Ensuring a smooth de-risking journey

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

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

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

5 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 ended on a particularly strong note and this continued into This was partly driven by pricing, with levels on pensioner bulk annuities in line with those last seen around the financial crisis. With a busy market and competitive pricing, on page 6, Louise Nash explores some of the tactics we used in 2017 to help schemes get the best possible value. Combining this attractive pricing with strong equity returns means buyout may now be more affordable than previously thought for many schemes, perhaps within touching distance if a proactive approach is taken. On page 9, Matt Wiberg considers how well-timed actions across both assets and liabilities, such as member choice exercises, could shave years off your de-risking journey. Whilst many schemes are targeting buyout as their end-game, others are targeting a long-term run-off strategy. Lok Ma compares the two strategies on page 12, considering the journeys to each and how longevity risk management is key to both. strategies, the cost-benefit of collateralised buy-ins is an area of the market which we expect to receive more focus in On page 15, I explore the wider perspective on collateral. Finally, on page 19, Will Griffiths shares his views on what we might expect from the bulk annuity market in At Willis Towers Watson, our market-leading team brings together experience and expertise across pension consulting, insurance, liability management exercises and project management to help our clients find the right solutions for them. We work alongside a wide range of clients as their strategic de-risking adviser, helping them to identify and plan their end-game strategy, and the steps they can take along the journey. We would welcome the chance to discuss further with you how you can take advantage of the opportunities in this market for your scheme, and ensure your scheme s de-risking journey is as smooth as possible. As more schemes are transacting large buy-ins, as well as insurers becoming more innovative with their investment Ian Aley Head of Transactions 3 Ensuring a smooth de-risking journey

6 Looking back at 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 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 key drivers for the level of activity in the market in 2017? Attractive pricing (relative to gilt yields) at levels last seen around the financial crisis Insurer appetite Greater longevity hedging opportunities for smaller schemes Figure 1. Volumes of business by year billion Bulk annuities Longevity swaps * Why was 2017 such a good year for pricing? For the last 18 months, we have seen bulk annuity pricing for pensioners typically achieve a higher yield than that available on a portfolio of gilts as shown in Figure 2. Whilst one of the reasons for the level of pricing is strong insurer and reinsurer appetite and competition within the market, other factors are: 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, improving pricing for both buy-ins and longevity swaps relative to the reserves being held by schemes. Greater innovation in insurers investment strategies - traditionally insurers have held a significant proportion of high-quality corporate bonds. Insurers are now increasingly sourcing and deriving alternative assets such as secure income assets (SIAs) (see Figure 3) and Lifetime Mortgages. These provide a good match for cashflows payable to pensioners and benefit from an illiquidity premium, feeding through into reduced premiums. Giving insurers time to source suitable assets as mentioned above, the best pricing in a post-solvency II world is available from a high-yielding, closely matching investment strategy. Giving an insurer time to source suitable SIAs for a specific cashflow profile, by entering into a price monitoring period, can lead to better pricing being achieved. We cover this in more detail later in the report. *Transactions announced to date 4 willistowerswatson.com

7 Figure 2. Typical insurer pricing relative to gilt yields Buy-in yield above gilt yields (pa) 0.35% 0.25% 0.15% 0.05% % % Over 2017, we helped 25 pension schemes to lock into attractive pricing Pricing attractive vs gilts Pricing expensive vs gilts % Dec 2010 Dec 2011 Dec 2012 Dec 2013 Dec 2014 Dec 2015 Dec % 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 'A' grade corporate bond spread above gilt yields (pa) Gilt yields Buy-in yield above gilts yields Corporate bond spread above gilt yields What s led to the increase in longevity swaps? Whilst traditionally longevity swaps have been mainly considered by the larger schemes, longevity swaps for as little as 100 million of pensioner liability have recently become considerably more attractive. These developments 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 business that they write. The increased flow of longevity risk to the reinsurance market has resulted in: A reduction in reinsurer pricing for smaller schemes. 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. Greater streamlining and standardisation of the contractual arrangements and running of hedges. Is there capacity in the market to manage the number of schemes looking to capture this opportunity? Capacity means two things in the de-risking market: Figure 3. SIAs These assets provide a secure income stream generated from: Real estate Infrastructure Real asset debt Contractual, inflation-linked, long-term cashflows Robust counterparties or tangible collateral backing Most economic value from cashflows Limited economic exposure What will 2018 have in store for this market? What should schemes do to ensure a smooth de-risking journey? And what should schemes looking to transact do to get ready? Read on to hear from our experts. 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

8 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 One message we hear time and again from the insurance market, as well as see on the cases we work on, is that if insurers can see a deal is likely to trade, they are much more likely to quote (thereby maximising competitive tension) and much more likely to offer the best pricing they can. Some of the key ways our clients are showing their commitment to the market are set out below: Demonstrating that both company and trustees are aligned in their objectives. For an insurer this is important, as it is less likely that one party will pull the plug on a potential deal at the last minute. One approach could be to set up a joint working party. This equally has benefits for many pension schemes as it is a cost effective way of operating. Schemes which have a journey plan in place and can articulate a clear vision to the market about their long-term objectives are very attractive to 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. Similarly, insurers are always happy to work with schemes that have completed buy-ins previously, as they believe they are more likely to complete trades. Finally, trustees and sponsors should look for opportunities to increase the scale of any transaction by combining buy-ins for schemes with the same sponsor for example we recently led a marquee transaction for four schemes with the same sponsor. The three smaller schemes, with buy-ins between 14 million - 16 million each achieved significantly more market traction and improved pricing by joining together, and also working alongside, the larger scheme which was completing a 75 million deal. Set a clear target For schemes with a particular target in mind, it can be a very successful tactic to articulate a target to the market and to confirm that a trade will go ahead if premiums below the target are achieved. This again gives insurers confidence that a deal can be reached and allows them to prioritise that deal over other schemes seeking pricing in a busy market. Keep an eye out for time-limited opportunities The insurers competing for buy-ins are driven by corporate reporting cycles as much as any other business and awareness of these external factors can help schemes achieve better value for money. For example, in 2017 we helped one client get a last minute significant additional discount by agreeing to work towards completing a deal before a key shareholder reporting meeting for the insurer. Work with a partner During 2017, we worked with several schemes to select a strategic insurance partner who best fitted with their wider selection criteria. Using market knowledge we were able to set a stretching pricing target at which a deal provided exceptional value for the scheme, and gave the insurer an exclusive period over which to source the assets needed to achieve that pricing. Particularly for larger deals with specific requirements, this approach can lead to significantly more favourable pricing than a traditional competitive process, as it allows the insurer to source assets over a period of time that more precisely match the liabilities 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

9 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 Willis Towers Watson s Asset Liability Suite software shared with the insurer Target price set for transaction Difference between premium and price target Insurer sourced and applied direct investment to Willis Towers Watson s client Improved reinsurance terms made available as insurer had achieved exclusivity January February March April May June Pre-monitoring -- a formal bid process run with all insurers Contracts agreed - transaction ready Insurer price optimisation Deal mobilisation triggered Target hit - deal 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

10 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

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

12 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 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

13 Figure 4. How an example 1bn scheme could close the gap to be in a position to buyout m Buyout deficit at January 2018 Investment returns Transfer exercise Winding-up lump sums More retirements Impact of competition on buyout pricing Buyout deficit at December 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 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

14 Run-off strategy: the DIY buy-in approach In recent months, one of the hot topics in DB pensions has been the refinement of the run-off strategy as an approach for relatively well-funded schemes. As this typically involves taking a leaf out of the insurance industry s book in managing liabilities in a low-risk manner, this approach has also been described as the DIY buy-in approach. In this article, Lok Ma compares the two main end-game options for pension schemes as they continue to mature in-scheme run-off vs buyout with an insurer. In practice, these two options share many similarities, are likely to be closely intertwined and longevity risk management is key to both. Comparison between the two end-game options A scheme in run-off and an insurer managing a portfolio of annuities will follow a similar approach. Both will hold a low-risk, low-return investment portfolio designed to match benefit outgo with asset income, alongside a risk reserve held as a buffer against any remaining financial, demographic and operational risks. The main difference, therefore, relates not to the approach for meeting the benefits, but in terms of how things are packaged up and who remains responsible for the risks: A scheme in run-off adopts an insurer-like strategy, but ultimately the sponsor retains the responsibility for and the risks associated with meeting the benefit payments. An insurance company packages up the approach as a product, and takes over these responsibilities and risks. 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 Cashflow matching (see call-out box) Required level of assets Lower: no passing on of profit (or commutation/transfer experience) Broadly similar Yes Higher: insurer charges for cost of providing risk capital (to be drawn upon following unfavourable experience) and a loading for profit Level of security Lower: the scheme continues to be exposed to residual financial, demographic and operational risks, and additional sponsor contributions may be required Higher: significant protection under insurance regulatory regime Longevity hedging (see call-out box) Optional Included The two end-game options should be considered in the context of the trade-off between security and cost, with the choice between them likely to be informed by the sponsor covenant and/or scheme size. For example, smaller schemes, or schemes whose sponsor covenant is uncertain beyond the short to medium term, are more likely to invest more aggressively in the short term to target buyout. This implies taking more risk in the coming years but, once bought out, residual risks are minimal. 12 willistowerswatson.com

15 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 Fall in price of matching asset Breakdown the reasons for price change Reason for volatility Level of cashflows expected from asset is reduced Change in market demands for return over risk-free rate Is the scheme affected? Still a concern for the scheme, as payment of benefits is impaired Less of a concern for the scheme, as not expecting to sell asset Staying flexible between the options Whilst we have so far positioned the end-game as a choice between two distinct options, in practice many schemes will adopt an approach of: Planning ahead: knowing the likely end-game means the right types of assets can be built up in good time. But staying flexible: it is worth bearing in mind the alternative end-game, which may become the preferable option should circumstances change: Journey plan Insure all liabilities Current position Alternative path Run-off Below we have set out a couple of examples of schemes that may change course: Scheme A Currently has a plan to buyout all liabilities in 10 years time. However, if investment performance turns out to be worse than anticipated, or the pricing of a bulk annuity contract becomes more expensive, it may adopt the cheaper run-off approach instead and continue to rely on the support of the sponsor over the long term. Scheme B Has a large non-pensioner population, making buyout expensive. Targeting run-off instead of buyout in the medium term means a lower-risk investment strategy can be adopted. In 10 years time the scheme will have matured substantially and therefore this, plus the payment of commutation and transfers, may mean buyout can be reconsidered. 13 Ensuring a smooth de-risking journey

16 Another example demonstrating how the two options are intertwined in practice is that a scheme in run-off may well enter into a partial pensioner buy-in. This can lead to improvements in funding level for the scheme, if a deal is available at the right price and makes sense in the context of the overall run-off portfolio. Managing longevity risk An insurer providing a bulk annuity will take on the risk 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 risk). By contrast, under a run-off approach, a scheme has a choice between insuring this risk (via a longevity swap) or retaining the exposure (self-insurance through incorporating an allowance within the risk reserve). Clearly, having greater certainty of cashflows is beneficial in terms of investing to meet the benefit outgo. But there are two important things to bear in mind: Cost of hedging longevity: the cost of hedging longevity risk is similar whether a scheme insures the risk separately, or it is priced into the premium for a buyin or buyout. Pension schemes can pay for this cost by partially recycling the risk reduction achieved and re-risking the assets to seek a slightly higher return. Case for hedging longevity: the case for reducing the exposure to longevity risk is stronger for a scheme adopting a low-risk investment strategy, as there is less scope for longevity risk to be diversified away in conjunction with other risks. Governance requirements 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 funds in anticipation of the end-game. For schemes choosing the run-off approach, the skills needed to manage residual risks and oversee the cashflows coming into and out of the scheme will be more familiar territory to an insurer than a typical pension scheme. Delegating the technical implementation of such a strategy to a specialist is an obvious way forward, but comes with a cost. The trend for moving to a fiduciary management model is likely to continue as schemes continue to mature. In this context, a transaction to pass on assets and liabilities to an insurer via a buy-in or buyout can be seen as the ultimate form of delegation to a third party. Conclusion Going into run-off or settling the liabilities with an insurer are two alternative options for a scheme s end-game. In practice, there are as many similarities as there are differences between the two options, and each could be the suitable long-term aim for a scheme depending on its specific circumstances. Being aware of both options and staying flexible between the two could well be the best philosophy, as schemes continue to mature and build up their funds in anticipation of the end-game. Case study: The MNOPF transacts a 490 million buy-in with Legal & General The Merchant Navy Officers Pension Fund (MNOPF) is on a journey plan to be fully funded in Willis Towers Watson is the Fund s Delegated Chief Investment Officer, helping the Trustee to achieve this journey. In early 2017, Willis Towers Watson identified an opportunity to exchange a proportion of the Fund s gilts for a buy-in, covering recent retirees in the Fund, at an attractive price. This buy-in covers the new retirees in the MNOPF since the Fund s 2014 longevity swap through Willis Towers Watson s Longevity Direct, a readymade Guernsey cell structure. Following a highly competitive bidding process, in December 2017 the Fund entered into a 490 million buy-in with Legal & General. The buy-in was paid for via an inspecie transfer of gilts. As well as managing more longevity risk, the buy-in has advanced the Fund s journey plan. Rory Murphy, MNOPF s Trustee Chair, said: This buy-in enables us to more effectively manage the risks faced by the Fund as a whole. There is also a positive message here for the wider pensions community: a well-run fund, with strong governance and expert advisors, can deliver valued and sustainable benefits to its members while successfully managing the risks and costs faced by its employers. 14 willistowerswatson.com

17 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 you want extra security with your buy-in? that many would immediately respond by acknowledging that this was a requirement of any transaction. However, as posed, this question does not take account of the additional complexity, cost and loss of return that is inherent in acquiring this potential added security. Neither does the question acknowledge that only the costs are certain whereas the additional security is unlikely to ever be accessed, and, if it is, the level is itself uncertain. If I were to reword the question to Would you like to pay a significant amount of money for something you never expect to need?, I suspect the answer would be very different. The reality is of course that neither of these loaded questions capture the full facts, but rather they demonstrate why trustees and sponsors should consider the full cost-benefit analysis when deciding whether they require a collateral structure. What is collateral? There are a number of ways in which a collateral arrangement may be structured, with different insurers taking slightly different approaches. The most commonly used, and perhaps most easily understood, is an approach that has been used for many years in the reinsurance market and is commonly known as a deposit back structure. This operates as follows: 1. The buy-in premium is paid by the pension scheme to the insurer. 2. The insurer then places a proportion of that premium in a separate account held by a custodian, thus establishing a collateral account holding the assets. The trustee has legal ownership of the collateral account with a charge for the insurer. 3. The insurer pays the pension amounts due under the buy-in policy. 4. The collateral assets held within the account are adjusted to reflect a constant proportion of the value of the remaining liability. Pension Scheme Collateral account 4 Surplus/ deficit Insurer 2 1 Premium 3 Pension payments 15 Ensuring a smooth de-risking journey

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

19 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. Own funds Surplus SCR SCR - capital to withstand a 1 in 200 year event. Under Solvency II, the Technical Provisions represents a fair value for the liabilities between a willing buyer and a willing seller Technical provisions MCR Risk Margin Best estimate liabilities Minimum Capital Requirement (MCR) - below which policyholders are exposed to unacceptable levels of risk. Additional capital for unhedgeable risks including longevity risk. Longevity reinsurance is widely used to reduce this capital requirement. The present value of the projected future annuity payments and expenses. Buy-in provider regulatory capital ratios at 31 December 2016 Aviva L&P Canada Life Legal & General Scottish Widows Just. Pension Insurance Corp SCR 152% 166% 154% 144% 147% 164% 180% MCR 607% 622% 617% 477% 471% 551% 605% Rothesay Life 17 Ensuring a smooth de-risking journey

20 What additional security does collateral offer? The primary benefit of a collateral structure is in the event of the insurer encountering financial difficulties the trustees have access to specific assets at an early stage. What does collateral cost? Collateral comes at a cost, and the costs vary both from insurer to insurer and according to the features of the structure. Invariably the costs may be considered as follows: i. Explicit costs The insurer will quote an explicit cost of structuring, establishing and maintaining the segregated fund. These explicit costs are typically around 1% to 3% of the buy-in premium. ii. Ongoing overheads The pension scheme also incurs material additional costs over the lifetime of the contract to cover the negotiation of the collateral, as well as operational maintenance and governance. iii. Implicit costs Perhaps the greatest cost, however, is the implicit cost of restricting the eligible assets so the insurer has to hold low-risk assets within the collateral account. This cost is either borne directly by the pension scheme (via a higher premium), or by the insurer (by using excess liquidity within their wider annuity portfolio - although the insurer will charge the scheme for that liquidity strain). To illustrate this point let us consider two contrasting collateral pools: Pool A: 35% direct investments, 35% corporate bonds and 30% gilts Pool B: 100% gilts Pool A is expected to generate a return of c1.4% a year more than pool B. The loss of this expected income for the insurer therefore generates a significant strain, a cost which must either be partially or fully paid by the pension scheme. Are there other options to increase security? Whilst the focus of this article has been the posting of collateral in order to enhance the security of a buy-in policy, there are alternative approaches, including: Agreeing surrender terms with the insurer which allows the trustees to surrender their buy-in policy and receive a payment representing an agreed proportion of the insurer s reserves. These structures usually include pre-agreed surrender triggers. The advantage of this approach is that it is cheaper both in terms of the additional premium and the ongoing costs of maintaining the arrangement. Setting aside a risk buffer which is available to the pension scheme in the event of the insurer failing, this might, for example, be equal to the aggregate costs of the collateral structure (explicit cost plus the saving in premium plus a capitalised value of the ongoing savings). So what should schemes do? Some schemes will feel very strongly about the need for collateral particularly those with sponsors in the finance sector. Other schemes should ensure they fully understand the full spectrum of additional costs being incurred by having collateral, and also the circumstances in which such collateral will be utilised, and what they will actually receive in this event. 18 willistowerswatson.com

21 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 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? The financial markets in 2017 were relatively benign for the bulk annuity market. Gilt and swap yields rose into January, dropped sharply soon after and then rose consistently from the middle of summer onwards. Credit spreads, a key driver for insurers pricing, did not move significantly for or against schemes (as can be seen in Figure 2 on page 5). It s possible that 2018 will see much of the same, however there are a number of market drivers that suggest we could be in for a bumpy ride. Such bumps often present great buying opportunities in this market but only for those in a position to move quickly, for example if they have a price target and agreed legal terms. Brexit negotiations, much like in the aftermath of the referendum vote itself, may well create a series of market adjustments. Corporate bond spreads may also widen if the perceived outcome of Brexit negotiations doesn t seem to be favouring corporate Britain. An increase in risk-free yields, particularly at longer durations, is likely to lead to a bigger reduction in insurer pricing due to the risk margin insurers are required to hold as part of their capital buffer. The risk margin is held against unhedgeable risks and it has a long duration. An increase in yields at longer durations will have a significant effect in reducing the amount of capital an insurer needs to hold feeding through to lower buy-in premiums. Pricing of CPI-linked benefits remains well above the typical Technical Provisions assumption a pension scheme would use, due to the extra capital an insurer needs to hold as they can t hedge CPI benefits exactly. While there is little sign of a liquid CPI market developing, CPI assets are structured from time-to-time and improve pricing for those schemes which secure an allocation to their transaction. Getting to the front of the queue Many schemes we speak to are considering how to build buy-ins into their journey plans, such that when they reach their end point they will have already secured the majority of their liabilities. In this way a pension scheme can take advantage of the long-term horizon of their journey plan to pick and choose optimal moments to approach the market and transact. This could be when financial markets move in their favour (as outlined above), after they ve seen the outcome of a liability management exercise improve their funding level and wish to lock-in these gains, when a new insurer enters the market offering strong pricing or when an insurer is very keen to write business before the year end. Spreading the purchase of bulk annuities will also help mitigate the risk that pricing worsens overtime (the benefits of price averaging as any investor knows), because no one knows what pricing will be like in 10 or 15 years time. It 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

22 A survey we ran in 2016 reported that over half of schemes are targeting completion of their journey plan between 2025 and While all of these won t be going down the route of settlement in the bulk annuity market, a considerable amount will be. This points to a significant increase in demand for bulk annuities, which may in turn mean it is better for well-prepared schemes to start this process of annuitisation before the rush begins. Insurer capacity Assuming a further increase in demand does materialise in 2018 then it will likely pose some interesting questions for insurers. Can they, and will they, maintain the current attractive levels of pricing across all transactions that they have? Even if they can and will do this, do they have the resource in their teams to be able to price all the deals that are brought to them? If not, which type of deals will they focus on and will this differ between insurers? This predicted increase in demand may be tempered slightly by more schemes exploring the approach of DIY buy-ins as set out on pages 12 to 14. Additionally, should any insurers seek to sell their backbook of annuities as Zurich and Aegon did in 2015 and 2016, then this would be expected to have a significant impact on the bulk annuity market capacity. As may be observed in Figure 6, the backbook market is significant although it is made up of a small number of large deals which results in it being somewhat unpredictable. Figure 6. Volumes of business including bulk annuity provider and reinsurer backbooks in the public domain billion * Bulk annuities Longevity swaps Backbook activity utilising bulk annuity provider Backbook activity utilising reinsurer capacity *transactions announced to date The longevity dilemma resolved? We had noted in this section of the report last year that the cost of longevity hedging had started to reflect the recent heavier deaths experience and that this had also started to flow through into bulk annuity pricing. This continued over 2017, with another year of heavier deaths and reinsurers adjusting to this by reducing their prices. On a like-for-like basis, the cost of a longevity swap has fallen significantly, and this is also feeding through into buy-in pricing (and is partially responsible for the attractive levels of pricing we ve seen). This also has the secondary impact of reducing the duration of liabilities that insurers need to invest to match, so making it easier to generate a higher yield. One aspect that doesn t change and is now more important than ever Is how a scheme positions itself with the market. The importance of this has changed markedly over the years, from 2007 when a lot of insurers would bend over backwards to accommodate pension schemes, to a decade later when all insurers will routinely decline transactions. This may have been unavoidable in certain circumstances, say if the market was very busy, but highlights the need to consider key aspects that can be presented in a positive light to insurers such as a well-established governance structure, a clear price target, clean data and strong company support as detailed on page willistowerswatson.com

23 Our senior transaction specialists: Ian Aley Head of transactions Keith Ashton Head of risk solutions Shelly Beard Senior director Katherine Gilder Director William Griffiths Director Gemma Millington Director Louise Nash Associate director Sadie Scaife Senior director Matt Wiberg Director Ensuring a smooth de-risking journey