Risk Settlement Market 2013

Transcription

1 Risk Settlement Market 2013

2 Contents Market Review Current market pricing 5 Getting the deal done 8 Buyout 9 Current topics and issues affecting the market 11 International pension settlement trends 14 Unforeseen longevity risk 16 Outlook for Contact details 18 1 Aon Hewitt

3 Executive summary We are pleased to introduce Aon Hewitt s annual review of the pension risk settlement market, covering bulk annuities, longevity swaps and other risk transfer solutions proved to be another busy year of settlement activity. In the UK we saw a continuation of very large scale longevity transactions being completed (although perhaps not as many as the industry had expected), a flurry of activity in the bulk annuity market, with a number of schemes seizing the opportunity to switch gilts for annuities to take advantage of attractive market conditions, and innovation in various forms. This included the introduction of medically underwritten annuities that seek to provide a more competitively priced solution for de-risking certain pensioner populations. In the US we witnessed $30 billion of gamechanging transactions, leading to fundamental change in the pensions landscape. Across Europe there were examples of innovative ways of better managing longevity risk. While we head into 2013 with continued uncertainty and volatility hitting pension schemes from all angles (be it in the shape of tough market conditions, the continued uncertainty relating to Solvency II or the challenges of dealing funding deficits), it remains absolutely clear that risk settlement is a key priority for both trustees and sponsors of defined benefit pension schemes. As well as reviewing the 2012 market, we provide analysis on current market pricing and opportunities to de-risk, a review of how well prepared schemes are to take advantage of these opportunities (look out for the results of our Settlement Readiness survey on page 9), and analysis of how risk settlement activity fits into longer term plans to buyout the scheme in full, explaining the concept of cheque writing distance. Aon Hewitt s Risk Settlement Group continues to provide clients with direction and leadership through the varied and complex solutions that exist in these areas. We provide a holistic view of the options available to clients and advise on the best course of action we are not afraid to say when it does not make sense to transact. We advised on many high profile deals in this market during the year, including the BAE longevity swap deal with Legal & General (the largest ever UK pensions transaction) and the 300 million Cookson buy-in transaction with Pensions Insurance Corporation (an innovative solution which paved the way for a further top-up relating to a smaller arrangement in the group). Our approach to advising on the range of options is comprehensive and robust, and when we move into transaction mode we bring a strong focus to getting the deal done, both in terms of making it happen and making sure the deal is right for our client. We have saved many millions of pounds through effective negotiation. If you would like to know more about Risk Settlement, please speak to one of the team, or your usual Aon Hewitt contact. Martin Bird Head of Risk Settlement martin.bird@aonhewitt.com Risk Settlement Survey

4 Market review 2012 We are pleased to have worked with Legal & General and Aon Hewitt to develop this innovative approach to managing risk exposure within the BAE Systems 2000 Pension Plan. This arrangement offers us a flexible approach to managing the key risk of longevity in the Plan. We are particularly pleased that we were able to complete the process in a structured and straightforward fashion within six months. Nigel Tinsley, Group Pensions Director BAE Systems Longevity hedging 2012 was a mixed year for longevity swap deals. Following the flurry of deals in the second half of 2011 covering 7 billion of liabilities, expectation was high for a busy 2012 market. Although Akzo Nobel and LV= both completed significant deals, in a year when both UBS and Credit Suisse withdrew from the market, the general market sentiment seemed to be one of slight disappointment that more deals did not make it across the finishing line. Chart 1: Recent deal activity Company Akzo Nobel (Courtaulds Pension Scheme) LV= BAE Systems 2000 Plan Size 1.4 billion 800 million 3.2 billion Sector Chemicals Financial Services Defence Provider Swiss Re / ReAssure Swiss Re Legal & General Date May 2012 December 2012 February 2013 Solution Pensioner bespoke longevity swap Pensioner bespoke longevity swap and non-pensioner (aged over 55) bespoke longevity swap Pensioner bespoke longevity swap However, much of the hard work done on cases in 2012 is expected to come to fruition in 2013, with a number of deals close to completion. Moreover, a number of new reinsurance companies have confirmed their intention to participate actively in the market, with over 10 reinsurers typically bidding on any given deal. M a r t i n B i r d Proof of capacity was demonstrated in February 2013, when BAE announced a 3.2 billion deal with Legal & General, 70% of which was reinsured with Hanover Re. Another noteworthy feature of the 2012 longevity market was the increasing level of standardisation of commercial terms on offer from both insurance companies and investment banks. Features such as security, collateral provisions and flexibility options (in particular in relation to termination and data adjustments) have rapidly become normalised across the market, making projects more straightforward. In addition, increasing standardisation is a key feature in opening up the market and making it more accessible to schemes below 1 billion looking to hedge their exposure to longevity risk. Combined with the current level of competitive pricing and availability of plentiful capacity, we expect 2013 to be a busy year. Bulk Annuity Market Dominic Grimley 3 Aon Hewitt In 2012, pension plan funding levels were still challenging and so there was not the unlocking of the substantial latent demand for de-risking through buyouts, despite full scheme buyout remaining the preferred destination for many sponsors. We believe the latent demand will surface, probably in a substantial manner, if overall funding levels improve. Where buyouts did occur in 2012, they tended to be for deals not demanding further funding for schemes that were already in a strong funding position (examples being a UK GM scheme and a new transaction for the Merchant Navy scheme) or where insolvency forced a transaction.

5 Pensioner buy-ins: an opportunity missed? A strong opportunity had developed in early 2012 for buy-ins for pension plans who had already de-risked a substantial portion of their assets. This opportunity was to secure pensioner liabilities using low risk assets (in particular gilts) at a lower cost than the funding reserve for the pensioners. Providers could offer such attractive pricing that appears to cover longevity risk for no cost because the value of gilts was so high compared to other assets. For more details see the chart on page 6. Some schemes took advantage of this opportunity to reduce their risk exposure significantly, such as the Cookson scheme, but there was market capacity to accommodate more. There were also significant pools of gilts being held by pension plans, so if they are planning to hold those gilts for the long-term as a matching strategy, did they miss the opportunity for better matching at no additional cost? Market holds up in a tough environment Chart 2 below shows how the market held up in There were some changes in the firms dominating business placed from quarter to quarter, but over the year Legal & General dominated the number of cases placed although the value of those was spread more evenly among the other significant providers in the market; Rothesay Life, PIC, Prudential, Aviva and Metlife. Also behind these direct writers, substantial reinsurance capacity to support transactions remains. Of the other traditional players, Prudential remains keen to secure mid-size or large transactions, Aviva is currently focusing on smaller deals below 50 million, having reviewed their business model in 2012, and Canada Life is not presently offering bulk annuities. Long Acre Life offered an imaginative new product with significant scope for profit-sharing in 2012, but the low yield environment was not supportive of early placements. Deutsche Bank (via their insurance subsidiary Abbey Life) offered bulk annuity products in 2012, but it was focused on transactions where longevity hedging was the preferred route. Lucida ceased to write business late in It was one of several new entrants to the bulk annuity market in who saw their progress hampered by the effects of the credit crunch and recession. Overall, this still left enough players for competitive transaction on all but the very smallest deals, where sometimes sheer manpower availability at the insurers was a limiting factor. Medical underwriting - a new trend Partnership registered the first bulk deals priced from medical underwriting in December, reflecting a year of hard work by them and more recently Just Retirement, to establish a potentially significant change to the bulk market. Legal & General also use this approach but only in a selective way. See page 11 for more details. Chart 2: Bulk Annuity Market Rank Bulk annuity market providers (2011 ranking in brackets) Cases written Value ( M) Market share (%) Cases written Value ( M) Market share (%) 1 PIC (4) 20 1, Rothesay Life (3) 3 1, , L&G (1) 90 1, , Prudential (6) MetLife (5) Aviva (2) , Partnership (-) 2 5 < Lucida (7) Canada Life (8) TOTAL 166 4, ,264 - Risk Settlement Survey

6 Current market pricing Overall pricing levels remain competitive, with plentiful capacity available from the global reinsurance markets ensuring healthy competitive tension Longevity Key features of longevity hedge pricing in 2012 and expected to continue in 2013 include: Overall pricing levels remain competitive, with plentiful capacity available from the global reinsurance markets ensuring healthy competitive tension Opportunities persist for schemes to be able to lock in to longevity deals with little or no impact on cash funding contributions Good data is imperative and has tangible value when it comes to negotiating the best deal. Information on contingent spouses benefits (for example marital status and spouses dates of birth) can have a material impact on pricing Consideration of commercial terms and their impact on pricing is critical. Although termination terms and collateralisation terms are becoming more standardised, there are still some key differences between providers and these need to be considered carefully Longevity hedging for non-pensioners is still a new area. Although there are some examples (for example the index-based deal between Pall and JP Morgan in 2011 and the bespoke deal for over 55s between LV= and Swiss Re in 2012), pricing and structural terms are still developing quickly Bulk Annuity P a u l B e l o k Matt Wilimington For much of 2012 there was a chance for free longevity cover if you were holding gilts to match pensioner liabilities (see chart 3 on page 6). The hedge offered by a buy-in includes full matching of interest rate and inflation risk (including the responsibility for keeping the hedge match accurate), and, importantly, also longevity cover. This opportunity occurred when pensioner annuity pricing was below the equivalent value of the liabilities based on gilt yields or to put it differently, a buy-in was available with a yield better than the yield on a gilt portfolio constructed to match (as best as bonds can match) the liabilities. Even if pensioner buy-in pricing is at a yield 0.25% per annum below gilt yield pricing, the cost can easily be justified in terms of risk protection it is equivalent to the cost of only one year s extra life expectancy from current assumptions. Pensioner buy-ins are now an established low risk asset class alongside bonds, LDI solutions and other opportunities. However it is important in comparing these products to take into account the extent of guarantee offered by a buyin, and for some schemes the potential value in getting a scheme closer to full decommissioning (and with it, the end of exposure to changing legislation, running costs and levies). 5 Aon Hewitt

7 For full buyout, the market has not been substantially tested by schemes as a whole. Those looking for even a sizeable full buyout transaction have had no problem so far in finding potential suitors, but the pricing of non-pensioners will inevitably carry a price reflecting the greater risk and more uncertain investment return opportunities of a less mature set of liabilities.... it is important to discuss potential annuity purchase target prices for each scheme, rather than rely on general indicators alone. Chart 3: Implied return on annuities less gilt yield As chart 4 below shows, the expected affordability has remained relatively stable, leaving potential buyout opportunities as schemes growth assets recover. Chart 4: Affordability Index - assets relative to annuity price, typical maturity scheme Deferred Pensioner Combined Jan 2012 Feb 2012 Mar 2012 Apr 2012 May 2012 Jun 2012 Jul 2012 Aug 2012 Sep 2012 Oct 2012 Nov 2012 Dec 2012 Jan 2013 Feb 2013 Disclaimer: The above information is based on the broad characteristics of a model pension scheme and our experience in the bulk annuity market. It is indicative and should not be relied on to determine bulk annuity pricing for a specific scheme or how that pricing changes over time. Risk Settlement Survey

8 Bulk Annuity Getting the right measure Pricing of annuities is driven by the cost of hedges and by the scope for insurers to achieve some investment outperformance, for example from the credit market. Insurers measure their pricing relative to these hedges. The cost of these hedges including interest rate and inflation swaps has been volatile, but volatility can provide opportunities as well as uncertainty. In comparison, one of the key measures a scheme would consider is price relative to the funding basis used, as this can drive whether any contribution is required to support a bulk annuity transaction. The funding basis is typically: Only reviewed triennially Is designed to measure the liabilities based on longerterm financing costs Is designed to establish costs for the scheme as a whole rather than pensioners in isolation May be a simple approach designed to set contribution rates only This can create a lot of noise in comparing annuity prices and funding reserves, as the difference between them will partly be clouded by the extent to which the funding basis truly reflects market conditions. Providers appreciate the training and analysis that can be given by settlement advisers and this allows them to target their resources on the cases most likely to go ahead. Pension plans will have a smoother process in assessing annuity transactions if they carefully consider their valuation measure before approaching the market. This way they are clear about their target price and can allow providers to focus accordingly. Inflation costs have been a particularly important factor in considering annuity pricing over the past year: RPI costs have varied as the ONS considered and then rejected changing the index CPI costs remain volatile due to the continued shortage of investment products giving CPI-linked income The costs of matching some particular scheme designs on inflationary pension increases have been volatile, reflecting limited supply in the swap market Counting the cost One factor that companies, particularly US sponsors, have considered more recently is the value of cover for all future costs under a full buyout. Some consider getting the right measure as: Buyout price versus Accounting implications remain highly relevant Technical provisions - future investment outperformance + Future expense and levies Although not all accounting standards are the same, schemes have typically been able to proceed with a buyin without an accompanying hit in their P&L account. A full buyout is clearly a settlement of liabilities, and particular consideration is needed of the implications if the accounting treatment of pensions is an important barometer for the sponsor. The narrowing of credit spreads since summer 2012 will have helped move accounting values to pension obligations towards more realistic levels, although the allowance for inflation costs may not have become more realistic. An additional important consideration for sponsors will be the extent to which there are presently unrecognised past losses that will need to be brought to the fore on settlement. This makes it important to discuss potential annuity purchase target prices for each scheme, rather than rely on general indicators alone. 7 Aon Hewitt

9 Are you ready? We know that conditions may not be right for all schemes to look at risk settlement today, but what can you learn from the deals that have been done. What s the best way to prepare if you think you might be transacting in one, three or five years time? In late 2012, Aon Hewitt launched a settlement readiness assessment, whereby any scheme in the country can fill in 20 multiple choice questions and receive back an assessment of how well prepared they are to transact, if the terms are attractive. Overall, the results of the settlement readiness assessments were as we anticipated, and showed that schemes are generally not well prepared. When pricing becomes attractive, schemes will be in competition with one another to secure the right deal, whether that is buyout, buy-in or longevity hedging. Those who are best prepared are more likely to get their deals done, while those who are least prepared risk missing the opportunity. For a free assessment of how well prepared you are, visit: or consider the table below. Lynda Whitney Getting the deal done Among those who replied to the settlement readiness survey (which include some self-selection as those interested in bulk annuities were more likely to complete the survey): 36% of schemes believe they have reliable data to pass to an insurer 56% of schemes have not considered the impact of a transaction on the scheme s risk profile 64% have no financial criteria in mind to determine what a good price looks like Chart 5: Settlement readiness assessments Actions to take 1 years time 3 years time 5 years time Preparation Confirm whether exit strategy is likely to be straight to buyout or via self-sufficiency Ensure both the trustees and company are involved in the discussion and supportive of the route Undertake training on the differences between buyout, buy-in and longevity hedging Ensure sufficient data is held or being collated for settlement purposes, including items such as contingent spouses benefits Analysis Undertake longevity analysis based on postcodes and scheme experience Agree clear criteria/triggers that describe the financial criteria for transacting, and then monitor the market against those criteria in detail high level high level Assess how a transaction would impact on scheme financials, including funding, contributions, company accounting, PPF levy etc. Deal readiness Ensure there is clarity on who needs to make go/no-go decisions and provider choice at different transaction stages Write comprehensive benefit specification, consider how to treat unusual benefits and discretionary benefits, and the merits of insuring different types of benefit Assess impact on day-to-day processes and administration Consider what assets would be used for the transaction either as funding or collateral high level Risk Settlement Survey Risk Settlement Survey

10 Buyout How far to full buyout? Paul McGlone While pensioner buy-in is a well established part of pensions risk management, most schemes still consider full buyout to be unaffordable. But in practice it may not be as far away as you think. The right combination of circumstances may mean that even schemes that are some way from fully funded might find themselves close to buyout earlier than expected Gilt reversion Gilt yields rising 0.5% more than expected by the markets will lead to liabilities falling by 8-10% and our view is that in the next three to five years this is a reasonably likely scenario. You need to have a flight plan in place to monitor and capture these gains if they arise. Cheque-writing distance Most pension schemes do not actually need to target being fully funded on a buyout basis they just need to aim to get within cheque-writing distance of being buyout funded to achieve it. Cheque-writing distance is not a conventional actuarial term, but at its core is the sound financial reasoning that at some point in a scheme s lifetime it will be sufficiently close to full funding that the sponsor will be willing and able to make a cash injection to secure the scheme in full. For a group of trustees considering how they reach eventual buyout, the challenge therefore is not to get to full buyout funding it is to get close enough that the case can be made for a cash injection. Note that cash injections are not often restricted by the same affordability constraints as annual contributions. While annual contributions need to be affordable on an ongoing basis, cash injections tend to be treated very differently, often in a similar way to a Capital Expenditure. For the right business case a company will be able to raise capital which is many times greater than annual contributions, and that is good news for pension scheme trustees. So what might cause a company to make a substantial cash injection? 1. First, the hassle factor: the scheme takes up a lot of management time and attention, and if it can be removed for a reasonable cost then why not? But this is hard to quantify and can only take you so far. 2. Second, the risk factor: the scheme leaves the business exposed to uncertainty, and removing that risk has a value. For example, even if all financial risks are hedged, just a single year increase in life expectancy could add 5% to a scheme s liability. 3. Third, the expenses factor: the scheme costs money to run not just trustee advisor fees and investment management fees, but company costs such as accounting disclosures as well. Capitalising those costs for a year period could be of the order of 3% of liabilities. With just those three examples you can see that a business case could be put together which justifies topping up the last 8% that a scheme needs, although clearly the actual number will depend on the sponsor s attitude as well as the costs of running the scheme. But it doesn t stop there 9 Aon Hewitt

11 Chart 3 on page 6 of this report shows that pricing of bulk annuities moves around, sometimes being more expensive than a gilt matching portfolio and sometimes less expensive. When pricing is at the gilts % level, you can secure a bulk annuity for perhaps 3% less than a gilts only funding target. If you combine those conditions with the 8% top-up outlined above, then a scheme that is, say, 90% funded on a gilts basis may find that the combination of attractive market pricing and a sponsor s cash injection are enough to secure the scheme. In actuarial terms, for a mature scheme, 90% funded on a gilts basis is equivalent to being fully funded on an actuarial basis that discounts at % above gilts. Building the business case: even if the trustees believe that there is a good business case, the sponsor may need persuading. Engaging the sponsor in discussion early ensures that they are ready when the conditions are right. So full buyout is not necessarily as far away as you think. But it will not happen by itself. As with a buy-in, there is preparation to be done: Financial modelling to establish the parameters for your scheme: how close to full funding do you need to be before a buy-in would make sense, and how long do you expect to take to get there? Getting ready for the deal: all of the issues highlighted for buy-ins are just as relevant for a buyout, but now extend to deferred members as well as pensioners. Whether your modelling tells you that you are one, three or five years away, there are things you can be doing to prepare Risk Settlement Survey

12 Current topics and issues affecting the market A new way of thinking Medical underwriting Two companies that specialise in enhanced annuities Partnership and Just Retirement are now active in the bulk annuity market, specifically for smaller pensioner populations. Others are considering entry and L&G have launched a different medically underwritten product variant to secure the benefits of individual executives who represent a potential concentration risk. Chart 6: Case study of medically underwritten deal Size 3.5 million, 18 members... the Purple Book 2012 [shows] there are more than 5,000 schemes in this market [of less than 400 members], representing about 350,000 pensioners... and assets under management of about 40 billion Pensions Policy Institute and Cass Business School A Healthier Way to De-risk Sector Provider Approach Outcome Small manufacturer Partnership One page questionnaire followed by GP reports requested One-third of members eligible for enhanced annuity, making bulk annuity viable Source: Pensions Policy Institute and Cass Business School A Healthier Way to De-risk Insurers processes vary but can include: Written questionnaires sent to members Telephone survey of members GP reports (in some cases) If this exercise reveals worse than average risk factors, the insurer may be able to offer more attractive pricing than one not utilising these techniques. With an individual annuity, the member gets the benefit of the enhancement so it is in their interest to provide medical information. However for the bulk annuity market engagement is harder to achieve, as the member does not receive a higher pension, so processes need to be quick and easy. We believe that standardisation of processes will be needed to ensure the medical underwriters compete strongly against each other. Member engagement can be easier to achieve if they do have something to gain, for example improved security of benefits. These market players currently focus on up to 400 lives because fewer members means: More chance of an overall price saving resulting from key individuals having material health issues The trustees may know whether the process is likely to be successful as they often know their key individuals personally It is attractive to insurers as fewer members limits the cost of a relatively expensive underwriting approach 11 Aon Hewitt

13 For existing bulk writers, this is a potential cause for concern. The bulk underwriting process is deliberately simpler to accommodate substantial numbers of lives, and has, until now, been approached on the basis of only using more limited information such as actual mortality experience to date, and wealth information to decide whether a population should be priced differently to the norm. A significant move towards medical underwriting could lead other insurers to conclude that they only get the healthier lives, pushing up their prices. At present, this is only a fear rather than a reality, because the medical underwriters are focusing on a particular part of the market. We are hopeful that a market can develop, and accommodating all the current players, with a clear target market for different models. It will be interesting to see how this market evolves over the next year or two, particularly if we see more insurers adopting medical underwriting. Experience from the individual annuity market of medical underwriting About 20% of individual annuities purchased are enhanced or impaired life annuities. Just Retirement believe Enhanced until proven standard. And Partnership have stated 50% of retirees could be eligible for enhanced annuities. A very broad range of medical and lifestyle conditions count towards getting an enhanced annuity, including everything from high cholesterol to smoking, to serious conditions such as heart disease. Insurers models can consider over 1,000 conditions and the inter-dependency of them - so it is a specialist area. The greater the proportion of individuals who buy enhanced annuities, the more that insurers have to assume that those who buy standard annuities are healthier lives, reducing the payments for them. Other current issues Ensuring solvency A new EU solvency regime for insurance companies, Solvency II, has been in the pipeline for some time, but further recent delays mean it could be 2016 or later before it fully takes effect. In the meantime, the UK regulator for insurance companies has changed from the Financial Services Authority to the new Prudential Regulatory Authority. UK insurers are already subject to local requirements that carry much of the same thinking on reserving and accurate business modelling as sought from Solvency II. The UK regulator does continue to consider the adequacy of its current requirements for insurers resilience reserves, having strengthened them after the credit crunch. Insurers have sought to pre-empt Solvency II in pricing, working around areas that remain unclear, but there is still some risk from the new standard. It may, for example, push down holdings in lower rated assets, affecting achievable returns. European pension schemes have faced their own threat in the meantime, with the EU potentially giving them new regulations inspired by Solvency II, known as Holistic Balance Sheets. Strangely, these have overtaken Solvency II itself in the intended speed of implementation, with the EU aiming to make material progress in 2013 towards the new occupational pension plan requirements. In practice, there is far greater uncertainty about the key details and practical implications of Holistic Balance Sheets than for Solvency II. From a UK viewpoint, there is a hope that this initiative will go down the list of EU priorities and not progress. However the worst case for UK pension schemes is to have much stronger funding targets enforced, which could act as a very strong steer for sponsors to seek buyouts much more actively. Risk Settlement Survey

14 Other current issues GMP equalisation There have been a number of announcements about the equalisation of Guaranteed Minimum Pensions (GMPs) from the current Government, with the aim of confirming and clarifying a requirement to equalise. These have done little to clarify the action required. Despite the inequality relating back to the period , the DWP has clearly hit problems in finding a workable solution, putting the release of further information back from autumn 2012 to spring In the meantime, it is unlikely that ongoing schemes will take action to equalise GMPs, but those schemes looking to progress to buyout and wind-up are likely to need to address this issue, as the one clear message from Government has been that no action to equalise is unlikely to be considered acceptable. Specific legal advice is required as part of a buyout with GMPs. Insurers do not themselves dictate action on equalisation, because they would not seek to take on the equalisation risks (except under certain tailored contracts to accept all types of risks). Actions to consider can include attempting to augment benefits for equalisation or buying additional indemnity protection under the annuity policy. Our experience is that most schemes do not look to equalise GMPs as part of a buy-in. However we would suggest they consider how any equalisation adjustments may be added to the policy if clarity emerges. Gaps in the inflation market Pensions are commonly designed to increase in line with a measure of inflation (RPI or CPI) subject to an upper limit. However, in periods of deflation, pensions cannot be reduced and so this 0% floor on pension increases would result in a permanent real increase in benefits in these conditions. The cost of buying this floor protection in the swap market is currently historically high, reflecting limited supply from banks. Annuity providers have to either purchase assets that closely match the liabilities taken on, or else conservatively reserve for the mismatch risk they are left with. At the time of writing (early 2013), some insurers are having to price in a considerable margin for guaranteeing increases with this floor. Another problem with market supply exists for pensions linked to CPI. The Government has still not issued any securities linked to CPI, and the supply of other CPIlinked increases does not result in the level of price saving relative to RPI-linkage that might be expected from considering how these indices compare. Schemes arranging a buy-in have flexibility to leave some aspects of the liabilities inside or outside the terms secured, while still successfully securing the majority of the risk. They can consider excluding those benefit features where market imperfections temporarily affect pricing, with the scope to negotiate contract terms that allow these features to also be secured later on when there are hopefully more benign market conditions. 13 Aon Hewitt

15 Settlement actions The $30 billion of pension settlement actions announced in the US market in 2012 has fundamentally changed the landscape. In previous years, pension liabilities annuitised had not exceeded $1 billion a year and no single transaction in the US had exceeded $1 billion since the 1980s. The US Pension settlement trends include: Lump sums offer to pensioners to have the option to take their benefits elsewhere. Note that the option of a transfer value for a pension in payment is not possible in the UK Annuity purchase this is very similar to the UK approach of buyout. Sponsors control the process and pensioners are not required to give consent for it to happen Combined lump sum and annuity purchase this gives the member a choice of an insured or an uninsured settlement International pension settlement trends The transactions by Verizon ($7.5 billion), GM ($26 billion) and Ford (up to $18 billion) in 2012 are ground breaking. In addition, dozens of US pension plan sponsors have implemented lump sum window exercises for terminated vested employees in order to shrink their pension plans (this is similar to enhanced transfer value exercise for deferred members that we have seen in the UK). These settlement actions became interesting in 2012 for US companies for the following key reasons: Flexibility shown by regulatory authorities on the settlement of pensioner liabilities Increasing costs of PBGC premiums (the US equivalent of the PPF levies) Recognition of the benefits of risk reduction With over $2 trillion in estimated pension liabilities in US corporate defined benefit plans, we could see even greater activity in future years. Chart 7: Comparison of the three major US settlement projects in 2012 Ford GM Verizon Announcement date 27 April June October 2012 Number of members involved 90, ,000 41,000 Settlement approach Lump sums Combined lump sums and annuity purchase Annuity purchase Insurance company involved n/a Prudential Financial Inc* Prudential Financial Inc* Approximate amount to be settled Up to $18 billion depending on percentage of members who elect to take up the option $26 billion $7.5 billion Approximate % of total pension liability settled ** Up to 25% 20% 25% Other information There will be a series of election windows for different groups of members through 2012 and 2013 Members were first offered a lump sum than those who did not select this option had their benefits brought out with the insurer Covered pensioners who retired before 1 January 2012 *Note that Prudential Financial Inc has no connection with Prudential plc in the UK. **Calculated as a percentage of total 2011 year-end pension obligation from company 10-K filing. Risk Settlement Survey

16 Settlement actions Rest of the World The rest of the World is not oblivious to the risk settlement transactions which are taking place in the UK and US. Over the past year, we have been working with a range of clients, in different countries, to help them understand the local market opportunities and assess their options. In Europe, pension plans in Ireland, Germany, The Netherlands and Switzerland have all expressed an interest in settling some of the significant defined benefit obligations which have accumulated on balance sheets. A significant barrier to transactions remains the (lack of) recognition of true life expectancies in these countries although steps have been taken, particularly in The Netherlands, to address this. A typical assumed life expectancy in Europe remains two to three years lower than in the UK. More economically minded organisations realise this and are considering risk transfer transactions in the context of a true best estimate. However for the remainder, the perception of paying both a risk transfer premium and a contribution to catch-up on longevity assumptions remains an issue. Over the coming months and years, as European regulators pay greater attention to life expectancy assumptions, we expect the catch-up to happen naturally and for buy-in, buyout and longevity swaps to become more attractive. In North America the major transactions carried out by GM, Ford and Verizon have created significant interest,not only in the US, but also across the border in Canada. That, coupled with both US and Canadian actuarial bodies recommending an increase in life expectancy assumptions, means that many North American organisations are now putting risk settlement much higher on their agendas. Case study: Assisting a global insurer We were asked to provide advice on mortality to a major insurer for a ground-breaking US group annuity deal in relation to liabilities of over $20 billion. A substantial element of our work involved analysing the pension plan s mortality experience data: The mortality experience dataset (i.e. the number of deaths that had occurred in the plan in the past) was very large but it had previously only been used for funding purposes. A higher standard of review is required for pricing and so it was critical that we examined the data for anomalies and made appropriate adjustments. We were not supplied with address information (e.g. post codes in the UK) that can be used for longevity rating purposes and so, in order to allow for differences within the population ( longevity heterogeneity ), we had to use alternative rating factors for the analysis. An important aspect of this was ensuring that the ratings factors were constant over time. This is an important (although often unmentioned) assumption and, without this aspect, the mortality analysis would have been flawed. We were delighted that our client successfully transacted this ground-breaking deal. 15 Aon Hewitt

17 Predicting longevity improvement We accept that future longevity improvement is uncertain and that the sensible option is to assess this risk using statistical methods. What no-one saw coming is that the only credible dataset we have for predicting future mortality improvement (i.e. national mortality data) might itself be flawed. Deaths are measured very accurately. After all, society takes the recording of deaths (and births) very seriously. However, to work out mortality rates, we need to know how many people were alive at the time and this, it turns out, is a completely different matter. In common with many (although not all) countries, the UK carries out a census every 10 years, in our case in years ending with a one, e.g Despite the laudable efforts of the various government agencies involved, this process is intrinsically unreliable because it depends on the honesty, accuracy and diligence of households in returning their census forms. But it gets worse - in the intervening years between censuses, the Office for National Statistics has to estimate the number of individuals alive by allowing for: Deaths accurate Estimated net immigration not very accurate at all Any systematic error in estimating net immigration is nigh on indistinguishable from actual mortality improvement, and, indeed, this is exactly what happened between the 2001 and 2011 censuses. Once the 2011 census results were available, it became apparent that preceding estimates of the national dataset had overstated the numbers of the very old (over 85 say) and understated the numbers of younger (which, bearing in mind we are in a pensions context, means 70 or younger). This meant that the projection model fitted to the unrevised national mortality data before 2011 overstated mortality improvement at very old ages and understated mortality improvement at younger ages. Unforeseen longevity risk Trying to predict longevity improvement is already difficult enough. The record of expert judgement over the past 50 years is notoriously poor. Mathematical methods are limited because future drivers of mortality improvement are not known today. The effect on predicted mortality rates is shown in chart 8. It is a sobering thought that this element of longevity risk is unlikely to have been included in any longevity risk models. In liability terms, the impact is fairly small, but this is a wake up call. We are aware that it is common for other aspects of longevity risk, besides data risk, to be omitted from current longevity risk models. Chart 8: Impact of the latest mortality projections on mortality rates in % +4% +3% Male Female Ratio of mortality rates +2% +1% Nil 1% 2% 3% 4% Age (x ) Risk Settlement Survey

18 Outlook for 2013 The snow aside, green shoots were appearing at the start of The equity market continued an upwards trend, with a particularly notable rise following the US taking action to avoid a fiscal cliff, and there was some loosening from the extremes to which the low yield environment had taken gilt prices. Looking ahead Clearly the economic environment is far from free of uncertainty, but we are hopeful of an overall further recovery in scheme funding positions, doubtless with some turbulence along the way. This could have a multiplier effect on the risk settlement market: Smaller shortfalls clearly encourage more de-risking activity As markets become more well-trodden and products become more standard, opportunities for smaller schemes will become more prolific More partial buy-ins can occur when schemes are less constrained by deficit recovery plans and the need to seek returns from parts of their portfolio which they may otherwise feel would ideally instead be de-risked Greater confidence in economic recovery encourages more corporate transactions, which often lead to accelerated plans to buyout pension liabilities Confidence could even without wanting to appear too optimistic encourage renewed growth in the market s participants or investors There will be competition for spaces in the provider s work plans for quotations and contract negotiations and as we discussed elsewhere in the report a clear advantage for better prepared schemes to push for prioritisation. There are a substantial number of risk settlement market participants, but with potentially different target markets, that may become more polarised as the number of potential transactions available rises. Behind the providers, there is substantial market capacity to take on longevity risk, and so the main potential supply side constraints are capital from investors in the direct writers, and for bulk annuities, investment opportunities in the credit and swap markets. We suspect this will not materially constrain risk settlement activity in In the current market environment, one notable feature is relatively cheap borrowing costs for some sponsors. This could encourage funding to support de-risking transactions, to remove unrewarded risk to the business faster and to take advantage of the tax-free status of the pension scheme. Overall, we feel we are approaching the point where the risk settlement market demand will materially grow again. 17 Aon Hewitt

19 Contact details Paul Belok If you have any further questions or want to know more about the Aon Hewitt Risk Settlement Group, and how they can help you, please contact one of the team. Martin Bird Tim Gordon Dominic Grimley Paul McGlone Lynda Whitney Matt Wilmington Risk Settlement Survey

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