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At start of this year the bulk annuity market was setting itself for another busy year building on the record levels seen in 2019, with further strong demand from pension schemes looking to insure some or all of their pension liabilities. How has this market fared during the Covid-19 crisis? What does this mean for schemes and sponsoring employers?
Alongside much of the country, the bulk annuity providers have successfully transitioned to remote working, with a continued strong appetite for new business as well as a focus on maintaining service delivery levels for existing schemes and individual members. Although overall market volumes for the year may ultimately be dampened to some extent, from the weakening of some scheme funding positions due to the effects of Covid-19 on the financial markets and sponsor businesses, we still anticipate a year of significant activity with total volumes potentially exceeding £25bn.
Some of the more extreme financial market movements in the second half of March have at least temporarily eased. However, long-term interest rates remain lower than at the start of 2020, mitigated to some degree by reduced inflation expectations. In isolation, these market movements will increase the value of pension liabilities. This will be true for pension schemes’ own funding measures, but it will also result in bulk annuity premiums being higher in absolute terms. Whilst the effect on funding positions will vary, those schemes that were well-hedged will have been largely protected from these adverse movements, as their hedging assets will have increased in value to offset the change in liabilities. A higher proportion of schemes considering a bulk annuity transaction in the shorter term are likely to be in this relatively low risk investment strategy and well-funded position, and so weathered the recent market turmoil relatively unscathed.
Importantly insurer pricing has other key drivers, which mean that opportunities can emerge in the bulk annuity market. Insurers’ investment strategies vary widely, but tend to include some exposure to credit assets. In recent years, insurers have increasingly explored illiquid loan-style investments to access attractive risk-adjusted yields. One consequence of the global pandemic and lockdown measures has been the turbulence in the corporate bond markets, with valuations falling and credit spreads widening relative to risk-free assets. Recognising their position as a largely buy and hold investor, credit risk management is a key priority for insurers to balance. Any flow through of widening credit spreads into pricing is subject to a number of complex insurer specific considerations, including their own risk appetite and ability to source credit assets, and views on potential default and downgrades. These are reflected through a sizeable haircut to any implied corporate credit spreads in the market.
Pricing improved during March and April, relative to a gilts valuation measure compared to the start of 2020, with a number of schemes already in the market being able to take advantage of this opportunity. Well-hedged schemes may continue to see that insurer pricing looks relatively attractive for insuring liabilities, particularly for shorter duration liabilities (e.g. pensioners), compared to a gilts liability measure.
The chart below illustrates the movement in pensioner pricing since the start of 2019. The dark green line shows the implied yield for a pensioner buy-in relative to a portfolio of gilts. Actual insurer pricing achievable may vary significantly depending on the commercial circumstances and specific transaction characteristics, as indicated by the green shaded area.
Chart - Bulk annuity pricing for pensioners
Covid-19 is likely to raise some challenging questions regarding longevity risks. Our longevity blog noted that the CMI has recently indicated that there may have been over 40,000 more deaths to the end of April in the UK than would have been expected without the coronavirus pandemic, based on ONS information.
Whilst 2020 has the makings of an exceptional year for mortality experience, it doesn’t necessarily mean that schemes’ future longevity expectations will be reduced. A watching brief is likely to be the name of game for trustees and sponsors in the short term, albeit with targeted analysis to aid understanding of their longevity risk exposures when considering transactions.
Pricing opportunities for the “right schemes”?
Insurer pricing is only one aspect in considering transaction opportunities. Focusing on partial transactions in the first instance, it is important to look holistically at the scheme and sponsor’s position, taking into account the wider funding and investment strategy. Our four point framework for identifying buy-in transaction opportunities can help here:
How does a buy-in impact expected future investment returns?
Does the buy-in help to reduce overall scheme risk?
Is it reasonable to invest in the buy-in, given that it is illiquid?
How easily can future scheme cashflow needs be met?
Improved insurer pricing relative to gilt returns may help the first couple of these tests be met. The question of “flexibility” is arguably of increased relevance in the current environment. By taking stock of the scheme and sponsor’s circumstances, it is possible to explore whether the scheme may be better served by maintaining flexibility in their investment strategy and not investing in a buy-in policy, or possibly re-considering the size of any proposed transaction.
It could make sense to preserve flexibility, for example, where any transaction would overly constrain the potential investment strategy for the remaining scheme assets in the post-Covid-19 world. Further for schemes holding risky assets, investing in a pensioner buy-in at this time is likely to mean that a higher portion of their assets would be passed to the insurer to fund the transaction due to recent falls in equity and property markets, compared to a pre Covid-19 crisis buy-in. Schemes and sponsors should consider whether the buy-in is still attractive in these circumstances, even if insurer pricing relative to gilts looks reasonably attractive.
Turning to full scheme transactions, for well-hedged schemes who have largely de-risked their assets, the solvency position may have improved due to the potential improvements in insurer pricing, particularly for the premium to insure pensioner liabilities. Insurers’ investment strategies for deferred liabilities are more nuanced given the variability and shape of those cashflows, in particular the duration of corporate bonds typically being too short to match these longer tail liabilities without significant reinvestment risks. As such, full buy-in pricing is more variable between insurers and heavily reliant on the individual insurer’s ability to source suitably matching assets.
While credit spreads are slightly elevated, compared to the levels at the start of 2020, there is still significant potential for market volatility. This means that the stage is set for possible future pricing opportunities to arise. It is important to recognise that these can be short-lived, which can encourage insurers and schemes to move quickly to secure deals. As a result, well-hedged schemes may wish to review their solvency position and consider whether getting ready to pursue a transaction may have merit. Such preparations can support a rapid approach to market and speedy execution.
For schemes looking to insure liabilities in the short to medium term, these preparations will be required in any case, and so prioritising actions even if an opportunity isn’t immediately on the cards may be beneficial, in order to be in a position to take advantage of any opportunities as and when these arise.
As always, preparation is key in order to be in the right place at the right time.
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