The End Game

From aiCIO Magazine's 2011 Liability-Driven Investing Issue: Plan sponsors, in their dream of dreams, would love to get here.

To see this article in digital magazine format, click here. 

It is an unenviable position for a company to know it is on the financial hook for something, but unaware for how much—it can stifle its growth and ambition. Over the past decade, increasing numbers of companies offering their employees a defined-benefit pension have found themselves in this position and considered liability-driven investment (LDI) as a way of defusing the risk that accompanied it. For the most part, LDI is still an inexact science—but it can help get a pension scheme under control and pave the way for a business to dispose of its liabilities completely through a buyout arrangement with an insurance company or other provider. Once this final part of the puzzle is in place, a company can usually forget it ever had a pension scheme and get on with its core business. 

Presented in this way, it may seem like a straight line from LDI to buyout, but recently the number of buyouts has taken a tumble. In the UK, the largest market for buyouts, only £281m of business was transacted by providers insuring complete or parts of pension schemes in the first quarter this year, according to consultants and actuaries Lane, Clark and Peacock. By contrast, the sector experienced a record level of business in 2010, when nearly £5.5bn of deals were carried out. As the financial situation in world markets almost collapsed under economic pressure over the past summer months, it is fair to assume this activity has not yet picked up in 2011. 

LDI managers have argued that the drop off in activity is partially due to pension scheme managers realising they do not need to buyout if they correctly implement a de-risking strategy. Mark Humphreys, head of UK Strategic Solutions at Schroders, said: “It is not necessarily the ultimate aim for all pension scheme trustees to buyout—some companies and their trustees just want their scheme to be run on a low risk, self-sufficiency basis.” Humphreys added that by combining a low-risk strategy with a separate portfolio of return-seeking assets, a pension scheme could improve its funding level and lock in some of the liability-matching proprieties of the other assets at the same time. “When we first talk to pension schemes, we see how they can get to self-sufficiency by moving their assets into gilts, corporate bonds, and other low-risk assets. We can then look at hedging longevity risk, which can be a better use of capital than moving straight to buyout.”

Julian Lyne, head of UK institutional business at F&C Investments, said: “LDI can stabilise a situation for a company and provide a stepping stone to give options. It is not clear that every pension scheme wants to buyout now—some businesses want to remove the risk from their balance sheet, but at a reasonable price—having an LDI strategy in place can help fill the gaps in the scheme and then they have other possibilities to consider, such as buy-in.” 

LDI managers advocating buyouts would be akin to turkeys voting for Christmas—keeping a client in its LDI programme could see management fees earned over 50 years or more. Dylan Tyson, senior vice president at Prudential Retirement in the US, which assumed the pension risk for $75m of the American-based Hickory Springs Manufacturing scheme in May, said: “For the large majority of companies, pension risk transfer adds value for shareholders and there are increasing numbers of plan sponsors asking about how it can be done. But in the short term they are looking at their risk tolerance and implementing de-risking strategies—over the past decade many have lost 35% of their funding status, twice. For many plan sponsors, LDI is a first step down the path of pension de-risking. For most sponsors it is not ‘if’ but ‘when’ they buyout.” Others in the market agree. Craig Gillespie, senior consultant at Towers Watson, said: “The ultimate aim for any company running a closed pension scheme is to buy out.” 


Although the ideaof a pension buyout is not new—in the US, insurance company Prudential bought out the Cleveland Public Library scheme in 1928 in the first deal of its kind—they became popular in the mid-part of the last decade in Europe as companies saw the opportunity to rid themselves of a risk that they did not consider integral to their business. At the time, many schemes were well funded and it was relatively easy to hand over the whole lot to a third party, albeit for a substantial fee.

Fast forward five years and company bosses have a very different prospect. The financial crisis has taken its toll on funding levels, and those considering offloading a complete package to an insurer to manage through to its conclusion have had to return to the drawing board. For many, this drawing board begins with an LDI strategy, and the decision to move on from that comes down to what each company needs. If the scheme it offers is still open to new members, a full buyout is impossible, for example. Finding these companies is rare, however: of the largest 100 listed companies in the UK, only three still offer defined-benefit pension schemes to new members. In the early 2000s, after many scheme assets had been hit by the burst of the tech bubble, many company directors woke up to how much it was costing to keep them open. Therefore, there are many more companies in the situation where a full buyout is enviable and others where it may become necessary, if not yet actually possible.

Jay Shah, co-head of business origination at Pension Corporation, which has carried out some of the largest deals in the UK, said: “Financial directors often look at buyout as a business decision and whether it is worth the cost of buying out just to get rid of the risk.” Buying out a pension scheme initially starts by getting it to a fully funded status, then the employer has to pay a premium to the insurer that is taking on the risk. It is not a cheap, or easy, decision to take.

M&A activity, which tailed off during the financial crisis, often dictates corporate policy on pensions, according to Shah. Companies with large pension schemes, either well-funded or in deficit, are seen as a huge risk to potential buyers. For those companies holding a pension scheme that are on the lookout to acquire a new unit, bosses must always be aware that they could be asked at any time by trustees and regulators to top up an ailing funding level and keep some cash in the bank just in case. For example, when British Airways was tying up with Spanish counterpart Iberia in 2010, one of the stipulations was that the UK airline got its £2bn pensions deficit under control and that it was ring-fenced from any of its new partner’s business. 

Aside from M&A activity, companies that have found themselves with schemes too underfunded to buyout are having to put plans for expansions on hold. “With a large pension deficit hanging over a company, it often cannot afford to write a cheque to take the next step as a business,” Shah said. “The value of a company will go up considerably if it loses the uncertain risk associated with its pension scheme.” 

Tyson at Prudential added: “Businesses have a large amount of cash on their balance sheets and in the current environment it costs less to raise capital to fund a buyout than it has for some time. That said, making a decision to buyout does not happen quickly and the market environment surrounding a buy-out transaction changes rapidly. 

Timing is a key factor in a buyout strategy, and the clock is ticking. “Typically a company wouldn’t still want to be waiting until the last pension is being paid to think about buyout as at that point it is too expensive,” said Gillespie at Towers Watson. “The ideal time is to wait until most members have retired and then buyout—insuring active members cost significantly more than retired ones due to the added risk involved.” Insuring a retired member costs an average premium of 0-5% according to Lane, Clarke and Peacock. This compares favourably with an average 25% premium for non-retired members. Paying administration costs until the scheme has wound down may also seem too much for some, but the cost of buying out—on average a 10% premium on the fully funded scheme total—often in one hit, is prohibitive for many. 

Lloyd Raynor, senior investment consultant at Russell Investments, said: “If a scheme carries out a liability hedge that covers interest rates, inflation, longevity, and market risk, they have in effect created their own buyout solution. Using a reinsurer to buyout the scheme does have benefits: A professional asset manager is looking after the scheme for you and there are economies of scale to be achieved by pooling administration costs with other schemes that have bought out—but company bosses have to remember that they are paying the profit the firm has made to someone else to make money from the deal.” Raynor added that some schemes, particularly smaller ones, may prefer forming their own stand-alone solution in a wrapper over which it has complete control. “Some firms are concerned about the potential for an insurer to go bust and what problems this would create for the scheme. In theory, they would be protected by government-assured compensation schemes, but this has never been tested to see what would be covered in reality.” 

This reluctance to take the plunge has not been missed by asset managers. F&C this year launched a pooled LDI solution for smaller schemes in the UK and Europe that may not have previously considered the approach due to the cost and sophistication concerns. “Dynamic and sophisticated LDI strategies had until recently been used by larger schemes due to the size of the workload involved and having to have the necessary governance budget in place to take advantage of market opportunities in a timely fashion,” F&C’s Lyne said. “Our Dynamic LDI product is focused on small- and medium-sized schemes that can enter the pooled fund and be confident they will always be in the ‘right’ instruments both at implementation and beyond in the same way a larger scheme with a more complex infrastructure would with a segregated mandate.”

Schroders, for one, is turning attention to defined contribution schemes to offer solutions to a previously untapped market. Indeed, diversifying their client base is one way of helping asset managers boost numbers as companies have shied away from implementing LDI strategies over the past 18 months, even if they agree with them in principle. According to market participants, many scheme managers have signed up to use an LDI strategy, but are waiting for interest rates to rise and hit trigger points at which it makes economical sense to execute the strategy. “Over the financial crisis, company bosses realised that governance structures within their pension schemes were not pre-emptive and we are now talking to schemes and their advisers about their objectives and putting structures in place even if now isn’t exactly the right time to pull the trigger,” Lyne said. 

LDI managers have time on their side, however. Depending on the severity of the funding shortfall, once locked in to this portfolio approach, it can take up to 15 years, if the markets do not crash again, to get to a fully funded level where a scheme would be able to buyout. Depending on the size of the scheme, it can take over a year to analyse the pension scheme’s liabilities, assets, and future changes in projections in order to present a company with a full costing. There are few businesses willing to bet on global economic stability in the current climate. 

Buyout firms, on the other hand, have had to find other options for business. Shah at Pension Corporation said it was working with several UK subsidiaries of multinational companies to manage their liabilities, including the UK arm of Japanese fabric producing firm Toray Textiles. For the moment, this has meant insuring pieces of a scheme’s liabilities rather than the whole package.

With trillions of pounds, dollars, and euros in pension liabilities, there is plenty of business to go around. Schemes simply have to decide how far down the de-risking road they want to go—and how much they are willing to pay to get there. 

-Elizabeth Pfeuti