The fact that we’re living longer than expected is good news. But for pension plan sponsors with burgeoning pension payments, it spells significant financial risk. Companies can transfer this risk to those better able to deal with its consequences, namely insurers or reinsurers, via transactions known as buy-ins and buy-outs. The third approach to hedging longevity risk – longevity swaps – will be discussed in a forthcoming article.
Both buy-ins and buy-outs involve pension funds buying bulk annuities from insurance companies that then pay the pensions, taking over the longevity and investment risk. In a buy-out, the insurance company takes over full responsibility for making disbursements to pensioners. In return for an upfront payment, the pension assets and liabilities are transferred to the insurer, shifting the obligation from the pension plan sponsor’s balance sheet to the insurer’s.
A buy-in, meanwhile, is a way of reducing the risk of dealing with a pension while the trustees remain ultimately responsible for the benefits. Under this method, the insurer agrees, for a fee, to make periodic payments that match those made by the sponsor to its members.
PICKING UP THE TAB
One of the largest buy-outs in the UK involved Thorn, the lighting and electrical retailer,. The trustees of the Thorn Pension Fund, which covers the company’s former staff, bought a bulk annuity contract from Pension Insurance Corporation (PIC) that provided an individual policy to each member of the pension fund. The pension fund was then wound up and sold for £1.1 billion ($1.8 billion) to PIC. The deal offered greater financial security to the trustees and a 5% improvement in members’ benefits. And Thorn no longer needed to worry about making extra payments if its former staff lived longer than expected.
The British Airways pension scheme’s buy-in with Rothesay Life in, meanwhile, affected one of the two defined benefit pension schemes sponsored by the airline. In this case, the liabilities were covered by an insurance agreement issued by Rothesay, under which the trustees retained ownership of the assets backing the transaction. In return for the proceeds of those assets, Rothesay agreed to pay the trustees an amount equal to the covered pensioners’ benefits.
While the future of buy-outs and buy-ins is debated due to limited capacity of bulk annuity markets, annuities’ costs and limited opportunities for diversification, buy-outs have yet to outlive their use. “Pension buy-outs remain the ultimate endgame,” says Guy Coughlan, chief risk and analytics officer and managing director with Pacific Global Advisors. “They are the only way to completely remove risk. There is no other approach that can quite fulfill the same role.”
By removing the pension plan from a company’s balance sheet, buy-outs free up management time and focus. “A pension plan consumes the risk capacity of any company,” Coughlan explains. “If you eliminate it, you can free up additional risk capacity, which can be channeled into a company’s core competencies. It also enables capital to be more profitably employed in its main business.”
While being a powerful tool, buy-outs come at a cost, Bernhard Brunner, director at risklab (a subsidiary of Allianz Global Investors) points out. Longevity swaps may be a cheaper approach. “Without the need to be funded, they can be used as stand-alone instruments to directly address longevity risk or provide custom-tailored solutions in combination with a liability driven investment strategy.”
One solution for all risks
“Buy-out methods tend to attract companies who want to reduce the size of a pension plan for any strategic reason,” adds Amy Kessler, senior vice president and head of longevity reinsurance at Prudential Retirement. “Sometimes, buy-outs may be used ahead of an acquisition or divestiture.” Kessler views buy-outs as an appealing way to reduce pension obligations and address all of the asset risk and longevity risk in one go. “A buy-out is the only way to have the pension obligation walk off a company’s balance sheet and onto ours,” she says.
And buy-outs aren’t necessarily costly. “Plan sponsors who say buy-outs are too expensive are still thinking about earning a return on assets of 7-8%,” Kessler remarks. “Not only is that extraordinarily difficult to do, but it can’t be done on a risk-free basis, and the cash implication in a market crisis has proven to be unacceptable.”
Nevertheless, the challenge of paying a premium upfront in the aftermath of the financial crisis has so far impeded buy-outs from becoming commonplace in the US. As pension funds now start to recover, US companies are better able to address their risk profile and consider buy-out as an option. “Corporate boards don’t want to retain the risk that their pension plans may require large cash infusions in the future to recover from market losses,” Kessler explains. “Instead, many companies are de-risking their pensions so their cash will be available to help survive the next business cycle or better yet, invest in business growth.”
BUY-IN OR LONGEVITY SWAP?
At first glance, buy-ins are less attractive than the more holistic buy-out option. They offer less flexibility when compared to their more versatile and powerful capital market cousin, the longevity swap. While hedging longevity risk, buy-ins also address interest rate and inflation risk, giving the pension fund a more comprehensive (and costly) solution than may be necessary. Swaps, which will be explored in detail in the third article of this series, exclusively target longevity risk and thus avoid stray costs. Yet true capital market solutions are still in the making. “Today, the longevity swaps being completed for pension funds may be passed through investment banks to reinsurers,” Kessler remarks, “but they are not yet a true capital market solution.”
Buy-ins also force plans to be funded up to the level of the annuity contract. And finally, the liabilities remain in the pension scheme. Nevertheless, they appeal to some companies, particularly those that are underfunded: buy-ins don’t lower their funded status. Others may opt for a buy-in as they feel connected to their retirees and actively want to continue writing out their pension checks, Kessler points out. Furthermore, companies might choose a buy-in to ensure their pension plan is being taken care of and increase their attractiveness before approaching a potential buyer.
Today, buy-ins and buy-outs, as well as an array of other de-risking solutions, are applied freely and interchangeably in the UK following the advent several years ago of regulatory and accountancy changes encouraging good risk management techniques, according to Kessler. This choice and flexibility is now arriving in the US market, which is starting to recognize the advantages of de-risking solutions that deliver “more consistent financial results and eliminate the risk that the pension fund might need a cash infusion in a down market,” she says.
As the market develops and grows, Coughlan expects to see “interesting transactions to come from insurers reinsuring their longevity risk or packaging it up in investments in the capital markets.” He predicts a “growing appetite” to take on longevity risk as more and more investors seek uncorrelated risks in order to diversify. “A lot of traditional assets are producing low returns,” he explains. “Receiving slightly higher returns from new types of investments is a plus.”
Pension plans need a host of techniques at their disposal to manage increasing longevity risk as life expectancy increases. Buy-ins and buy-outs might be traditional instruments, but they remain valid solutions in today’s market.
Yet they have their shortcomings, and new options need to be explored. As Bernhard Brunner and colleagues note in a risklab study, “Longevity hedges via capital markets can be a powerful tool for risk mitigation … therefore, an efficient capital market for longevity risk seems desirable.”
