UK Risk Settlement. Longevity swap activity expected to increase. Any de-risking strategy should include consideration of bulk annuities

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1 Aon Hewitt Consulting Retirement August 2017 UK Risk Settlement Headlines In this issue Exceptional annuity pricing expected to continue until at least early 2018 Longevity swap activity expected to increase - Annuity market opportunities Any de-risking strategy should include consideration of bulk annuities - Increase in longevity swap deal activity Corporate accounting changes open the door for de-risking opportunities - Annuities a natural fit for a de-risking investment strategy So far, 2017 has offered strong opportunities for bulk annuity transactions and this is expected to continue for the coming months. Annuity market opportunities A two year period from mid-2016 to mid-2018 could mark the clearest period of capacity from all - Corporate accounting changes eight providers in the market the unobstructed stretch between large back-book deals that open the door for risk settlement take up insurer resources and the available capital. Early 2016 saw 9.5bn of Aegon back-book shared between Rothesay Life and L&G which dominated the market for a number of months, opportunities and 2018 could see parts of the back-books for Prudential and potentially Standard Life (who between them hold around 60bn of annuities) do the same. - Global pension risk transfer trends - Contact information 5.1bn of bulk annuities was placed in the first half of 2017, as set out in our separate Risk Settlement Market Update paper. There were only sub 1bn deals and as in 2016, many of the purchasing schemes were repeat buyers. Many more schemes are discussing future annuity purchase, but have not yet passed the stage of considering feasibility for a future transaction. For some, an annuity purchase does not yet make financial sense, because of assets tied up in other strategies that cannot yet be released, e.g. a growth-focussed asset portfolio with a comparatively small holding in low risk assets that use materially geared derivative holdings to gain interest rate protection. Annuities will become easier to buy as the funding level improves and the low risk asset allocation is then increased. But for many schemes, an annuity purchase has been feasible throughout 2017, and they may come to regret not capturing current pricing. Pensioner pricing improvements best traditional pricing in a decade For annuities covering pensioners, we have seen pricing up to 0.5% p.a. better than the best pricing available at the start of 2016, from several providers. We are measuring this relative to gilt yields, given that is the key metric for many pension scheme decisions. This yield improvement partly reflects several developments: The current high level of competition from the right market participants, with several seeking to increase their annuity volumes from 2016 and not yet managing to do so. The yields available on long-term illiquid asset opportunities such as mortgages and infrastructure. Increased confidence in using these assets following sign-off of insurers first year end returns under the new Solvency II regulatory regime.

2 Chart sourced from Aon's Risk Analyzer How to read this chart This shows the return from a bulk annuity for pensioners, relative to the yield on a comparable gilt portfolio Annuities shown as 'Cheap' if giving a better return than gilts This comparison ignores the material value from annuities giving a better hedge including longevity cover Expected pricing for a typical scheme is shown by the blue line Best prices typically fall in the darker shading, some auctions fall in the lighter shading. Pricing outside the shading typically represents an unusual liability profile An improvement in the cost of longevity reinsurance, from the reinsurance market reacting to the growing evidence of slowing longevity improvements since 2010 and, in particular, in response to material published by the CMI released earlier this year. A continued fall in the gap between gilt and swap yields since last summer, which has helped to make pricing look more affordable relative to trustees gilt-based funding measures. This has resulted in yields of up to gilts+ 0.7% p.a. measured on a market consistent approach, for the most attractive recent deals. Buy-out in prospect We have also seen a marked improvement in many schemes funding gaps to meeting full buy-out cost over This has been particularly dramatic for schemes that had substantially hedged interest rate risk and benefitted from strong overseas equity returns last year. In many cases, the schemes will not be fully aware of the new gap to full buy-out. The pricing of buy-out deals has been volatile and is hard to capture in routine valuations. But there has been a strong opportunity to place full schemes this year, with three providers particularly keen for this long-tailed business, and six of the market participants now having written full buy-outs. Best pricing on full buy-outs is more changeable over time, and more schemes should be considering their true likely shortfall to buy-out and the actions to bridge it following the recent market developments. We recommend discussion with a bulk annuity specialist to reflect how the circumstances of the scheme match providers in the market and to reflect the latest opportunities in this ever changeable market. The true test of current pricing is for a scheme to approach insurers for competitive annuity quotations in a well-designed auction process. Overall we are concerned that several sponsors have had an opportunity to completely eliminate DB pension risk for a considerably better price than expected in 2017 but have not as yet analysed the opportunity. Increase in longevity swap deal activity After a quiet start to the year, pension scheme longevity swap activity has picked up in recent months, with two transactions announced bringing the total volume of deals to 1.4bn for 2017: 300M transaction completed by Zurich for the Skanska Pension Fund, with most of the risk reinsured with SCOR 800M transaction completed by Legal & General for the Scottish Hydro-Electric Pension Scheme (reinsurer not disclosed) The second of these transactions was the first to use Legal & General s pass-through structure, which is now the insurer s core intermediation offering. This structure involves the scheme taking on the credit risk of the reinsurer, and in return paying a lower intermediation fee to Legal & General.

3 Outlook for longevity hedging The period of relative inactivity in the longevity swap market was driven, at least in part, by concerns over a dislocation in longevity insurance pricing, which we were vocal in publically calling out last year. The issue was whether reinsurers who ultimately provide the majority of risk-taking capacity for longevity swaps were suitably reflecting the recent change in trend towards a slowdown in the rate of future rate of improvement in longevity. Having pushed the reinsurance market hard via public comment and negotiation on specific deals, Aon has seen longevity insurance pricing start to reduce, to better reflect current trends. Martin Bird, Head of Aon's Risk Settlement Group, commented in a recent press release, dislocation has become relocation : Thankfully the market has now effectively re-located and the strike price for a typical longevity swap has reduced significantly. We believe that pricing is back in synch and that dislocation is no longer a major concern. In the last quarter of 2016, reinsurance pricing levels for the UK pension risk transfer market showed that pension schemes which chose to delay longevity risk transfer or swap deals, were seeing price reductions of up to 2%. Similarly, during the first half of 2017, a similar pattern has emerged as the reinsurance market has continued to react to the latest data and changed its pricing accordingly. This means there are opportunities in the market for schemes looking to hedge longevity risk and, as such, we are expecting longevity hedging activity levels to pick up towards the end of this year and beyond. However, as Martin further commented: prospective purchasers of longevity risk protection should still take steps to ensure that the pricing they receive is fully up-to-date and competitive. Annuities a natural fit for a de-risking investment strategy There is no doubt that schemes which have hedged their interest rate and inflation risks have benefited over the last few years. Many such schemes have seen their funding levels improving against a difficult and volatile economic backdrop. A matched position for key financial risks fits in with a pension scheme s long term funding plan, regardless of whether this is self-sufficiency, or buy-out and later wind-up. The recent statement from the Pension Regulator made it clear that trustees should aim to reduce their reliance on the sponsor this means taking advantage of opportunities arising, both in respect of funding and improving their investment strategy. It is possible for underfunded schemes to match their interest rate and inflation exposure more efficiently by leveraging the matching assets which they do hold. The remainder of their portfolio can be diversified and held in growth assets. As there are downsides to leveraging, trustees will be expected to make a decision on the maximum level of gearing they are comfortable with in the context of their overall investment strategy. On the assumption that a scheme s funding plan will eventually deliver a better funded position, we expect scheme trustees to switch their growth assets into additional matching assets to protect this over time. Leverage levels will also reduce. At this point, if these assets can be swapped for a bulk annuity for a comparable yield we would expect such a strategy to be pursued by most schemes. Bulk annuities a safe investment Bulk annuities are the ultimate matching asset for a pension scheme, and naturally build on an LDI strategy: - They hedge all pension scheme risks including longevity and demographic risks; - The hedging of risks is precise with no approximation; - No monitoring or rebalancing is required at any stage; - They deliver additional security to both trustees and members, and reduced risk and volatility for the sponsor; - The scheme reduces its own investment management and governance costs; - A gradual switch into bulk annuities delivers a demonstrable step towards buy-out and wind-up if this is the long term objective for the pension scheme. For most schemes it is hard to justify a long term investment strategy which allows for gradual switching towards matching assets but does not take bulk annuities into account it is unlikely that such a strategy will deliver optimal results. We encourage pension scheme trustees and sponsors to do the following: - Consider their scheme s long term target a scheme being underfunded on its Technical Provision basis does not mean that long term objectives cannot be discussed; - Decide which risks should be hedged first it is unlikely that a scheme will pursue longevity hedging in isolation from inflation and interest rate risks if these are not otherwise covered; - Decide on their investment strategy any LDI strategy should incorporate a specific maximum leverage target; - Decide on their asset de-risking triggers these should include consideration of bulk annuities, including an assessment of what would be seen as an appealing price for a policy; - Keep close to the bulk annuity market, so that the scheme is tracking appropriate opportunities; - Carry out the appropriate preparation (such as data cleanse) so that there are no delays in going to market when the time is right, and the scheme is attractive to insurers. UK Risk Settlement Aon Hewitt August

4 Corporate accounting changes open the door for risk settlement opportunities While there are many strong reasons to purchase an annuity at current prices, some sponsors are subject to tight constraints on the exact corporate accounting impact which do need to be considered before any material investment transaction. Whilst pensions insurance has clear benefits, the cost of the premium is often larger than the accounting reserve; sometimes leading to a worsening of the balance sheet position captured in the corporate accounts. The resulting impact differs depending on the accounting standard and the particular exercise. Forthcoming changes to accounting treatments, most notably on the standard used by US parents, potentially relax this barrier to settlement. US parents to reconsider de-risking following changes to US GAAP The accounting standard used by most US parents is undergoing significant changes for years starting 15 December The key change is that all components that make up the annual pension expense, with the exception of the service cost, are now being removed from the "Operating Income" subtotal. The accounting items affected by insurance purchase, such as the expected return on assets, interest cost, and potential settlement costs will all feature elsewhere in the accounts. With many US parents significantly focused on the expense associated with the "Operating Income", this could mean that de-risking the pension scheme no longer has a perceived undesirable impact. While this change may not be welcome for sponsors who have previously received credit from the elements removed (such as recognition of expected investment returns on the pension scheme's growth assets), it does remove a barrier for some corporates to support de-risking. In fact, the inability to claim these credits means that there is less of an argument for sponsors to continue running closed schemes raising the case for full buy-out. If you would like to investigate how these accounting changes affect your pension arrangements and the potential settlement opportunities now available, then contact the Risk Settlement Group or your usual Aon contact. Global pension risk transfer trends Global group annuity volumes continued to grow rapidly in H consistent with experience in recent years. There is appetite throughout the world to remove pension risk from sponsors' balance sheets which: (a) reduces volatility in corporate financial results; and (b) typically results in greater security for members' benefits. The de-risking strategies adopted overseas are similar to those used in the UK typically being a combination of: - Implementing lower risk and/or more efficient investment strategies; - Running member options exercises (e.g. lump sum payments in the US); - Purchasing group annuity contracts. US The first half of 2017 showed a dramatic150% increase in US group annuity volumes from $2.4bn in H to $5.6bn in H This increase follows consistent year-on-year growth in group annuity transactions since 2013 when the market wrote a mere $3.8bn of business in a full 12 month period. There were a number of notable transactions in H including Sears' $515m group annuitisation with MetLife and The Hartford's $1.6bn buy-out with Prudential US. The Hartford's transaction resulted in a $485m pension settlement charge to net income after tax and a reduction in stockholders equity of approximately $140m. The fact that The Hartford was willing to accept these adverse accounting impacts demonstrates corporates' desire to remove the volatility and risk of pension plan liabilities from their balance sheets and focus on running their "true" business without the financial distraction of running a DB pension plan as well. The accounting pain associated with pension risk transfer can be successfully messaged to shareholders by highlighting the greater stability in a company's future financial results which pension risk transfer transactions deliver - an attractive outcome for shareholders. We expect more sponsors to accept the accounting impact of pension risk transfer following the changes to US GAAP, which come into effect for accounting years starting after 17 December Canada Group annuity volumes have also grown substantially in Canada with some commentators expecting business written to have trebled in H compared to the first half of This suggests that 2017 will once again be a record year for Canadian group annuity transactions a trend we expect to continue for a number of years due to the Canadian market lagging well behind UK and US volumes despite having in excess of $1tn of DB liabilities. Source: Year-end 2016, Aon Hewitt Investment Consulting s survey of the most significant U.S. insurers. Settlement transactions include both annuity lift outs and plan terminations UK Risk Settlement Aon Hewitt August

5 Contact information If you would like further information, please contact your Aon Hewitt consultant or alternatively one of our advisers on the Risk Settlement Group: John Baines Hannah Cook Tim Gordon Tiziana Perrella Paul Belok Phil Curtis Dominic Grimley Tom Scott Martin Bird Karen Gainsford David Hill Michael Walker About Aon Aon plc (NYSE:AON) is a leading global provider of risk management, insurance brokerage and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 72,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative risk and people solutions. For further information on our capabilities and to learn how we empower results for clients, please visit: Aon plc All rights reserved. The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.