Written by Becky Wood, Trustee Director, Vidett
Earlier this year, we hosted our first ‘Risk Transfer Conference’, bringing together over 200 professionals from the industry. The day was made up of various panels, including one with representatives from Isio, Legal and General, Linklaters and Cardano.
The session looked at how we can capture different investment opportunities in the run up to a transaction, focusing on different timescales and how this could influence behaviour. The panel offered insights on how trustees and sponsors should approach each situation and overcome barriers to ensure a successful outcome.
Whilst for many pension schemes this is a well-trodden path beginning several years before the transaction, rising gilt yields in 2022 and increasing credit spreads led in many instances the journey has accelerated. The panel looked at what insurers and trustees could consider six weeks out, six months out and two years out.
Six weeks out – preparation is vital
As the market gets busier, insurers will not be able to quote on all transactions. They’ll prioritise deals that give them the best chance of a transaction. To be selected, pension schemes need to prepare and demonstrate what one insurer called ‘A BADGE’ – which stands for affordability, benefit specification, assets, data, governance and engagement.
Well-funded schemes are on the increase, which sees them seeking to manage buyout funding level volatility (so reducing their potential for funding level falls). The three main market risks that impact buyout pricing are:
- interest rates
- credit spreads
It’s worth noting, for all these risks, insurers will invest differently and have different expectations.
It can be beneficial for some pension schemes to partner with one insurer during the preparation stage to access best assets and prices, as well as assistance with data cleansing preparation if required and preferential reinsurance pricing. Conversely, doing this could mean losing the competitive tension of an auction process. Even if advisers are comfortable with the sole insurer approach, trustees need to be happy too, particularly as they have a duty to get the best price in the market and losing competitive tension may mean that is lost.
From a pension trustee’s perspective, price is often most important when looking to transact but it’s not the only factor. Partnering with an insurer can bring benefits, not least removing the execution risk in an auction process where trustees are relying on multiple parties.
However, if trustees are considering going down the sole insurer route, it is vital the employer is on board too as they will either be funding any shortfall or looking to share in any surplus and will have a keen interest. Trustees also need to be comfortable with the insurer’s covenant. This is important in all transactions, but even more so where you aren’t exploring the market more widely. Trustees also need to get advice to support their decision.
Assuming the scheme is well-prepared, it comes down to the ‘how’ and ‘who’. Trustees need to ensure they have the power to enter the transaction and have considered who will be responsible for getting it over the line. Ensuring everyone is on the same page is essential when dealing with a compressed timeframe.
Six months out – easing the pressure
Although it can be hard to generalise, when you have a little bit more time there are a few common themes when considering investment priorities. Making the portfolio as liquid and flexible as possible should be a key focus.
It’s also important six months out to understand the insurer’s pricing basis and sensitivities, the value of the insurer’s price and the scheme’s assets. Once the size of any gaps are known, stress test these gaps to understand how they could affect the viability of the transaction. Also consider what actions could help close these gaps, such as making changes to the investment strategy.
Two years out – proactive and careful planning is vital
Pension schemes on a de-risking journey need a clear investment strategy outlining what they want to achieve. Two years is still a short time frame and the gap analysis and actions to close any gap are vital. Firm agreement is needed with the sponsor about how any gap will be funded so this is ready to roll out when the transaction comes through.
Consider the risks and potential to be thrown off course and how to mitigate these as far as possible. Investment risks include markets, credit spreads, interest rates and inflation. Think about when to remove high growth assets (equity, diversified growth funds (DGFs), real assets, private assets etc) as it is unlikely much growth is needed at this stage.
Free capital can flow into high quality, liquid credit assets to provide a degree of alignment with insurance market pricing models. Linking the credit strategy with the journey plan is important as expected time to execution will drive decision making.
For efficiency and to reduce ‘leakage’ through the transaction, it may be possible to target a full or partial in-specie transfer for standard gilts and corporate bonds. If this is the target, a well-developed strategy and (ideally) direct collaboration with the insurer as early as possible will help the effectiveness of this type of transition.
At two-years out it’s about doing something sensible, both with hedging strategy and residual strategies so the investment strategy can do some of the work to get the scheme where it needs to be. A lot depends on the market opportunities at the time though. You’ll need a clear pathway to liquidity too – targeting100% liquid with six months to go so the transaction can go through smoothly.
Understanding liquidity is vital, as some assets may not be as liquid as you think. Sometimes pension trustees will be left with assets which cannot be redeemed within the proposed transaction timetable, meaning alternative solutions need to be investigated including deferred premiums.
Capturing investment opportunities and successfully navigating the complexities of risk transfer needs preparation and proactive planning whatever the time scale to transaction. This includes monitoring market opportunities, understanding the liquidity of assets and ensuring the most effective mirroring of insurer pricing when close to transaction.
If you have any questions or want to find out more on this topic, please get in touch with Becky Wood.