BUYOUT MARKET WATCH JLT EMPLOYEE BENEFITS BUYOUT TEAM Q4 2016

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1 BUYOUT MARKET WATCH JLT EMPLOYEE BENEFITS BUYOUT TEAM Q KEY DEVELOPMENTS THE MARKET IN NUMBERS SPOTLIGHT ON PRICING SPECIAL FEATURE Market activity in the run up to year end New business volumes, market shares and large deals Affordability trends and regulatory pressures Bulk annuity investments in a low interest rate environment As schemes and sponsors focus on activities to be closed off this year, they cannot ignore the significant uncertainties that lie ahead. The US s decision to elect Donald Trump, the UK s deliberations on what Brexit should look like and important upcoming elections in France, Italy and Germany mean that now, more than ever, is no time to be complacent about the risks schemes are running. The response is a measured assessment of interrelated risks and potential pursuit of de-risking activities and market-related opportunities, where achievable. The recent upwards creep of longterm interest rates may be seen by many as offering both relief and pricing opportunities, although, as we explain in our final article, low interest rates are no reason to postpone a buy-in/ buyout investment. Whilst new business volumes will almost certainly finish lower for 2016 compared to the last two years, momentum is building towards the year end. When back-book transactions totalling 9.4bn are taken into account, overall capacity deployed is broadly comparable. The first 1bn+ deal for the year was announced in November 2016, and there s been good news for small schemes too. Aviva have transacted the first deals through their streamlined proposition for as little as 650k, with JLT advising the first of these. The smallest longevity swap, at 50m, was also written by Zurich Assurance. RUTH WARD Senior Consultant JLT Buyout Team Ruth_Ward@jltgroup.com

2 JLT EMPLOYEE BENEFITS BUYOUT TEAM BUYOUT MARKET WATCH Q BULK ANNUITY MARKET UPDATE Lower levels of activity in the first half of 2016 have created opportunities for the second half of the year. All expectations are for a bumper second half to the year, with a number of large transactions recently announced, including the 1.1bn buyout of the Vickers Group Pension Scheme with Legal & General, the largest announced so far this year, and a 250m buy-in for the Smiths Industries Pension Scheme, written by PIC. In addition, ICI have announced three further buy-ins during H2 2016: a 750m buy-in with Legal & General in July and two transactions in September of 390m with Legal & General and 590m with Scottish Widows. This brings the number of transactions for ICI to 5 during The July transaction was settled shortly after the Brexit vote, taking advantage of a pricing opportunity afforded by a temporary widening of credit spreads. Volatile market conditions often lead to pricing opportunities, and those schemes in the market with agreed affordability triggers are able to take advantage of these. LV= have announced their withdrawal from the individual lifetime annuity market. This suggests that their entrance to the bulk annuity market is unlikely in the near future, especially following their postponement announcement last year. Scottish Widows are currently working to extend their proposition to provide terms for deferred liabilities, with the expectation they will quote for full scheme buyouts by Q Aviva have developed a streamlined solution to enable smaller schemes to complete both pensioner buy-ins and full scheme buyouts. During the last quarter, JLT have obtained a number of quotations and completed transactions for schemes with liabilities of under 5m, including one transaction for a scheme with liabilities under 700k. PIC announced in September a 100m investment in CPI-linked infrastructure debt for Teesside Renewable Energy Plant; an example of an insurer sourcing better yields from illiquid assets with which to support keener pricing. In October Zurich Assurance announced they had completed the smallest ever longevity hedge (to date) at just 50m. We expect transactional activity in 2016 to be short of 2015 numbers, but recent transactions announced and the usual hectic last quarter may push transaction levels toward 10bn. However, when a couple of relatively large back-book transactions are included ( 6bn and 3bn transfers of annuities from AEGON to Rothesay Life and Legal & General respectively), insurer capacity deployed so far over 2016 does not look dissimilar to levels seen over 2014 and TRUMP CARD 2016 has seen two surprise election outcomes: Brexit and the Trump presidency will not only herald the president elect, but elections throughout Europe, including in France, Italy and Germany, and could lead to a significantly changed political landscape. All of which will continue to lead to uncertainty in financial markets. The market s current expectation following Donald Trump s election is that his promise to spend vast amounts of money on rebuilding US infrastructure will result in increased inflation and rising yields. Coupled with the increased probability of a Fed rate hike in December, this might mean that the Sterling will continue to depreciate against the US dollar in the near future. We ve already seen long-term Gilt yields rise by around bps following the US election on 8 November 2016 (to end November). Of course, how all this plays out in future depends on whether Trump sticks to his plans and the way in which European and global politics unfold as we head into This in turn will affect schemes abilities to complete buyouts and buy-ins in the next few months, in terms of affordability, pricing and corporate transactional opportunities. Schemes with a clear understanding of affordability and good governance will be best placed to take advantage of pricing opportunities.

3 JLT EMPLOYEE BENEFITS BUYOUT TEAM BUYOUT MARKET WATCH Q THE MARKET IN NUMBERS The figures in charts 1-4 cover transactions up to 30 June 2016, as most insurers no longer publish Q3 new business figures. We will cover the year-end position in the next edition. NEW BUSINESS VOLUMES Chart 1: Bulk annuity and longevity swap market volumes since Chart 2: Medically underwritten bulk annuity market volumes since bn m Bulk annuities Longevity swaps Note: The 2014 figure ( 542m) in chart 2 differs from the estimate of 700m reported by other commentators, since it excludes two deals written by Just Retirement which were in fact transacted on a non-medically underwritten basis. MARKET SHARES Chart 3: Bulk annuity market shares (2008-mid 2016) Chart 4: H bulk annuity market shares 1% 2% 3% 9% 27% 0% Others Canada Life JRP 6% 1% 24% 0% Others Canada Life JRP Scottish Widows 33% Scottish Widows 27% 21% 10% Aviva Pension Insurance Corporation Rothesay Life Prudential 3% 33% 0% 0% Aviva Pension Insurance Corporation Rothesay Life Prudential Legal & General Legal & General Note: Market shares include historical acquisitions.

4 JLT EMPLOYEE BENEFITS BUYOUT TEAM BUYOUT MARKET WATCH Q LARGEST DEALS Largest deals pre 2015 Largest deals in 2015 Largest deals in 2016 (to end Nov) Buy-ins Buyouts Longevity swaps ICI 3.6bn ( 3.0bn L&G and 0.6bn Prudential, 2014) Total UK 1.6bn (PIC, 2014) Civil Aviation Authority 1.6bn (Rothesay Life) Aon 900m (PIC) ICI 750m (L&G) and 630m (Scottish Widows) TRW 2.5bn (L&G, 2014) EMI 1.5bn (PIC, 2013) Philips 2.4bn (PIC) Vickers Group 1.1bn (L&G) BT 16.0bn (PICA, 2014) Aviva 5.0bn (Swiss Re/ Munich Re/SCOR, 2014) AXA UK 2.8bn (RGA) Scottish Power 1.0bn (Abbey Life) SPOTLIGHT ON PRICING AFFORDABILITY The JLT pensioner buy-in affordability index tracks the relative cost of insuring pensioner liabilities against proxy Technical Provisions. Chart 5 suggests that affordability worsened slightly over Q for both level benefits (i.e. those not increasing in payment) and index-linked benefits Ratio % Level, age 60 Level, age 70 Level, age 80 LPI 5%, age 60 LPI 5%, age 70 LPI 5%, age Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep 16 Chart 5: JLT pensioner buy-in affordability index Note: The figures given are for illustrative purposes only. Trustees own Technical Provisions assumptions are scheme-specific and hence may differ from those assumed in our analysis. The buy-in price(s) obtained for a given scheme will vary according to a number of factors at the time of approaching the market, including financial conditions and outlook, expected longevity of membership, and insurer appetite and capital requirements.

5 JLT EMPLOYEE BENEFITS BUYOUT TEAM BUYOUT MARKET WATCH Q REGULATORY UPDATE The Insurance Act 2015 became effective from 12 August 2016 for non-consumer insurance, for both new contracts and renewals. It places the party to be insured under a new duty of fair presentation, replacing the general obligation to disclose all material facts. If the duty of fair presentation is breached, insurers will potentially have a range of remedies. These include avoidance of the policy (without a return of premium in the case of deliberate or reckless breaches) and other proportionate remedies for more minor breaches. Trustees and sponsors should take care to disclose anything that could be material when seeking bulk annuity quotations and check with insurers if they are unsure. HM Treasury announced in October 2016 that it has cancelled its plans to introduce a secondary annuities market, which was due to open in April It explained that it had become clear that creating the conditions to allow a competitive market to emerge could not be balanced with sufficient customer protections. In late November 2016 the DWP launched a new consultation on GMP equalisation, which puts forward a more workable solution than its earlier proposals in The method proposed would be based on a one-off calculation of actuarial value (against an opposite sex comparator), followed by conversion of the (whole) GMP and relevant excess benefits into non-gmp pension under an amended version of the legislation that already allows GMP conversion. The new consultation runs until 15 January 2017, although some technical points will be addressed in future consultations. If it stands, the method will not be compulsory - the DWP makes it clear that other approaches are possible - hence schemes using it would still be taking some risk, although the DWP does state that the Government believes that the proposed method meets the equalisation obligation derived from EU law. The Court of Appeal ruled that the trustees of the Barnardo s pension scheme cannot switch the index they reference for revaluation and pension indexation from the Retail Prices Index (RPI) to the Consumer Prices Index (CPI). The decision centred around the interpretation that CPI does not constitute a replacement for RPI and will affect schemes with similarly worded rules, who may have been considering switching to CPI-linked increases as a means of reducing scheme deficits. In early October, the Prime Minister announced a Great Repeal Bill to be introduced to Parliament in the next Queen s Speech. The Bill aims to convert all EU requirements into British Law as soon as Britain exits the bloc. It will replace the 1972 European Communities Act (ECA), which gives EU law instant effect in the UK, and give Parliament the power to absorb parts of EU legislation into UK law and scrap elements it does not want to keep. It will include powers to change laws using secondary legislation as negotiations over the UK s future relationship with its partners continue. The process will be separate from Article 50 negotiations, which will activate the formal mechanism to leave the EU. The Bill will probably be passed as an Act of Parliament in 2017, but will not take effect until Brexit day likely to be in 2019 since the UK still has to comply with EU requirements until it actually leaves. EU legislation which affects pension schemes and insurers would be converted into UK law, but parts of this could be amended once the Bill has passed. However, the plans for this Bill could be changed depending on the Supreme Court s judgement in the Government s appeal against the High Court ruling that the Government could not trigger Brexit without parliamentary approval.

6 JLT EMPLOYEE BENEFITS BUYOUT TEAM BUYOUT MARKET WATCH Q BULK ANNUITY INVESTMENTS IN A LOW INTEREST RATE ENVIRONMENT SHOULD WE WAIT FOR YIELDS TO RISE? There are good reasons, for some schemes, to defer buying in some or all of their liabilities. Waiting for yields to rise is not one of them. Similar comments apply to hedging interest rate (and inflation) risk more generally. Yields have fallen over the last two years, as has the market s expectation (derived from current pricing) of how high they will rise. Nonetheless, yield rises are still already priced in to current valuations. Unless there is a strong conviction that yields will rise at a faster pace than this, waiting for increases is not a reason to delay. Below, Chart 6 shows: The yield curve as at 30 September 2014 The expectation on 30 September 2014 of what the yield curve would be on 30 September 2016 The actual yield curve as at 30 September 2016 The expectation on 30 September 2016 of what the yield curve will be on 30 September A key driver of how longer-term yields will move is the development of short-term yields, i.e. the Bank of England base rate. Chart 7 shows the market s expectation of what the base rate will be in future years (as derived from the Gilt curve), showing this expectation in September 2014 and then September It is generally expected that the new base rate norm, when it emerges, will be lower than the historic norm. Chart 6: Current and 2-year forward Gilt curves (Source: Bank of England, JLT) Yield (per annum) 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Maturity (years) Gilt yield curve 30 September year forward Gilt curve 30 September 2014 Gilt yield curve 30 September year forward Gilt curve 30 September 2016 Chart 7: Implied 1-year nominal rates (Source: Bank of England, JLT) 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 31/3/ /3/ /3/ /3/2020 Yield (per annum) 31/3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/ /3/2038 Forecasts as at 30 September 2014 Forecasts as at 30 September 2016

7 JLT EMPLOYEE BENEFITS BUYOUT TEAM BUYOUT MARKET WATCH Q 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 saw an improvement in their buyout positions despite falling rates following the UK referendum in June Don t forget that there are many other financial factors that influence insurers premiums; adverse movements in these could offset any benefits derived from rising interest rates and are expected under certain scenarios. Non-financial factors, such as longevity trends, insurer appetite and solvency capital requirements can also have an impact and can be less easy to predict. 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 months 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. JLT has recently published two Let s Talk articles looking at this subject in more depth - the first focussed on the buy-in/buyout position and the second considering bulk annuities as part of a fully integrated funding plan. These are available on request.

8 CONTACTS RUTH WARD FIA Senior Consultant tel: DAVID BARRATT Senior Consultant tel: BUYOUT MARKET WATCH 2015 SUMMARY 8 THE JLT EB BUYOUT TEAM Our team have advised on over 170 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. Over the last couple of years: Our team have advised on 33 buy-ins and buyouts, including 9 medically underwritten transactions We have brokered deals with 7 out of the 9 insurers trading regularly in the market over this period, including the first bulk annuity transaction with Canada Life following their entry into the market in early Whilst all reasonable care has been taken in the preparation of this publication, no liability is accepted under any circumstances by Jardine Lloyd Thompson for any loss or damage occurring as a result of reliance on any statement, opinion, or any error or omission contained herein. Any statement or opinion unless otherwise stated should not be construed as independent research and reflects our understanding of current or proposed legislation and regulation, which may change without notice. The content of this document should not be regarded as specific advice in relation to the matters addressed. Unless otherwise stated, the data on which the analysis in this report is based is provided by insurers on a regular basis. Market data is sourced from Thomson Reuter, FT.com and Google Finance Beta. We have also referenced JLT s internal valuation assumptions guidance. All analysis has been undertaken by JLT. We have relied on the data provided and have not independently verified this information. JLT Employee Benefits. A trading name of JLT Benefit Solutions Limited. Authorised and regulated by the Financial Conduct Authority. A member of the Jardine Lloyd Thompson Group. Registered Office: St Botolph Building, 138 Houndsditch, London EC3A 7AW. Registered in England No VAT No December