely understood the problem. This has not been helped by a lack of corporate disclosure on the exact nature of the risk at hand. While 95% of the FTSE 100 detail their key enterprise risk exposures within their annual accounts – and further outline the hedging strategies that have been put in place to deal with them – only a small handful of companies do the same with DB pension risk, despite the fact that it may constitute the largest risk faced by the business.

And this lack of disclosure means that pension risk management still struggles to make it on to board-level agendas. Indeed, in a recent survey of over 200 CFOs from the head offices of UK quoted companies 82% of them said the company pension scheme features as an item on the agenda at fewer than half of company board meetings each year. Any pension scheme is in effect a financial services business – the FSA would certainly, and rightly, not countenance this level of scrutiny.

5. A lack of understanding about the exact nature of the risk posed by schemes

Undeniably, scrutiny and management of scheme risk has improved in recent years. But there is still a way to go. And a key requirement is better and more up-to-date information. Pension scheme liabilities, in general, are only fully evaluated once every three years during the triennial valuation process. Frequently, by the time the valuation is finalised – up to 15 months after the valuation date – the information is out-dated and inappropriate for decision-making.

Funding positions fluctuate dramatically with market movements and over a period of months or years the changes can be substantial. While liability information may be adjusted for changes in membership and economic conditions in between full valuations, such ‘roll-forwards’ remain mere approximations. This can contribute to a gross underestimation of the actual risk posed by the pension scheme.

A Captive Solution: Reducing the Price of Buyout

For full buyouts to work and for the market to fulfil its potential to offer a solution to the DB problem, it is clear that the insurance industry has to come up with a better proposition than is currently available to CFOs and trustees. First of all, the issue of price must be addressed.

Studying the economics of buyout in more detail, the 140% of IAS19 buyout cost mentioned earlier is made up of the insurer’s best estimate of the value of the liability (say roughly 120% of the IAS19 liability) plus an additional 20% that represents the insurer’s profit. That 20% of profit counts towards the capital the insurer is required by the regulatory authorities to provide to back its liabilities. Then, roughly speaking, the insurer itself is required to put up another 20% of capital as equity, making in all 40% of capital to back the 120% liability.

This poses an interesting question for CFOs – what would happen if, rather than provide half of the regulatory capital, they instead invested the full amount in order to recapture the insurance profit? After all this is what quite a number of large companies do when they set up captive insurance companies to handle other forms of risk. Were they to do the same with their pension risk, the cost of buyout in the example would be reduced, as they would not have to pay the premium to an insurance company. The problem is that a pure captive solution such as this for delivering pension buyouts would consolidate the pension liability on the sponsor’s balance sheet – often hugely distorting it – and would not remove balance sheet volatility.

The solution offered by Long Acre Life – a new insurance initiative focussed on delivering buy-in and buyout solutions – addresses this concern. Long Acre Life aims to deliver the economic benefits of a captive solution yet also borrows from the world of mutual insurance, enabling multiple parties to participate in the same entity (the insurance company), thereby removing the need for any single party to consolidate. The financial implications of this insurance type structure (one allowing access to insurer capital) are substantial – giving the potential to reduce the cost of buyout from 140% to around 120% of the value of IAS19 liabilities.

Addressing the Other Objections

Once the cost of buyout is reduced, the other barriers to transacting outlined in this article appear far from insurmountable. With the cash position of UK plc looking remarkably healthy right now (UK companies’ cash flow has grown 40% since the depths of the financial crisis ), most CFOs are looking for investments to put their cash to good use. For many, the opportunity to remove a volatile risk in return for an asset on the balance sheet offering a stable annuity-based income would be seen as a good use of shareholder’s funds.

A further, board-level, incentive for such a solution is the increasing pressure from shareholders and analysts on sponsoring companies to bring the amount of disclosure on their pension risk exposures in line with that afforded to all other corporate risks on the balance sheet. Of course, pension risk disclosure and management requires a detailed understanding of the exact nature of the liability. Yet technological developments (Long Acre Life uses PensionsFirst’s PFaroe, for instance) provide precisely the right tools for such an analysis – allowing CFOs to access up-to-date and accurate valuation information at a click of a button. With this level of timely and detailed analysis, CFOs can be both better informed and much better placed to seize opportunities as they arise.

Which brings us to the final barrier – timing. Admittedly, prices in the buyout market in general may compare unfavourably to those of 2008, or even the start of last year. But CFOs may have to accept that the heady days when schemes could transact at not too much over their technical provisions may never be seen again. Innovative solutions offered by new entrants into the market, however, mean that the end-game need not also be out of sight.

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