U.K. shaping up to be especially brisk place for buyout activity
Bulk annuity markets on both sides of the Atlantic are set for a bumper 2018 as improvements in funding levels, changes to longevity risk and better insurer pricing create a rare opportunity for sponsoring employers.
Sources said the impact of these elements is being felt in particular in the U.K., with consultants and actuaries preparing for a busier 2018 than recent years.
"As soon as you get a chunk of light, a lot (of companies) are keen to try to … take the risk off the books and preferably to buy the whole (pension fund) out," said Harry Harper, head of buyouts at JLT Employee Benefits in Manchester, England. "There's not much love between the company and their pension schemes anymore — it went long ago."
Sources said 2017's U.K. buyout and buy-in market amounted to about £12 billion ($16.6 billion) in transactions, the fourth year in a row that volumes exceeded £10 billion. They expect about £15 billion-plus in deals this year.
Three major factors are playing out in the U.K. right now for corporations that is making a decision to transfer pension risk to insurance companies altogether easier.
Improving equity markets, a hint of interest rates going up and decreased longevity in recent years — which have allowed some pension funds to reduce liabilities — all "point toward improving conditions for investing toward a buyout end goal," said Suthan Rajagopalan, head of longevity reinsurance at Mercer LLC in London.
Improved equity markets and falling liabilities have led to better funding levels for U.K. corporate defined benefit funds. "We have this almost rare bit of good news: It is the first time we have seen buyout funding levels materially tick up and improve" since the crisis in 2008, said Charlie Finch, London-based partner at Lane Clark and Peacock LLP. Companies sponsoring DB funds have faced difficulties with funding levels despite record employer cash injections over the past few years, he added.
Last year ended with the highest level of affordability for full buyouts since before the crisis, with the average FTSE 100 U.K. fund seeing its position improve by almost 10% since August 2016. Mr. Finch said one of five FTSE 100 companies is now more than 80% funded relative to the cost of a full buyout with an insurer, compared with one in eight a year earlier.
"Probably a lot of companies out there don't quite realize the strides they've made in the last 12 months," with pension fund valuations typically taking place only every three years, said Mr. Finch. "When (funds are) over 80% funded they are relatively close to full self-sufficiency or a buyout position; (they) should be thinking about how they close that final gap, what is their end-game plan," he said.
At the same time, longevity is being repriced by insurers, with participants not living quite as long as previously modeled.
"That has been a feature for a few years, particularly through the heavier death months, the winter months, and insurers have begun to reflect that in their projections," said Ian Aley, London-based head of transactions at Willis Towers Watson PLC. Insurers are "getting comfortable there has been a bit of a shift, and are reflecting their underlying mortality assumptions on that basis. It makes the buy-in or buyout more affordable."
Changing investment strategies by insurers themselves also has affected pricing. Historically, insurers invested their annuity business in corporate bonds, with the vast majority quoted on public markets. But the introduction of capital requirements in 2016 under the Solvency II directive put greater emphasis on the matching of their income stream to benefit payments. This led to insurers developing their "investment capability to access direct investments not on public markets — typically illiquid" assets, said Mr. Aley. This gives them better matching and a better yield on invested assets. "That passes through to their pricing. If you put those two (elements) together, it's almost a … perfect storm because the two key drivers of pricing have moved in the direction of pension schemes. And as that happens, it bridges the gap" between funded status and securing an annuity, driving up demand to transfer risk.
Added to that is external pressure given recent high-profile cases in the U.K. where some companies have been scrutinized over their pension funds and deficits.
There is "real appetite for U.K. corporates and FTSE 100 (firms) particularly to remove risk from the balance sheet. My sense is U.K. CEOs have had more questions on pensions," said John Baines, partner with Aon's U.K. retirement and investment business in London. "It is a clear, easy, demonstrable way to explain to shareholders you've got it under control."
And for multinational companies, the weaker pound sterling relative to other major currencies, plus uncertainty surrounding the U.K.'s exit from the European Union, might also push them further along the buyout path, said sources.
"Having a multinational exposure ... tends to mean that the U.K. fund is probably not massively material overall and the desire to get it derisked is partly driven by a desire to spend management time more efficiently. And if exchange rates move, maybe the top-up needed to take that final step of derisking is less costly with a weaker pound," said Mr. Rajagopalan.
Pension risk transfers also are expected to boom in the U.S. this year, but for different reasons.
Sources said $22 billion to $25 billion of deals were written last year.
However, improved funding levels are having an impact on the U.S. market. "We have seen tremendous interest in pensions risk transfer among our clients and also just in general within the pension community," said Ned McGuire, a managing director and member of the pension risk solutions group at Wilshire Consulting, an arm of Wilshire Associates Inc., Santa Monica, Calif.
For some funds this is in the consideration stage, thinking about the right assets to transfer when the opportunity arises. "And they start to think about more hibernation strategies, being able to maintain the plan at a level that is as least costly as possible, but also being ready to transfer the liabilities when the opportunities present themselves," Mr. McGuire said. "As we get to higher funded ratios, those are the conversations that are occurring with corporate plan sponsors."
He added that improving ratios are "going to be a significant tailwind to considering pensions risk transfer and hibernation strategies," a liability-driven style of investment.
Ari Jacobs, Chicago-based senior partner and global retirement solutions leader at Aon Hewitt, said the firm is hearing more about hibernation strategies.
"At some point in time, (funds) get to the end of the glidepath and that's when hibernation kicks in," with equity allocations moving to around 10% or even zero in some cases. Companies then choose between hibernation and settling all liabilities. "Few companies today have gone as far as to settle everything, and still look to settle incrementally," he added.
But tother factors specific to the U.S. pension fund market are driving risk transfer deals.
WTW's Mr. Aley said the U.S. is seeing risk transfers for a different cohort of participants from those in the U.K., with a trend to transferring the liabilities of participants who are no longer accruing, but also not yet drawing, benefits. He said this relates to Pension Benefit Guaranty Corp. premiums, which are driven by participant numbers rather than the benefits themselves.
"In the U.K. (there is) quite a bit of activity in top-slicing — a buy-in of the highest income individuals where there's a greater degree and concentration of longevity risk; whereas in the U.S. it is the opposite," transferring lower-income individuals. "Myself and my opposite number in the U.S. are doing the same advisory structure for clients, but ending up with the opposite end of the liabilities (insured) given the local aspects," Mr. Aley said.
On top of the PBGC premiums, U.S. corporations also are considering the impact of corporate tax reform, which "creates a pretty good incentive for companies to fund their plan on a more accelerated basis," since minimum funding contributions are tax deductible, said Mr. Jacobs.
The headline corporate tax rate will reduce to 21% from 35% under the law passed late last year.
"We are seeing a number of organizations increasing or accelerating funding by September 2018 that allows them to take advantage of the previous tax deduction" level, he said.