Back in September 2014 we addressed just this question - arguing that waiting for rates to rise before considering a bulk annuity (buy-in/ buyout) investment is a potentially misguided strategy.
Now, over two years later, long-term interest rates are some 1.5%-1.6% per annum lower (as measured 30 September 2014-2016), with significant falls and volatility in the aftermath of June’s “Brexit” vote, and our original arguments are even more pertinent. We rehearse these briefly here, while our complementary article, “Bulk annuity investments - still offering good value for money as part of a fully integrated funding plan?” considers the merits of a buy-in/buyout in the wider context of a fully integrated risk management strategy.
We can provide a more in-depth analysis and scheme-specific commentary on request.
The perennial question
Trustees, sponsors and their advisers alike frequently ask bulk annuity brokers, “is now a good time to buy in/out?” With both long- and short-term interest rates at historic lows and real yields (i.e. inflation-adjusted interest rates) still significantly below zero, a common follow up is “shouldn’t we wait for interest rates to return to more normal levels?” Our counter question to trustees and sponsors remains “if you have the ability to buy in/out or otherwise de-risk your investment strategy today, can you really afford to wait?”.
Will the position improve if interest rates rise?
It’s important to be clear on which “position” we’re talking about. Whilst buy-in/buyout pricing has increased in absolute terms as interest rates (at all durations) have fallen, so too has the value of schemes’ liabilities and the market value of their bond holdings and liability driven investments (LDI).
It’s unusual to consider the (potential) buy-in/buyout premium in isolation, except as a measure of a sponsor’s debt on insolvency. The relative size of the premium - to the total asset value/ scheme funding liabilities/company accounting liabilities, depending on the situation - is more important and it is often less obvious how this will change with movements in interest rates, or other factors.
For example, some schemes that were well-protected (“hedged”) against changes in interest rates have seen an improvement in their buyout positions despite falling rates since the UK referendum in June 2016.
What could the impact on premiums be?
Don’t lose sight of the fact that insurers are already pricing in “expected” future interest rate rises. Even though interest rates at all durations look low today, by historical standards, they are still priced to rise in future years and this is reflected in the buy-in/buyout premiums that insurers are quoting.
Chart 2 illustrates what the market expects the government liability (Gilt) yield curve to look like in two years’ time (the “2-year forward curve”).
There might only be an advantage in waiting for interest rates to rise if it turned out that the market had significantly underestimated the amount by which they would rise or the timing of this. Under such a strategy, trustees would effectively be betting against the market and would run the risk of other factors moving against them in the meantime.
There are many other factors that influence insurers’ premiums; adverse movements in these could offset any benefits derived from rising interest rates and, what is more, are expected under certain scenarios. Take credit spreads, i.e. the difference between interest rates on corporate and government bonds. At times of improving economic outlook we would generally expect interest rates to rise and credit spreads to get narrower (since corporate debt would be expected to become less risky) - see chart 3. Hence although higher interest rates would be expected to lead to lower annuity prices in absolute terms, this effect might be offset by narrower credit spreads.
What about the impact on scheme assets and liabilities?
Similarly to buy-in/buyout premiums, the market values of fixed and index-linked bonds and LDI investments already reflect the market’s expectations for future increases in interest rates (and inflation).
Ultimately the extent to which premiums and scheme asset values move together will be determined by how well the scheme assets match both the scheme’s liability profile and the insurers’ own investment portfolios. Some trustees opt for intentionally mismatched strategies to try and gain from unexpected interest rate rises (or equity market rallies). Such strategies leave schemes exposed to falling interest rates and growth asset values and trustees should take appropriate advice on whether the sponsor could make good any resulting funding level deterioration before embarking on this type of strategy.
What about the liabilities? The assumptions that trustees use to assess their scheme funding liabilities can vary significantly from those that insurance companies will make when evaluating the same liabilities for pricing purposes. There are many reasons for this, but the immediate consequence is that the gap between the funding liabilities and insurance premiums may vary substantially over time and, in particular, could widen even at times when premiums more generally are falling.
What else drives insurer pricing?
There are many other factors in addition to interest rates and other financial factors that affect market pricing of bulk annuities. These include:
- Longevity trends
- Insurer appetite
- Solvency capital requirements.
The trend has been for some of these to strengthen (i.e. increase insurance premiums) over time, for example increasing life expectancies and more stringent capital requirements for certain liabilities under Solvency II - a new European-wide insurance supervisory regime that became effective in January 2016.
However, insurers themselves have been working to offset some of these effects - for example, by sourcing alternative illiquid assets which provide higher yields, allowing them to support keener pricing for schemes ready to take advantage of this.
Schemes themselves can influence the pricing they receive by demonstrating they have undertaken sufficient preparatory work before approaching the market.
What if I wait?
There could be a time in the future when buying a bulk annuity looks more attractive than it does today, but there are two main problems with waiting for this to come around.
Firstly, since many pension schemes follow similar investment strategies, a “good time” for your scheme to buy-in/buyout is likely to be a “good time” for lots of other schemes. At such times, demand for bulk annuity quotations can significantly outstrip insurers’ ability to produce them and there is no guarantee that trustees will even be able to get a quotation, let alone transact a buy-in. For example, during a pricing opportunity in 2008 linked to widening credit spreads following the collapse of Lehman Brothers, one particular insurer turned down around 90% of quotation requests received.
Secondly, there can be a few weeks’ lead in time to a bulk annuity transaction - well prepared schemes that have already assessed affordability and have a firm commitment to trade will always be at an advantage. Some schemes, for example the ICI Pension Fund, benefited recently from credit spreads widening in the period immediately following the “Brexit” vote.
We are aware of plenty of cases where schemes have been ready to complete a buy-in or buyout but have delayed in the expectation of an improvement in pricing which has just not materialised.
What should I do next?
Our view is that trustees and sponsors should insure their liabilities as soon as they can afford to do so. There is no guarantee that the position will look better in future and, even if it does, it may prove more difficult to get a quotation and execute a transaction. In practice, this is likely to mean that trustees for all but the smallest schemes insure their schemes’ pensioner liabilities (or subsets of these) in the first instance, and cover more members at a later date.
JLT can do a quick initial assessment to help trustees and sponsors understand the affordability of a buy-in/buyout and discuss sensible next steps depending on the results and likely timescales for a transaction. For some overseas parent companies, the weakened sterling will potentially make it easier to bridge any shortfall in a transaction. Even if a trade doesn’t look possible for another five years or more, there are steps that can be taken now to prepare. Indeed the majority of preparatory steps materially improve scheme data quality and governance and are therefore worthwhile in their own right - they need not be costly.
Where can I get help?
Our Buyout Team would be happy to explain more and help you explore possibilities for your scheme. Alternatively, please speak to your investment consultant or usual JLT contact.
The JLT Buyout Team has advised on c170 buy-in and buyout deals with 11 separate insurers. Our conversion rate is consistently around 60% or above, as measured by one leading insurer; significantly higher when deals that transact within a further 24 months are included.