Get ready for buy-out: Investment considerations
Tom Seecharan, Rothesay
A good deal can still go wrong if your scheme is not well prepared on the asset side of the transaction. With a bit of planning, however, good can become great.
We discuss the most important considerations here, such as:
- How will your premium move with changes in market conditions and can you immunise yourself from such changes?
- What assets will the insurer accept and what will you need to sell?
1. Work out what you want to achieve, and plan ahead
“What is the best mix of assets to hold as you approach the market? Should a scheme hedge with gilts or swaps? How many corporate bonds should you hold?”
These are some of the most common questions that pension schemes ask us when they are starting to contemplate a buy-out. The short answer to all these question is “It depends on what you are trying to achieve.”
If you have reached full funding and just want to reduce any volatility while you approach the market, then full hedging with either gilts or swaps, plus some limited exposure to corporate bonds (less than 50%) will achieve this. Achieving perfection isn’t really possible as different insurers’ prices will move differently so you can’t match them all.
If you are looking for a smooth asset transfer by holding assets that an insurer will take as payment, then gilts are very simple to transfer, corporate bonds should be also (although it will depend on how you hold these bonds and insurers may not want to hold all the same bonds). It may also be possible to novate swaps but this will depend on the details of the swaps and who the counterparty is, etc.
Where other asset classes are held, it is most likely they will need to be sold and the earlier this planning starts the better (particularly for higher risk or illiquid asset classes).
2. How can you get absolute certainty your price won’t change?
Even after you have agreed a price, the affordability of a transaction can drift away if you aren’t careful – but there are ways you can get this risk under control.
“Paying for a bulk annuity is more complicated than buying a house – but it doesn’t have to be!”
If you’ve ever bought a house, the chances are you agreed a fixed price, your deposit was held in cash and your mortgage was for a fixed amount also. Even if the purchase took months to complete, and moving was stressful, one thing you shouldn’t have needed to worry about was your assets (deposit and mortgage) and liabilities (the house price) moving apart from each other. With a bulk annuity things are more complicated, but there are still ways to get this risk under control:
- Price-lock – this is an agreed mechanism that the insurer tells you in advance for how the premium will move. This means you can work out in advance how the premium will move versus your assets over the month or two that it might take to complete the transaction and whether you need to make any changes to your assets to bring the two in line.
- Price-lock portfolio – a price-lock is often set out as a complicated formula but it is sometimes expressed instead as a list of assets. This can be easier to understand and, more importantly, it means you could buy those assets and deliver them as payment also. This simultaneously removes a source of risk and ensures a quick and easy premium payment process. Win-win.
- Gilt-lock – this is a price-lock portfolio where the only assets listed are gilts. At Rothesay, this is our standard approach. In addition to the gilts having the same value as the premium, we also design the gilt-lock to have the same risk profile (both interest rates and inflation) as the underlying liability profile. Typically, we try to reduce your hassle even further by basing our gilt-lock as far as possible on gilts you already own.
- Asset-lock – this is the name for a price-lock portfolio which is entirely comprised of assets already held by the pension scheme. This has the benefit that the pension scheme is already completely immunised against price movements and, in the off-chance the deal doesn’t conclude, the scheme has not had to make changes to their asset mix which would now need to be unwound, potentially at great cost.
- Price-lock period – the period the insurer agrees to hold the price-lock for, typically six weeks.
- Boundary conditions – sometimes an insurer will build in protection for themselves that, in the event of pre-defined, significant changes in market conditions, the insurer would no longer have to honour the price-lock but has the right to re-price the transaction.
You would be forgiven for wondering why doesn’t every scheme just request an asset-lock with a 12-week price-lock period and no boundary conditions? This is not always possible. The size and nature of a transaction will dictate what an insurer is willing to offer. In addition, there may be a trade-off between risk and cost.
A long price-lock period with no boundary conditions is extremely valuable for a scheme because significant market risk is being passed to the insurer. Taking on this risk is therefore something they may charge for. All this needs to be considered carefully. A good price with no boundary conditions may actually be a better offer than a better price but with boundary conditions.
3. How you can help us to give you our best
Working with a specialist pension risk transfer adviser will help you through this complex process and engaging with us early will help us give you a better outcome.
It takes time and a good level of engagement with the scheme for an insurer to build and refine a price-lock portfolio which best meets a pension scheme’s objectives. We are generally happy to do this work and you can help us by providing early visibility on the assets held, setting out a clear objective and allowing us to engage with your investment adviser. This will give us the best chance to formulate a proposal which works for you.
About the author
Tom joined Rothesay’s Business Development team in 2019 and has over 19 years’ experience as a pensions actuary advising schemes and sponsors on assessing and managing pensions risk. Previously, Tom was involved in over 100 transactions as head of KPMG’s UK Pensions Risk Settlement team.