Ensuring a Smooth De-Risking Journey De-Risking Report 2018

Ensuring a smooth de-risking journey De-risking report 2018

Contents Ensuring a smooth Looking back at 2017...... 4 Getting the best value in the bulk annuity market...... 6 de-risking journey Is a buyout more affordable than you think?...... 9 De-risking report 2018 Run-off strategy: the ‘DIY buy-in’ approach...... 12 When should buy-ins be collateralised?...... 15 Where next for the bulk annuity market?...... 19

1 Ensuring a smooth de-risking journey Our credentials

Size and volume Client-focused solutions Experienced adviser on transactions ranging in size Streamlined approach which includes from £2 million to £16 billion pre-negotiated contract terms for cost efficient and quick transactions Advised on the first buy-in transaction in 1999. We have subsequently advised this client on four Strong relationships with the provider market, further deals leading to the best solutions for our clients A team which has experience of over 700 The only adviser to have led transactions using all transactions, including leading 25 buy-ins and of the available structures buyouts in 2017 of which 6 were over £100 million Longevity risk is integrated within the investment Advised more than 20 schemes who have put risk framework to enable active decisions in place multiple buy-ins, using both umbrella Settlement is a key part of our fiduciary investment contracts and open market approaches offering and at the heart of our strategic advice Leading adviser to insurers on annuity portfolio sale transactions Advised on over half of all longevity hedge deals ever transacted

Innovation We have an unrivalled history of innovation and embracing new ideas. For example, we were the lead adviser in respect of: The first collateralised buy-in The first all-risks buyout The first software tracking system to track live insurer pricing The first umbrella contract for repeat buy-in transactions The first novation of a longevity swap Our Longevity Direct offering was the first readymade vehicle for pension schemes to access the longevity reinsurance market 135 pension schemes and six insurers/reinsurers use Willis Towers Watson’s market-leading Postcode Mortality Tool

2 willistowerswatson.com Welcome

Welcome to Willis Towers Watson’s 2018 de-risking report, looking at the key themes in the longevity hedging and bulk annuity market over the next year. This report provides a look back at activity in the market during 2017, as well as an overview of what we consider to be the key themes for 2018 in order to help schemes ensure a smooth de-risking journey on a potentially bumpy road ahead.

2016 ended on a particularly strong strategies, the cost-benefit of collateralised buy-ins is an note and this continued into 2017. area of the market which we expect to receive more focus This was partly driven by pricing, with in 2018. On page 15, I explore the wider perspective on levels on pensioner bulk annuities in collateral. line with those last seen around the financial crisis. With a busy market and Finally, on page 19, Will Griffiths shares his views on what competitive pricing, on page 6, Louise we might expect from the bulk annuity market in 2018. Nash explores some of the tactics we used in 2017 to help schemes get the best possible value. At Willis Towers Watson, our market-leading team brings together experience and expertise across pension Combining this attractive pricing with strong equity returns consulting, insurance, liability management exercises means buyout may now be more affordable than previously and project management to help our clients find the right thought for many schemes, perhaps within touching solutions for them. We work alongside a wide range of distance if a proactive approach is taken. On page 9, clients as their strategic de-risking adviser, helping them Matt Wiberg considers how well-timed actions across both to identify and plan their end-game strategy, and the steps assets and liabilities, such as ‘member choice’ exercises, they can take along the journey. could shave years off your de-risking journey. We would welcome the chance to discuss further with Whilst many schemes are targeting buyout as their you how you can take advantage of the opportunities end-game, others are targeting a long-term run-off strategy. in this market for your scheme, and ensure your scheme’s Lok Ma compares the two strategies on page 12, de-risking journey is as smooth as possible. considering the journeys to each and how longevity risk management is key to both.

As more schemes are transacting large buy-ins, as well as Ian Aley insurers becoming more innovative with their investment Head of Transactions

3 Ensuring a smooth de-risking journey Looking back at 2017

2017 was a busy year in the bulk annuity and longevity hedging market, with volumes in the first half of the year significantly higher than over the same period in 2016. Overall, as can be seen in Figure 1, volumes exceeded those of 2016 and in particular, the level of longevity swaps was higher than seen over the last few years. As well as schemes approaching the de-risking market for the first time, we have also seen a high number of schemes completing follow-on transactions. Indeed, our research shows that over one-quarter of the bulk annuities written in 2016 and 2017 were repeat transactions. What were the Why was 2017 such a good year for pricing? key drivers for the level of activity in the For the last 18 months, we have seen bulk annuity pricing market in 2017? for pensioners typically achieve a higher yield than that available on a portfolio of gilts as shown in Figure 2. Whilst Attractive pricing (relative to gilt yields) at levels last seen one of the reasons for the level of pricing is strong insurer around the financial crisis and reinsurer appetite and competition within the market, Insurer appetite other factors are: Greater longevity hedging opportunities for smaller schemes Reduction in life expectancy - following three consecutive years of higher than expected deaths, insurers and reinsurers are taking steps to reduce their life expectancy assumptions, Figure 1. Volumes of business by year improving pricing for both buy-ins and longevity swaps relative to the reserves being held by schemes. 40 25.4 Greater innovation in insurers’ investment strategies - 35 traditionally insurers have held a significant proportion £ billion of high-quality corporate bonds. Insurers are now 30 increasingly sourcing and deriving alternative assets 25 such as secure income assets (SIAs) (see Figure 3) and Lifetime Mortgages. These provide a good match 20 for cashflows payable to pensioners and benefit from 5.9 15 9.3 6.4 an illiquidity premium, feeding through into reduced 13.2 2.6 7.0 12.3 premiums. 10 10.3 11.0 4.3 Giving insurers time to source suitable assets – as 2.2 7.2 5 5.6 mentioned above, the best pricing in a post-Solvency II 4.9 4.5 0 world is available from a high-yielding, closely matching 2010 2011 2012 2013 2014 2015 2016 2017* investment strategy. Giving an insurer time to source suitable SIAs for a specific cashflow profile, by entering into Bulk annuities a price monitoring period, can lead to better pricing being Longevity swaps achieved. We cover this in more detail later in the report.

*Transactions announced to date

4 willistowerswatson.com Figure 2. ‘Typical’ insurer pricing relative to gilt yields 'A' grade corporate bond spread above gilt yields (pa) 0.35% Over 2017, we helped 25 4.00% pension schemes to lock into attractive pricing 3.50% 0.25%

Pricing attractive vs gilts 3.00% 0.15% 2.50%

0.05% 2.00%

1.50% - 0.05% 1.00% - 0.15% Buy-in yield above gilt yields (pa) 0.50%

Pricing expensive vs gilts - 0.25% 0.00% Dec 2010 Dec 2011 Dec 2012 Dec 2013 Dec 2014 Dec 2015 Dec 2016

Gilt yields Buy-in yield above gilts yields Corporate bond spread above gilt yields

What’s led to the increase in longevity swaps? Figure 3. SIAs Whilst traditionally longevity swaps have been mainly These assets provide a secure income stream considered by the larger schemes, longevity swaps for generated from: as little as £100 million of pensioner liability have recently become considerably more attractive. These developments Real estate Infrastructure Real asset debt have partly been driven by Solvency II, which means most insurers have now put in place reinsurance treaties to hedge the longevity risk on both historic annuity business and new Contractual, inflation-linked, long-term cashflows business that they write. The increased flow of longevity risk to the reinsurance market has resulted in: Robust counterparties or tangible collateral backing Most economic value from cashflows A reduction in reinsurer pricing for smaller schemes. Limited economic exposure Smaller schemes are now benefiting from what has historically been ‘big scheme’ pricing as reinsurers absorb some of the more prevalent risks present in smaller schemes within their wider longevity risk portfolios. What will 2018 have in store for this market? Greater streamlining and standardisation of the contractual arrangements and running of hedges. What should schemes do to ensure a smooth de-risking journey? And what Is there capacity in the market to manage should schemes looking to transact the number of schemes looking to capture do to get ready? Read on to hear from this opportunity? our experts. Capacity means two things in the de-risking market:

Willingness to write new deals (in particular for bulk annuity providers, they need capital to back those deals) Resource to price and implement new deals Whilst the first was not a problem in 2017, there were times when the market was particularly busy and insurers were selective on which deals to deploy their resources on at various points during the year. However, there have been some new entrants to the market – Phoenix entered the buy-in market for larger deals – and we are aware of several reinsurers looking to enter the market for longevity swaps.

5 Ensuring a smooth de-risking journey Getting the best value in the bulk annuity market

2017 was a very busy year in the bulk annuity market. We also saw some of the most competitive pricing in several years from insurers, particularly in the run up to the end of the year. In this article Louise Nash explores the different tactics we have used to help schemes achieve the best possible value.

Show the market you mean business Set a clear target One message we hear time and again from the For schemes with a particular target in mind, it can insurance market, as well as see on the cases we work be a very successful tactic to articulate a target to on, is that if insurers can see a deal is likely to trade, the market and to confirm that a trade will go ahead they are much more likely to quote (thereby maximising if premiums below the target are achieved. This again competitive tension) and much more likely to offer the gives insurers confidence that a deal can be reached best pricing they can. Some of the key ways our clients and allows them to prioritise that deal over other are showing their commitment to the market are set schemes seeking pricing in a busy market. out below:

Demonstrating that both company and trustees Keep an eye out for time-limited are aligned in their objectives. For an insurer this is opportunities important, as it is less likely that one party will pull the plug on a potential deal at the last minute. One The insurers competing for buy-ins are driven by approach could be to set up a joint working party. corporate reporting cycles as much as any other This equally has benefits for many pension schemes business and awareness of these external factors as it is a cost effective way of operating. can help schemes achieve better value for money. For example, in 2017 we helped one client get a last minute Schemes which have a journey plan in place and significant additional discount by agreeing to work can articulate a clear vision to the market about towards completing a deal before a key shareholder their long-term objectives are very attractive to reporting meeting for the insurer. insurers as business partners, as they understand that the scheme is making a strategic purchase and have one eye on potential repeat business in future. Work with a partner Similarly, insurers are always happy to work with schemes that have completed buy-ins previously, as During 2017, we worked with several schemes to they believe they are more likely to complete trades. select a strategic insurance partner who best fitted with their wider selection criteria. Using market Finally, trustees and sponsors should look for knowledge we were able to set a stretching pricing opportunities to increase the scale of any transaction target at which a deal provided exceptional value for by combining buy-ins for schemes with the same the scheme, and gave the insurer an exclusive period sponsor – for example we recently led a marquee over which to source the assets needed to achieve transaction for four schemes with the same sponsor. that pricing. Particularly for larger deals with specific The three smaller schemes, with buy-ins between requirements, this approach can lead to significantly £14 million - £16 million each achieved significantly more favourable pricing than a traditional competitive more market traction and improved pricing by joining process, as it allows the insurer to source assets over together, and also working alongside, the larger a period of time that more precisely match the liabilities scheme which was completing a £75 million deal. of a specific scheme in order to optimise pricing. Agreement of the legal documents upfront also allows the scheme to be ready to react to short-term market opportunities, for example, volatility around elections or the Brexit negotiations. We typically see that when schemes trade has more influence on the level of pricing achieved than which insurer is selected.

6 willistowerswatson.com Case study: Bringing it all together - Project Ireland Monitoring market pricing using Asset Liability Suite and working with the insurance partner to optimise assets creates additional value.

Pre-monitoring Daily monitoring of market pricing

Insurer sourced and applied direct Willis Towers Watson’s investment to Willis Towers Watson’s client Asset Liability Suite software shared Improved reinsurance terms with the insurer made available as insurer had achieved exclusivity

Target price set

for transaction and price target premium between Dierence January February March April May June

Pre-monitoring -- a formal bid process Contracts agreed - Insurer price Deal mobilisation Target hit - deal run with all insurers transaction ready optimisation triggered executed same day

Our client wanted to secure a £250 million buy-in for a market-leading price and also wanted to select an insurer who they believed was the right strategic fit for the scheme and sponsor. As part of Project Ireland, we ran a process to select a preferred insurance partner based on a wide range of selection criteria. Once the Trustee and sponsor had identified their preferred provider, the insurer was set a stretching target premium to try to achieve over an exclusivity period of six months. To help both parties understand how this target moved relative to markets, we used Willis Towers Watson’s Asset Liability Suite software, with the insurer and the Trustee able to see the target price online daily.

This was the first time software has been used in this way in the buy-in market. The transparency of the target was key for the insurer to find the perfect asset – the confidence of being able to transact quickly if the price target was met gave the insurer the certainty needed to source a high-yielding, well matching asset and negotiate hard with their reinsurers. Whilst the monitoring was ongoing, the other aspects of the transaction, such as legal terms, were prepared so the buy-in could happen quickly once the target price was met.

Over the first five months of the monitoring period, the insurer reduced the transaction price by in excess of 5% through securing a more optimal asset and improved longevity reinsurance pricing. As the June 2017 general election approached, the insurer’s price was only slightly above the target and all parties were aware that a small amount of volatility would allow the target to be hit. The scheme was prepared to take advantage of potentially unique market conditions. The preparation paid off. On the Monday following the election, the insurer confirmed it could meet the price target. The contract was signed within three hours.

7 Ensuring a smooth de-risking journey Asset Liability Suite: daily measuring of the affordability of a bulk annuity The Bulk Annuity Module provides daily information on the affordability of a bulk annuity covering some or all of your liabilities, using detailed pricing information provided by the main insurers in the bulk annuity market and supplemented by our Transactions team’s current experience of the pricing achieved on actual deals in the market. This will give you confidence in the likely outcome of a quotation process, giving you the information you need to engage with stakeholders and prepare a credible proposition to approach the insurance market with, ensuring you get maximum attention and your transaction is prioritised.

8 willistowerswatson.com Is a buyout more affordable than you think?

After a decade of misery in scheme funding, strong equity returns, attractive bulk annuity pricing and the prospect of rising yields mean that end-game plans for schemes are being drawn up or dusted off. Some schemes now find themselves well-funded (say, 85% plus) against their buyout measure (or solvency measure). Whilst on first glance they may appear to be a number of years away from being able to buyout, Matt Wiberg considers how well-timed actions across both assets and liabilities could shave years off the time it takes in practice.

Step 1: Understand how big the buyout deficit expensive than the cost of insuring a 60 year-old pensioner really is with the same benefits, so if the scheme will be largely pensioners in five years’ time, this should be reflected in the The first step is to understand how far you may be from the projections. true buyout cost. Although schemes are required to measure their funding level against a buyout cost at each statutory valuation, it is important to understand how reflective this is Being able to accurately monitor your funding of the actual cost of fully settling all benefits – both now and position will become more important as you in the future. approach fully-funded status to allow you to lock

Even if you do track the affordability of buyout between in gains as these emerge and avoid overfunding. valuations, terms available in the market do vary significantly over time – possibly by up to 5% or more – and the Step 2: Understand the levers assumptions that were set at the last valuation may not be reflective of current pricing. For example, insurers are Next, you should consider how to close the remaining now reflecting the recent heavier deaths experience in gap. You may be expecting a combination of asset their pricing, and an increased supply of Consumer Price outperformance and contributions to do most of the heavy Index (CPI)-linked assets is making the pricing of CPI-linked lifting, most schemes are. When discussing with your liabilities significantly better than they were three years sponsor, it is likely to be worth considering the present ago. If your assumptions (or even your buyout funding level) value of future scheme expenses which the sponsor is have not been assessed for a couple of years, you may be indirectly, or directly, meeting. surprised at how affordable buyout could now appear. Shaving a number of years worth of costs off a journey Similarly, if you are targeting buyout in the future, then it is plan can amount to a significant value which can be offset important to understand the cost at that point. For example, against the deficit. the cost of insuring a 60 year-old deferred pensioner is more

Action 1:

The first action you should consider on the liability side is an audit of your data.

Although your data may be adequate for the administration of the scheme on a day-to-day basis, enhancements will be required before the scheme can be wound up, so perhaps now is the time to sort out any remaining data niggles. Getting your records in order will have a number of potential benefits; it will allow you to provide more personalised details to members on their options with respect to their benefits, it could reduce the cost of the bulk annuity policy and also the costs of any indemnity insurance/run-off insurance secured by the trustees following the buyout. Key data actions for any buyout activity which can have material price savings will be:

Locate any members you have lost contact with Review any long-term suspended pensions and deferred members well over normal retirement age to determine if these members have actually died Gather data on marital status and spouses

9 Ensuring a smooth de-risking journey Action 2:

Providing members with more details about their options can help close the gap to buyout, whilst benefiting members – so a potential win-win.

Many schemes that are well funded will have a relatively low-risk investment strategy, which is reflected in the assumptions used to calculate transfer values, leading to cash amounts which are very attractive to members who value flexibility over the form of retirement benefits a final salary scheme provides.

Transfer values will be lower than the cost of buying the same benefits with an insurer as part of a buyout and wind up of the scheme. What isn’t always appreciated is that the transfer value paid to a member in a well-funded pension scheme is likely to be up to 40% higher than the surrender value of a deferred annuity policy – that is, the payout the member would get if they left the scheme following a buyout. Members who are putting off thinking about the retirement options for their defined benefit (DB) pension until they are ready to retire may wish to know this information before a buyout deal is done. Schemes approaching their goal of buyout should therefore consider a bulk exercise to inform deferred members of their retirement options sooner so they can understand the choices available to them and make the right decisions. There are advantages from the scheme’s perspective too, simply reminding members that they can transfer or retire early can really help to reduce the buyout cost, with the latter reflecting the fact that an early-sixties retired member is significantly cheaper to insure than a deferred member of the same age.

Pension levelling options, which provide members with more consistent income throughout retirement rather than a step-up at State Pension age, can help members afford to retire earlier, particularly those with lower pensions for whom the State Pension will be more critical to retirement planning—so you could consider whether offering this option in the scheme would be attractive to all parties.

Pension increase exchange exercises should also be considered, particularly if unusual increases are guaranteed under the scheme rules – for example pensions with an annual increase floor of 3% and annual increase cap of 5%, which are very expensive to insure as the provider won’t be able to find matching assets. In this scenario, an exchange which looks really attractive to members will also save money relative to the insurance cost.

Planning to pay winding-up lump sums, which may not be material in terms of liability, will have an impact on the insurers’ expense loadings so should be considered.

A combination of these member choice exercises could have a significant impact on the funding of the scheme and the time taken to reach buyout.

Action 3:

Finally, think about how and when you will engage with the insurance market.

Building relationships with the insurers will be key to getting maximum engagement and the best pricing when the time is right for your scheme to transact. Large transactions, particularly those involving a significant proportion of deferred members, are capital intensive for the insurers and they may need time to source the capital required. For the largest schemes, a full buyout may be better managed as a series of bite sized chunks – transactions of £100 million - £500 million tend to attract the best pricing in the market at the current time. For all schemes, having a process to monitor the bulk annuity market against key liability measures will allow you to spot pricing opportunities so as to advance your plans.

10 willistowerswatson.com Figure 4. How an example £1bn scheme could close the gap to be in a position to buyout

160

140

120

100

80 £m

0 Buyout deﬁcit Investment Transfer Winding-up More Impact of Buyout at January 2018 returns exercise lump sums retirements competition deﬁcit on buyout at December pricing 2018

When combined, and coupled with a proactive approach, all of these actions could lead to a significant improvement in funding level over a relatively short period of time. Figure 4 shows how an example £1 billion scheme could close the gap from being 85% funded at the beginning of 2018 to fully funded and ready to buyout at the end of 2018.

Some schemes are already ahead of the pack when it comes to achieving their ultimate goal due to their current funding position, but the drivers of improved funding levels will influence all schemes to a greater or lesser extent. Ultimately, securing a full buyout in the insurance market may become a competitive activity, with not all schemes getting the engagement they need from the insurers to reach their price targets. Those schemes which can demonstrate their commitment to the process are likely to be prioritised by the insurers and achieve the best outcomes.

11 Ensuring a smooth de-risking journey Run-off strategy: the ‘DIY buy-in’ approach

In recent months, one of the hot topics in Comparison between the two end-game DB pensions has been the refinement of the options run-off strategy as an approach for relatively A scheme in run-off and an insurer managing a portfolio of annuities will follow a similar approach. Both will hold a well-funded schemes. As this typically low-risk, low-return investment portfolio designed to match involves taking a leaf out of the insurance benefit outgo with asset income, alongside a risk reserve industry’s book in managing liabilities in a held as a buffer against any remaining financial, demographic and operational risks. low-risk manner, this approach has also been described as the ‘DIY buy-in’ approach. The main difference, therefore, relates not to the approach for meeting the benefits, but in terms of how things are In this article, Lok Ma compares the two packaged up and who remains responsible for the risks: main end-game options for pension schemes A scheme in run-off adopts an ‘insurer-like’ strategy, but as they continue to mature – in-scheme ultimately the sponsor retains the responsibility for and run-off vs buyout with an insurer. In practice, the risks associated with meeting the benefit payments. An insurance company packages up the approach as a these two options share many similarities, are product, and takes over these responsibilities and risks. likely to be closely intertwined and longevity risk management is key to both. Figure 5 sets out the similarities and differences in more detail.

Figure 5. Comparison of a run-off strategy and using a bulk annuity insurance product

Strategy Run-off Buy-in / buyout

Investment strategy Broadly similar

Cashflow matching (see call-out box) Yes

Required level of assets Lower: no passing on of profit (or Higher: insurer charges for cost of commutation/transfer experience) providing risk capital (to be drawn upon following unfavourable experience) and a loading for profit

Level of security Lower: the scheme continues to be Higher: significant protection under exposed to residual financial, demographic insurance regulatory regime and operational risks, and additional sponsor contributions may be required

Longevity hedging (see call-out box) Optional Included

The two end-game options should be considered in the the short to medium term, are more likely to invest more context of the trade-off between security and cost, with the aggressively in the short term to target buyout. This implies choice between them likely to be informed by the sponsor taking more risk in the coming years but, once bought out, covenant and/or scheme size. For example, smaller schemes, residual risks are minimal. or schemes whose sponsor covenant is uncertain beyond

12 willistowerswatson.com Cashflow matching Any discussion about a run-off strategy is likely to touch on the merits of a cashflow-matching approach, and the concept of cashflow-driven investment. Insurers have adopted these approaches for many years for their annuity businesses.

The concept of cashflow matching is simple: a well-funded scheme can afford to buy a portfolio of low-risk, income-generating assets that is expected to meet the benefits as they fall due – for example, corporate bonds and direct investments (such as property and infrastructure) alongside the more commonplace gilts and swaps.

Under this approach, a scheme no longer expects to have to sell its assets, making the scheme more resilient to the day-to-day fluctuations in market pricing:

Market volatility Reason for volatility Is the scheme affected? Breakdown the reasons for price change Still a concern for the scheme, Level of cashflows expected as payment of benefits is from asset is reduced impaired

Fall in price of matching asset

Change in market demands for Less of a concern for the return over risk-free rate scheme, as not expecting to sell asset

Staying flexible between the options Planning ahead: knowing the likely end-game means the right types of assets can be built up in good time. Whilst we have so far positioned the end-game as a choice between two distinct options, in practice many schemes will But staying flexible: it is worth bearing in mind the adopt an approach of: alternative end-game, which may become the preferable option should circumstances change:

Journey plan Insure all liabilities

Current Alternative path position

Run-o

Below we have set out a couple of examples of schemes that may change course:

Scheme A Scheme B Currently has a plan to buyout all liabilities in 10 years’ Has a large non-pensioner population, making buyout time. However, if investment performance turns out to be expensive. Targeting run-off instead of buyout in the worse than anticipated, or the pricing of a bulk annuity medium term means a lower-risk investment strategy contract becomes more expensive, it may adopt the can be adopted. In 10 years’ time the scheme will cheaper run-off approach instead and continue to rely on have matured substantially and therefore this, plus the the support of the sponsor over the long term. payment of commutation and transfers, may mean buyout can be reconsidered.

13 Ensuring a smooth de-risking journey Another example demonstrating how the two options are Conclusion intertwined in practice is that a scheme in run-off may Going into run-off or settling the liabilities with an insurer are well enter into a partial pensioner buy-in. This can lead to two alternative options for a scheme’s end-game. In practice, improvements in funding level for the scheme, if a deal is there are as many similarities as there are differences available at the right price and makes sense in the context between the two options, and each could be the suitable of the overall run-off portfolio. long-term aim for a scheme depending on its specific circumstances. Being aware of both options and staying Managing longevity risk flexible between the two could well be the best philosophy, as schemes continue to mature and build up their funds in An insurer providing a bulk annuity will take on the risk anticipation of the end-game. that pension scheme members ultimately live longer than expected (although in practice they will lay off this risk to reinsurers who are global consolidators of the Case study: The MNOPF transacts a risk). By contrast, under a run-off approach, a scheme £490 million buy-in with Legal & General has a choice between insuring this risk (via a longevity swap) or retaining the exposure (self-insurance through The Merchant Navy Officers Pension Fund (MNOPF) incorporating an allowance within the risk reserve). is on a journey plan to be fully funded in 2025. Willis Towers Watson is the Fund’s Delegated Chief Clearly, having greater certainty of cashflows is Investment Officer, helping the Trustee to achieve this beneficial in terms of investing to meet the benefit outgo. journey. But there are two important things to bear in mind: In early 2017, Willis Towers Watson identified an Cost of hedging longevity: the cost of hedging opportunity to exchange a proportion of the Fund’s gilts longevity risk is similar whether a scheme insures the for a buy-in, covering recent retirees in the Fund, at an risk separately, or it is priced into the premium for a buy- attractive price. This buy-in covers the new retirees in or buyout. Pension schemes can pay for this cost in the MNOPF since the Fund’s 2014 longevity swap by partially recycling the risk reduction achieved and through Willis Towers Watson’s Longevity Direct, a re-risking the assets to seek a slightly higher return. readymade Guernsey cell structure. Case for hedging longevity: the case for reducing Following a highly competitive bidding process, in the exposure to longevity risk is stronger for a December 2017 the Fund entered into a £490 million scheme adopting a low-risk investment strategy, as buy-in with Legal & General. The buy-in was paid for via there is less scope for longevity risk to be ‘diversified an inspecie transfer of gilts. away’ in conjunction with other risks.

As well as managing more longevity risk, the buy-in has advanced the Fund’s journey plan. Governance requirements Rory Murphy, MNOPF’s Trustee Chair, said: As with all aspects of managing a pension scheme, a better governance model is likely to lead to a better outcome for a scheme that is still in the process of building up sufficient “This buy-in enables us to more funds in anticipation of the end-game. effectively manage the risks faced by the Fund as a whole. There is also a positive For schemes choosing the run-off approach, the skills needed to manage residual risks and oversee the cashflows message here for the wider pensions coming into and out of the scheme will be more familiar community: a well-run fund, with strong territory to an insurer than a typical pension scheme. governance and expert advisors, can Delegating the technical implementation of such a strategy to a specialist is an obvious way forward, but comes with deliver valued and sustainable benefits a cost. The trend for moving to a fiduciary management to its members while successfully model is likely to continue as schemes continue to mature. In this context, a transaction to pass on assets and liabilities managing the risks and costs faced to an insurer via a buy-in or buyout can be seen as the by its employers.” ultimate form of delegation to a third party.

14 willistowerswatson.com When should buy-ins be collateralised?

2017 was a year in which a large number of mid-sized buy-ins occurred as pension schemes sought to lock into attractive pricing. Pricing tended to be optimal for transactions of £100 million to £500 million. This size of transaction is also the level at which some insurers may be willing to offer collateralised deals. Trustees are therefore faced with a decision as to whether to attempt to enhance the security of the buy-in transaction through the use of bespoke collateral structures.

In this article Ian Aley explores the likely benefits and associated costs involved with securing a collateral structure.

I imagine if trustees were asked the simple question “Do different approaches. The most commonly used, and you want extra security with your buy-in?” that many would perhaps most easily understood, is an approach that has immediately respond by acknowledging that this was a been used for many years in the reinsurance market and requirement of any transaction. However, as posed, this is commonly known as a ‘deposit back’ structure. This question does not take account of the additional complexity, operates as follows: cost and loss of return that is inherent in acquiring this potential added security. Neither does the question 1. The buy-in premium is paid by the pension scheme to acknowledge that only the costs are certain whereas the the insurer. additional security is unlikely to ever be accessed, and, if it is, the level is itself uncertain. 2. The insurer then places a proportion of that premium in a separate account held by a custodian, thus establishing If I were to reword the question to “Would you like to pay a a ‘collateral account’ holding the assets. The trustee has significant amount of money for something you never expect to legal ownership of the collateral account with a charge need?”, I suspect the answer would be very different. The reality for the insurer. is of course that neither of these loaded questions capture the full facts, but rather they demonstrate why trustees and 3. The insurer pays the pension amounts due under the sponsors should consider the full cost-benefit analysis when buy-in policy. deciding whether they require a collateral structure. 4. The collateral assets held within the account are adjusted to reflect a constant proportion of the value of What is collateral? the remaining liability. There are a number of ways in which a collateral arrangement may be structured, with different insurers taking slightly

Surplus/ Pension Scheme 4 Insurer deficit Collateral account

2 1 Premium

3 Pension payments

15 Ensuring a smooth de-risking journey Key areas of a collateral offering to be The likelihood of an insurer failing is low, which indicates that considered the most likely scenario for the collateral to be required is one where the economy is in severe stress. This leads most As with any financial structuring there are a number of key recipients of collateral to require eligible assets to be both areas of consideration when evaluating a collateral structure, secure and liquid – typically cash and government bonds. each requiring scrutiny when contrasting one insurer’s Such restrictions on the eligible assets provides the trustees offering against another’s. with a great deal of comfort. 1. What proportion of the buy-in premium is being However, in order for insurers to provide competitive posted as collateral? premiums, they need to invest in higher-yielding assets such The amount of collateral being placed into the collateral as corporate bonds and direct investments (for example, account and how this level is maintained is critical to the infrastructure projects). A strict definition of eligible assets value of the structure. Insurers offer varying levels of prevents insurers from achieving this higher yield, resulting in collateralisation and these should be considered carefully. an additional cost – see below. Ideally from the pension scheme’s perspective the trustees would like sufficient assets to be able to replace the 3. How does the pension scheme access the assets? buy-in with another provider. Whereas from the insurers’ The level at which the trustees are able to access the perspective, such a ‘replacement value’ represents an collateral assets is also an important consideration. open-ended commitment and therefore, a number of Typically, buy-in collateral structures include a number of regulatory challenges. ‘trigger events’ whereby the trustees are entitled to take full control of the assets – such as failure to make payments, a Typically the assets held within the collateral account decline in the insurer’s solvency funding level or credit rating, represent a fixed percentage (possibly less than 100%) of or insurer insolvency. the best estimate liability, hence a lower amount than the original premium and less than the present value of the cost of paying the future benefits. Who offers collateral structures? Collateral structures are not available to all, typically insurers 2. What assets are allowed to be posted in the will engage in discussions on collateral for transactions of collateral account? upward of £400 million. Not all insurers will readily offer Agreeing the assets that are allowed to be held within collateral structures, whilst others offer temporary structures. the collateral account (eligible assets) is also of great That said, most are open to negotiation. importance, and here there is again a further balance to be achieved. Those insurers that are willing to offer a collateralised deal have reservations as to the sustainability of such structures, indicating that should demand be significant, then either the cost of collateral will rise or they will be forced to stop offering such deals.

Security of a buy-in without collateral In order to consider the value of collateral, it’s important to consider the security without a collateral structure.

Buy-ins are provided by UK regulated insurance companies. This status provides multiple layers of security, therefore the counterparty risk must be considered in the context of each insurer’s overall financial strength, the priority status of an insurance policyholder in an insurer insolvency event, and the regulatory regime administered by the Prudential Regulation Authority.

In addition, there is the protection offered through the Financial Service Compensation Scheme (FSCS), which would provide cover in the event of the failure of the selected insurer. Currently the FSCS protection is set at 100% of the value of any claim.

16 willistowerswatson.com Insurer Capital Under Solvency II, a European-wide capital adequacy regime, insurers are required to hold capital at all times to a standard agreed with the regulator to be their Solvency Capital Requirement (SCR). Quoted Solvency II ratios are calculated as Own Funds/SCR.

Surplus SCR - capital to withstand a ‘1 in 200’ year event. SCR Own funds

MCR Minimum Capital Requirement (MCR) - below which policyholders are exposed to Risk Margin unacceptable levels of risk.

Additional capital for ‘unhedgeable risks’ including longevity risk.

Longevity reinsurance is widely used to reduce this

Best estimate capital requirement. liabilities willing seller

Technical provisions Technical The present value of the projected future annuity payments and expenses. Technical II, the Technical Under Solvency liabilities between a willing buyer and a a willing buyer liabilities between represents a fair value for the for value a fair represents Provisions

Buy-in provider regulatory capital ratios at 31 December 2016

Aviva Canada Life Legal & Scottish Just. Pension Rothesay Life L&P General Widows Insurance Corp SCR 152% 166% 154% 144% 147% 164% 180% MCR 607% 622% 617% 477% 471% 551% 605%

17 Ensuring a smooth de-risking journey What additional security does collateral offer? Pool B: 100% gilts

The primary benefit of a collateral structure is in the event Pool A is expected to generate a return of c1.4% a year more of the insurer encountering financial difficulties the trustees than pool B. The loss of this expected income for the insurer have access to specific assets at an early stage. therefore generates a significant strain, a cost which must either be partially or fully paid by the pension scheme. What does collateral cost? Collateral comes at a cost, and the costs vary both from Are there other options to increase security? insurer to insurer and according to the features of the Whilst the focus of this article has been the posting of structure. Invariably the costs may be considered as follows: collateral in order to enhance the security of a buy-in policy, there are alternative approaches, including: i. Explicit costs The insurer will quote an explicit cost of structuring, Agreeing surrender terms with the insurer which allows establishing and maintaining the segregated fund. These the trustees to surrender their buy-in policy and receive explicit costs are typically around 1% to 3% of the buy-in a payment representing an agreed proportion of the premium. insurer’s reserves. These structures usually include pre-agreed surrender triggers. The advantage of this ii. Ongoing overheads approach is that it is cheaper both in terms of the The pension scheme also incurs material additional costs additional premium and the ongoing costs of maintaining over the lifetime of the contract to cover the negotiation the arrangement. of the collateral, as well as operational maintenance and governance. Setting aside a risk buffer which is available to the pension scheme in the event of the insurer failing, this iii. Implicit costs might, for example, be equal to the aggregate costs of Perhaps the greatest cost, however, is the implicit cost of the collateral structure (explicit cost plus the saving in restricting the eligible assets so the insurer has to hold premium plus a capitalised value of the ongoing savings). low-risk assets within the collateral account. This cost is either borne directly by the pension scheme (via a higher So what should schemes do? premium), or by the insurer (by using excess liquidity within their wider annuity portfolio - although the insurer will charge Some schemes will feel very strongly about the need for the scheme for that liquidity strain). collateral – particularly those with sponsors in the finance sector. Other schemes should ensure they fully understand To illustrate this point let us consider two contrasting the full spectrum of additional costs being incurred by collateral pools: having collateral, and also the circumstances in which such collateral will be utilised, and what they will actually receive in Pool A: 35% direct investments, 35% corporate bonds and this event. 30% gilts

18 willistowerswatson.com Where next for the bulk annuity market?

Will Griffiths looks at what 2018 has in store for the bulk annuity market and how activity during 2017 is going to be partly responsible for shaping this.

2018 is already shaping up to be a busy year in the bulk annuity market, with some schemes deciding to delay transactions at the end of 2017 in order to seek greater engagement at the start of this year. This means that the first quarter, which historically has been a relatively quiet time for the market, is likely to be anything but. With the end-of-year rush firmly established as a consistent feature of this market, we expect 2018 will set a new record for bulk annuity business written. However, there are several key factors which will determine whether we will have a record breaking year.

What impact will financial markets have? Pricing of CPI-linked benefits remains well above the ‘typical’ Technical Provisions assumption a pension The financial markets in 2017 were relatively benign for the scheme would use, due to the extra capital an insurer bulk annuity market. Gilt and swap yields rose into January, needs to hold as they can’t hedge CPI benefits exactly. dropped sharply soon after and then rose consistently from While there is little sign of a liquid CPI market developing, the middle of summer onwards. Credit spreads, a key driver CPI assets are structured from time-to-time and improve for insurers pricing, did not move significantly for or against pricing for those schemes which secure an allocation to schemes (as can be seen in Figure 2 on page 5). their transaction.

It’s possible that 2018 will see much of the same, however there are a number of market drivers that suggest we could Getting to the front of the queue be in for a bumpy ride. Such bumps often present great Many schemes we speak to are considering how to build buying opportunities in this market but only for those in a buy-ins into their journey plans, such that when they reach position to move quickly, for example if they have a price their end point they will have already secured the majority target and agreed legal terms. of their liabilities. In this way a pension scheme can take advantage of the long-term horizon of their journey plan to Brexit negotiations, much like in the aftermath of the pick and choose optimal moments to approach the market referendum vote itself, may well create a series of market and transact. adjustments. Corporate bond spreads may also widen if the perceived This could be when financial markets move in their favour (as outcome of Brexit negotiations doesn’t seem to be outlined above), after they’ve seen the outcome of a liability favouring corporate Britain. management exercise improve their funding level and wish An increase in risk-free yields, particularly at longer to lock-in these gains, when a new insurer enters the market durations, is likely to lead to a bigger reduction in insurer offering strong pricing or when an insurer is very keen to pricing due to the ‘risk margin’ insurers are required to write business before the year end. hold as part of their capital buffer. The risk margin is held against ‘unhedgeable’ risks and it has a long duration. Spreading the purchase of bulk annuities will also help An increase in yields at longer durations will have a mitigate the risk that pricing worsens overtime (the benefits significant effect in reducing the amount of capital an of price averaging as any investor knows), because no one insurer needs to hold – feeding through to lower buy-in knows what pricing will be like in 10 or 15 years’ time. It premiums. could be that insurers will find new and innovative ways to lower their pricing and regulations and capital requirements may be weakened. Equally buy-in pricing may increase, for example, the availability of longevity reinsurance may start to decrease as demand outstrips supply, and yields on SIAs may fall as both pension schemes and insurers compete for the same assets.

19 Ensuring a smooth de-risking journey A survey we ran in 2016 reported that over half of schemes Even if they can and will do this, do they have the are targeting completion of their journey plan between 2025 resource in their teams to be able to price all the deals and 2030. While all of these won’t be going down the route that are brought to them? of settlement in the bulk annuity market, a considerable If not, which type of deals will they focus on and will this amount will be. This points to a significant increase in differ between insurers? demand for bulk annuities, which may in turn mean it is better for well-prepared schemes to start this process of This predicted increase in demand may be tempered slightly annuitisation before the rush begins. by more schemes exploring the approach of ‘DIY buy-ins’ as set out on pages 12 to 14. Additionally, should any insurers Insurer capacity seek to sell their backbook of annuities as Zurich and Aegon did in 2015 and 2016, then this would be expected to have Assuming a further increase in demand does materialise in a significant impact on the bulk annuity market capacity. 2018 then it will likely pose some interesting questions for As may be observed in Figure 6, the backbook market is insurers. significant although it is made up of a small number of large deals which results in it being somewhat unpredictable. Can they, and will they, maintain the current attractive levels of pricing across all transactions that they have?

Figure 6. Volumes of business – including bulk annuity provider and reinsurer backbooks in the public domain 65 60 55 50 45 40 35 £ billion 30 25 20 15 10 5 0 2010 2011 2012 2013 2014 2015 2016 2017*

Bulk annuities Longevity swaps Backbook activity utilising bulk annuity provider Backbook activity utilising reinsurer capacity

*transactions announced to date

The longevity dilemma resolved? One aspect that doesn’t change and is now more important than ever… We had noted in this section of the report last year that the cost of longevity hedging had started to reflect the recent …Is how a scheme positions itself with the market. The heavier deaths experience and that this had also started to importance of this has changed markedly over the flow through into bulk annuity pricing. years, from 2007 when a lot of insurers would bend over backwards to accommodate pension schemes, to a decade This continued over 2017, with another year of heavier later when all insurers will routinely decline transactions. deaths and reinsurers adjusting to this by reducing their This may have been unavoidable in certain circumstances, prices. On a like-for-like basis, the cost of a longevity swap say if the market was very busy, but highlights the need to has fallen significantly, and this is also feeding through into consider key aspects that can be presented in a positive light buy-in pricing (and is partially responsible for the attractive to insurers such as a well-established governance structure, levels of pricing we’ve seen). This also has the secondary a clear price target, clean data and strong company support impact of reducing the duration of liabilities that insurers as detailed on page 6. need to invest to match, so making it easier to generate a higher yield.

20 willistowerswatson.com

Bulk annuities Longevity swaps Our senior transaction specialists:

Ian Aley Keith Ashton Shelly Beard Head of transactions Head of risk solutions Senior director [email protected] [email protected] [email protected] +44 207 170 2692 +44 173 727 4629 +44 207 170 2975

Katherine Gilder William Griffiths Gemma Millington Director Director Director [email protected] [email protected] [email protected] +44 117 989 7425 +44 161 833 6234 +44 121 644 7309

Louise Nash Sadie Scaife Matt Wiberg Associate director Senior director Director [email protected] [email protected] [email protected] +44 173 727 4255 +44 113 390 7170 +44 207 170 2176

21 Ensuring a smooth de-risking journey About Willis Towers Watson

Willis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has 40,000 employees serving more than 140 countries. We design and deliver solutions that manage risk, optimise benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas – the dynamic formula that drives business performance. Together, we unlock potential. Learn more at willistowerswatson.com.

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