UK Risk Settlement. Phoenix Group optimise their de-risking strategy with 1.2bn buy-in following a longevity swap

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1 UK Risk Settlement May 2017 Headlines Phoenix Group optimise their de-risking strategy with 1.2bn buy-in following a longevity swap Longevity swap to bulk annuity is a viable de-risking approach Pension Regulator's statement encourages de-risking A case study - Phoenix scheme tackles risk, step by step In this issue Phoenix Group case study - Phoenix scheme tackles risk, step by step - Impact of the annuity for Phoenix In this case study, we summarise the steps taken by the Trustee of the PGL Pension Scheme, advised by Aon, and the Phoenix Group (as sponsor) to derisk the Scheme, leading to the innovative 1.2bn bulk annuity recently agreed with Phoenix Life Limited. This transaction was a landmark case - it was the largest buy-in of 2016, the first conversion of a longevity swap and the first bulk annuity for Phoenix Life. - Converting the longevity swap Measured risk taking - Planning for a December transaction The PGL Pension Scheme has been managed to a strong funding position over time. It was an early mover at locking in asset gains fully: it hedged most of its interest and inflation risk, against a cautious liability measure, in Its funding experience has hence been relatively stable, with improvements in the funding level arising in most quarters. These improvements have arisen from taking measured investment risks, and from sponsor contributions. - Lessons learnt Longevity swap as a stepping stone to a bulk annuity purchase The Pension Regulator's 2017 statement encourages de-risking Contact information UK Risk Settlement Aon Hewitt May 2017 The Trustee had worked with Aon to replace a traditional asset strategy. In recent years the Scheme invested profitably in favourable hedge fund strategies, infrastructure, distressed debt and specific new bond issues. The Scheme was an early mover in several of these sectors, and the positions have been replaced or reduced over time as the need for risk-taking reduces further. Managing liabilities The Scheme was closed, for new Defined Benefits being earned by members, in On a clear journey to de-risk, the Trustee worked with the sponsor to agree the terms of a sequence of liability management options firstly following closure and then again in 2015 following the introduction of Pensions Freedom changes by the Government. Members were offered enhanced transfer values or (for retired members) terms to exchange pension increases. Both exercises were run by Aon and attracted strong engagement levels and take-up. The Trustee and the sponsor were conscious that these options would not be appropriate for all members. As such, they agreed a carefully planned exercise to communicate the options in stages to different groups of members, with a preferred independent financial adviser selected in conjunction with the sponsor. This ensured that members could benefit from the flexibilities, but that their individual circumstances would also be considered. The exercises improved the solvency position by around 100M, bringing the Scheme materially closer to being able to secure benefits in full. Aon and the Trustee are working to provide a continuing suite of options to members retiring in future, expanding the Scheme's administration to accommodate this. 1

2 The Phoenix de-risking journey Successful member option exercises Longevity risk With financial risks, such as interest rate and inflation, tightly contained compared with most schemes, longevity had become the main unsecured risk for the Scheme (the risk that members live longer than assumed). In 2014, Aon advised the Trustee on a longevity swap purchase covering all pensioners at the time. After considering its options Phoenix concluded that it would be able to offer the longevity protection for its pensioner members through its life company, Phoenix Life Limited. While Phoenix Life have received and transferred longevity risks many times as a key insurance market consolidator, this was its first longevity swap transaction. Aon were appointed to help structure and plan the swap carefully and ensure it met the key objective of risk management in line with best market practice, including the set-up of a bespoke collateral arrangement. Half the risk was also reinsured by Phoenix Life to RGA in order to further spread the exposure. Long term goal In 2015 the Trustee, as advised by Aon, and Phoenix agreed a wider package of measures with an agreed long-term goal of full security for all members, to be achieved as soon as possible, without taking unnecessary risk. This led to discussions about the terms on which a bulk annuity from Phoenix Life Limited could be mutually beneficial for Phoenix and the Scheme. After detailed planning and negotiation, a 1.2bn annuity was implemented in December 2016, replacing the existing longevity swap. This was an important transaction for the Phoenix Group and another key step in de-risking the PGL Scheme. Aon clearly understood the needs of the Trustee and acted accordingly, and, equally importantly, also engaged effectively with all of the parties. Aon s ability to work in an open and pragmatic manner, whilst leveraging their strong market knowledge, helped to bring a complex deal together and ensured a successful transaction. Richard Zugic, Senior Corporate Actuary, Phoenix Group Impact of the annuity for Phoenix The bulk annuity in December 2016 permanently addressed benefit security for around half of the Scheme, and demonstrated a key step in achieving the long term goal. The pricing of the annuity was agreed as part of the wider package of measures, which included innovative funding arrangements with Phoenix, designed to improve the Scheme's finances further while automatically reacting to Scheme experience in the meantime, and agreed treatment of some discretionary benefit terms. Overall the package ensured that the timing for securing the other half of the Scheme was also brought nearer. Aon also ensured that the annuity price was such that the transaction could not worsen the security for the remaining, uninsured, members. Under a typical bulk annuity deal, the cost of the transaction may subsequently change, once members' data and benefits are checked and confirmed. But the Trustee wished to remove this price uncertainty by 'fixing' the cost, irrespective of later changes to data and benefits. Terms were carefully agreed for Phoenix Life to cover residual data risks and other potential latent liabilities associated with the transaction. This provided valuable protection for the Scheme and also reflected the point that any risks in the Scheme were already effectively "in the Phoenix Group". Providing this risk cover is not a trivial undertaking for an insurer, and the Scheme and its advisers worked closely with Phoenix to allow audit of the Scheme history. This due diligence is typical in the annuity market where comprehensive risk cover is sought, and enabled Phoenix to be comfortable that the residual risks were manageable, because the Scheme had been well run, and were accurately priced. UK Risk Settlement Aon Hewitt May

3 Converting the longevity swap The bulk annuity required the conversion of a collateralised longevity swap, with its own new collateral arrangement. The annuity was treated as an expansion of the longevity swap, not a new insurance agreement. This was carefully reflected in documentation, as it enabled Phoenix Life to utilise beneficial transitional arrangements for reserving under the "Solvency II" regulatory regime. As the collateral arrangements were being changed, and made significantly larger, custodians and investment managers for the relevant accounts were replaced. The old collateral accounts were disinvested and terminated, and new collateral accounts were simultaneously created, receiving the annuity premium payments. A key objective was ensuring that the quality and level of collateral available was as high as possible, while carefully working within the constraints of the regulatory regime. By including strong collateral and comprehensive data risk cover, the overall terms of the annuity were in line with the best available from the wider market. The longevity reinsurance with RGA remained in place, although it was also updated at the same time to allow for the impact of a recent bulk pension increase exchange completed by the Trustee. Longevity hedging as a stepping stone to bulk annuity purchase For UK pension schemes further away from annuitisation, or seeking to retain investment risk in the scheme for a longer period prior to annuitisation, longevity swaps offer a meaningful reduction in risk and a step towards later annuity purchase. However, it is important that the swap mechanics, and the contractual terms, allow for easy of conversion to a bulk annuity at a later stage. In particular, Trustees purchasing longevity insurance need to make sure that contractual provisions The number of legal documents to simultaneously implement ran well into double figures, in part reflecting the many different collateral accounts associated with the longevity swap and bulk annuity transaction. Hence a wide range of advisers needed to be satisfied that everything was ready for signing. Throughout, strong engagement by Phoenix Life of its regulators, the PRA and the FCA, helped to ensure that there were no regulatory impediments to execution of the transaction. Aon assessed the value of the annuity, allowing for the existing benefit of longevity protection already in place and its value, and for terms available in the prevailing market, to ensure the annuity was an attractive proposition for the Scheme. Planning for a December transaction The annuity took effect on 19 December This is unusual, being past the point in the year where markets become illiquid, making large asset transactions much more difficult to implement. Advance planning made it possible. An exact portfolio of bonds had been pre-agreed as sufficient for full payment to buy the annuity, designed so that Phoenix Life did not need to trade these stocks on receipt (they already gave a reasonable match for its assessment of the liabilities taken on). The Scheme had made arrangements to maintain its 100% protection for interest rate and inflation risks for its remaining liabilities, not covered by the annuity, during and after the transaction. The bond portfolio set aside for the annuity hence gave a complete "price lock", meaning the affordability of the allow them to carry out a competitive tender and place business with a bulk annuity provider offering the most competitive price, without penalties being levied by their current longevity swap provider. Further, it is likely that the Trustees and the reinsurers (the risk takers) of an existing swap will seek to keep the longevity reinsurance in place in some shape or form with the new bulk annuity provider. Therefore, it s important to have contractual provisions that allow the longevity swap provider, sitting in the middle of a longevity swap transaction, to be replaced with the new bulk annuity provider, without any termination of the contract and the associated financial penalties. As such, this is one of the key transaction had been protected long before documents were agreed, and also gave complete flexibility on transaction timing. Lessons learnt While some of the Scheme's circumstances won't apply universally, there are key elements in its de-risking journey that will become familiar to other schemes seeking to reach full buy-out over time. Agreement of objectives between the trustees and sponsor will help planning, particularly in the long-term. Financial risks must be brought under control, and a healthy funding level targeted, to make the path to buy-out less volatile. Increasingly nimble decision-making and robust preparation will tend to produce significantly better outcomes. Well-designed liability management offers, developed in open collaboration between the trustees and the sponsor, are likely to materially reduce a scheme deficit and give members benefit packages more suited to their circumstances. Insurance opportunities will arise, and most schemes will secure annuities in stages, checking at each stage that the purchase is in the best interest of all members. Bringing a transaction this complex together needed a lot of dedication and belief from the Trustee, and determination and commitment from our advisers at Aon and Gowling WLG working closely together; all key to making this happen Keith Jones, Trustee Chairman areas of focus when putting in place a longevity swap. The number of reinsurers facilitating the transaction should also be considered. Even though the Trustees are not directly contracting with the reinsurers, the more reinsurers supporting the transaction, the more complex it can be to restructure as a bulk annuity in the future. Whilst simplicity and ease of future conversion is desirable, in some circumstances there can be material financial benefit in using a number of reinsurers to support a longevity transaction. As such, the complexity associated with using more than one reinsurer needs to be balanced with any cost savings that can be achieved. UK Risk Settlement Aon Hewitt May

4 The Pensions Regulator's 2017 statement encourages de-risking The Regulator's annual funding statement, published May 2017, sets out some interesting themes and strong views on how pension scheme managers should be managing their downside risks. So how can risk settlement address some of the key points raised in the statement? Market conditions and Integrated Risk Management The pricing of annuity contracts remains attractive when compared to the yield available on gilts. The implied yield on an annuity policy can equate to an effective return above that achievable on gilts, and should strongly be considered as one of the options available to secure higher returns whilst reducing risk. Long-term, illiquid, asset strategies may be appropriate for some schemes searching for higher returns that are not directly linked to bond yields. However, those targeting an eventual buy-out with an insurer are likely to be better served by a buy-in, if affordable, together with more liquid assets such as gilts, swaps and credit that could be transferred to an insurer and whose values move in a similar way to insurer pricing to reduce overall volatility as the end goal gets closer. Insurers continue to refine their pricing approaches in light of the Solvency II regulatory regime introduced last year and we have recently seen improved pricing on transactions, including deferred member liabilities. There is no need to wait until you are at cheque writing distance before seeking specialist advice being within 10% of your price target is a good time to take action as you may be closer than you think. Affordability and managing deficits Those schemes in a strong position should consider how to lock down risk and home in on their desired end game either self-sufficiency or buy-out, and that end game should be kept under review as market dynamics may change over time. Should a phased approach be used to annuitise, or all liabilities settled at the same time? What is the likely timeframe to the end game? How should longevity risk be addressed as part of a self-sufficient strategy? In all cases, it is worth completing preparatory work sooner rather than later e.g. cleaning data and documenting the benefit structure, so that the scheme is able to capitalise on any short term pricing opportunities that present themselves in the market. Small schemes Investment offerings for small schemes have improved in the recent past, and the annuity market remains busy for these schemes too. Whilst the headlines are generally grabbed by the larger or more complex transactions, insurers are willing to quote on smaller transactions and pricing can be attractive if you are well prepared and engage with the market at the right time. Bulk annuity pricing Chart sourced from Aon's Risk Analyzer How to read this chart This shows the return from a bulk annuity backing pensioners Return shown relative to yield on a comparable gilt portfolio, after allowing for cost of hedging pension increases Annuities shown as 'Cheap' if giving a better return than gilts This ignores the material value from annuities giving a better hedge (e.g. protecting against longevity) cost shown relative to Aon s BAMM longevity assumption Our house view of pricing for all pensioners in 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 UK Risk Settlement Aon Hewitt May

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. Risk. Reinsurance. Human Resources.