The pension buy-out dilemma: In defense of long-term investing 

Until the 1990s, most pension plans held a portfolio of assets designed to deliver growth over the long term. Plan sponsors and trustees were comfortable managing the shorter-term ups and downs of the markets.   

In the early 2000s, Boots shocked the UK pensions industry by selling out of equities and investing all of the plan’s assets in high-quality bonds. At the time, industry participants were caught off-guard, with many dismissing the possibility that other plans could follow suit on the grounds that the necessary volume of bonds did not exist. But big falls in the equity markets in the first three years of the twenty-first century, coupled with a sudden drop in long-term discount rates, were a catalyst for many more plans to follow Boots’ lead. 

In the subsequent twenty-year period, capital markets have slowly but surely adjusted to changing demand from the pensions industry. Corporate Bond markets grew quickly, given that borrowers enjoyed historically low costs and bank balance sheets were forced to reduce after the Global Financial Crisis. Meanwhile, the de-risking of defined benefit pension plans gained momentum. These days, it is a generally accepted principle that the ultimate goal of pension plan trustees is to transfer all of the pension plan obligations to insurance contracts and subsequently wind up the plan. But is buyout the only answer?

The risk transfer market is currently very buoyant, with record volumes of defined benefit assets and liabilities transferring to insurance companies. A major catalyst for the increased demand to transact has been the improvement in scheme affordability arising from higher interest rates. This has accelerated de-risking.  

Both the price and the volume of demand for risk transfer are directly impacted by interest rates but given that plans are generally already hedged against changes in interest rates, the transactions themselves are unlikely to impact them. However, the mass transfer of pension liabilities from defined benefit pension schemes to insurance companies is likely to have a profound impact on risk pricing and the functioning of capital markets. 

Just as the capital markets were not ready in 2001 for plans following the example set by Boots, the capacity for a sudden sea-change (in the market or at a business level) doesn’t exist on the insurer’s side just yet.  

Defined benefit plans face a crossroads. Their trustees and sponsors need to consider their approach to the endgame, in particular whether it is in their beneficiaries’ best interests to transfer liabilities to an insurance company or to invest for the longer term. This potentially pools their interests with other plans in fit-for-purpose long-term investment vehicles.  

While risk transfer to insurance companies is the right decision for many plans, there are arguments for alternative courses of action in terms of cost, security and regulation. In turn, there is an array of options for plan trustees and sponsors that may align better with their long-term objectives.

In jurisdictions like the UK, trustees have the responsibility to take all reasonable action to maximize the likelihood that their plan pays the benefits in full to all eligible individuals, on time and for life. The cost of a solution that achieves security for members is generally perceived as out of the plan’s control. It is not a surprise that demand has ballooned, as sponsoring employers are also keen to remove the balance sheet impact associated with providing for largely legacy staff. 

While the cost of transferring liabilities has fallen, this does not necessarily mean that transactions represent better value today. It simply means that market conditions for maturity transformation have changed. It is only the plans that under hedged their exposure to interest rates that have experienced a windfall gain in terms of settlement costs.  

Across Europe, the consolidation of pension promises into larger, more robust and well-governed vehicles has generally been preferred to the bulk buyout route. Pension arrangements where benefits are insured at the point of accrual are the exception to this. Under this approach, investment flexibility is retained, scale economies are achieved, and insurer margins are not crystallized. Pension promises can be financed with a healthier risk appetite than what a highly rated insurer can tolerate, and ultimately, this lowers the long-term cost of pension provision.  

The surpluses that may arise in a plan could be used to provide discretionary increases to benefits, such as those plans that have lost real value due to high inflation. Provided that a plan has the scale to manage costs and access investment opportunities available only to larger investors, its managers can dial up or down risk appetite in line with the plan’s objectives. In contrast, most life insurers operate at credit ratings that require their shareholders to continually finance 150-200% of their regulatory solvency capital requirements (see page 13 of the EIOPA Insurance Risk Dashboard). Even though this is a high burden on shareholders, it has not precluded attractive returns on equity in recent years.  

Another significant source of cost is the inefficiency associated with the transaction process. Investing in illiquid cash flow-matching assets makes sense for both pension plans and insurers alike. However, most plans still need to move to a highly-liquid low-risk fixed income portfolio well in advance of transacting – only for insurers to potentially re-invest in illiquid fixed income post-transaction. Pension plans are denied the opportunity to earn an illiquidity premium for a considerable period. 

Insurers need to add the cost of delays in reinvesting the assets into their upfront premium pricing, and borrowers are denied access to a key source of capital. This is a lose-lose-lose for pension plan members, insurers and economies. While there have been some positive developments in this space, the reality is that to engineer a competitive buyout transaction and manage out-of-market risk, most plans must first de-risk into highly-liquid, high-quality bonds. 

A source of profitability for life insurers historically has been the release of reserves as mortality experience has proved worse than the level of prudence built into premium quotes. In recent years, allowance for longer life expectancy has formed part of pensions and insurer reserving, but there is no guarantee that life expectancy will continue improving at the rates previously anticipated. There appears to be increasing evidence in the US of a slowdown in mortality improvements due to factors like circulatory disease and diabetes, and these patterns may yet diffuse into European data.  

The heightened inflationary environment seen since 2022 has underlined the opportunity cost associated with insuring benefits. In many countries, including the Netherlands, Ireland and to some extent the UK, pension benefits are subject to conditional indexation or discretionary increase practices. Plan managers worked on helping beneficiaries retain purchasing power but in many countries, structural inefficiencies and the lack of available investments has meant that domestic inflation has been expensive or impossible to hedge. A legitimate question has emerged around the merits of paying high upfront premia to insure core benefits with insurance counterparties when plan managers could instead consider investing in a manner that could help beneficiaries retain purchasing power over time.  

Finally, many plans have engaged in partial buy-in transactions to stage the insurance of their benefits. While there are significant benefits associated with this approach, the UK LDI crisis of 2022 highlighted the drawbacks of having a large illiquid investment when liquidity demands arise elsewhere in the plan’s investment portfolio. Liquidity is a valuable resource. While it may be difficult to evaluate the value of the flexibility that it provides a pension plan, reduced access to liquidity could result in plans being forced to sell assets at a loss in the future.  

Historically, pension promises made under final salary schemes were often made before the modern body of financial services consumer protections came into being. While many promises were insured at the point of accrual, the majority of pension plans were established with a view to allowing investment returns to carry out the heavy lifting in delivering on those promises over time. Now that defined benefit provision is on the wane, the insurance of past service benefits has, somewhat curiously, found itself being perceived as an upgrade in the security of those benefits, even in markets like the UK where the stock of defined benefit liabilities overwhelms the general accounts of insurance companies.  

The cultural and legal backdrop against which the pension promise was made can also vary significantly. In many European markets, there are no funding requirements or tax incentives, yet the media is not filled with the stories of the defaulting sponsors that strike fear into the hearts of markets like the UK. Many of these countries score high on adequacy and sustainability metrics in surveys such as the Mercer CFA Global Pension Index.

Developed market society has a lot of confidence in insurance regimes today, but the reality is that no one knows where politics could take that regulation over time. Over the long life of a buyout, it is likely that there will be several financial crises and liquidity crunches. As previous economic cycles have shown, there is generally political gain to be had from the relaxation of regulatory standards as the memory of such crises wane, with the resulting regulation inevitably favoring shareholder returns, rather than policyholder premia or security.  

While pension plan trustees engaging in risk transfer activity invariably assess the financial strength of prospective insurance counterparts, such assessments can only look at the organization and the regulatory protections at a point in time, and certainly not over the life of the arrangement. In contrast, buy-ins and buyouts are generally irrevocable transactions. Without a doubt, well-funded smaller plans with weak sponsor covenants are likely to improve the security of member benefits through transacting with an insurer, but even so, the opportunity cost should be carefully weighed up.  

The regulation of the pension promise has often been retrospective. In many jurisdictions (sometimes intentionally and sometimes unintentionally), it has also reinterpreted the original promise. This is particularly the case for how the discharging of liabilities is defined for pension plan trustees. The defined contribution area is perhaps where this is most pronounced. For example, a debate has emerged surrounding whether the duty of care that trustees have to their members extends only to the point where they exit the vehicle, or more widely to their retirement outcomes. Indeed, the latest EU IORP Directive makes clear that ‘where members and beneficiaries bear risks, the risk management system shall also consider those risks from the perspective of members and beneficiaries.’  

However, the discharging of liabilities is also conceptually problematic in defined benefit, and perhaps nowhere more so than in the UK. The UK pensions regulatory regime establishes that debt on the employer is measured with reference to market annuity rates, which very explicitly bakes going to the insurance market into industry thinking. Buyout becomes difficult to ignore when setting long-term strategy. The latest funding code guidance from the Pensions Regulator is unlikely to change this thinking, but even with the mature bulk annuity market enjoyed by the UK, it does not make sense from a capacity perspective.

As of June 2023, Mercer’s data suggests a cumulative £200-250 billion or so of buy-in and buy-outs have been transacted, with many multiples of that in outstanding liabilities when measured on a settlement basis. Pension schemes have a reasonable amount of investment flexibility but the insurance regulations applying to UK insurers, specifically the hold-to-maturity bias and the ‘matching adjustment’ framework, are causing insurers to approach their investment strategies in a similar manner. As an increasing proportion of defined benefit liabilities moves to insurance balance sheets with investment regulations likely to drive common behaviors, the UK is arguably setting itself up for instability and a systemic event. Besides the PRA’s recent concerns about funded reinsurance, who is the marginal buyer of long-dated sterling fixed income in the event of a yield or spread sell-off?

Nonetheless, there is much to praise in recent insurance regulations, in particular within governance and disclosure. In the European Union, the second IORP Directive has transposed much of these developments into pensions regulation, while also placing a greater emphasis on retirement adequacy. Similarly in the UK, a strong pensions regulatory regime will soon be bolstered by the new Code which majors on plans having an effective system of governance. 

Pension plans that want to stay in the game must operate like insurance companies, albeit without the solvency requirements. In Europe, plans have recently appointed Risk Management and Internal Audit Key Function Holders and must bring their standards of governance in line with insurers. Rather than pushing the transfer of liabilities to insurers, this often reinforces a trend towards consolidation where bigger, more resilient and well-governed plans can deliver on the pension promise. Critically, a financial stability objective, in particular towards the long end of the interest rate curve, requires investors to approach pension financing in different ways.

Larger plans that benefit from scale economies can reasonably weigh up the pros and cons of the insurance route, and, regardless of whether they are open to future accrual or not, can often justifiably conclude that bearing the longer-term cost of running off the liabilities remains in the members’ interests. Plans with cautious risk appetites are likely to be exploring cash flow matching approaches, potentially without the rigor applied by insurance companies. Such plans enjoy a wider investment opportunity set. For example, retaining the ability to invest in fixed income that has pre-payment or convertibility features, or in longer-term income-generating assets such as infrastructure equity, private markets, or real estate where matching characteristics may well be imperfect but perfectly adequate.

In many countries, there are simply no active risk transfer markets. Pension plans have little option but to soldier on, or to contemplate wind-up. In countries like the Netherlands, the Government has enacted legislation from July 1, 2023 which will considerably shake up the system. The change means a move toward a defined contribution model, with a compensation mechanism designed to appease members forgoing defined benefits that they have previously accrued. In markets like Ireland, funding regulations make it extremely difficult to merge defined benefit plans into vehicles such as master trusts, and while plan consolidation is part of the regulator’s agenda, the toolkit to achieve this is still lacking. Many multinationals are keen to achieve scale through pooling solutions. In the UK, risk transfer markets and alternative solutions coexist. This market has seen defined benefit consolidators, synthetic buy-in offerings and captive reinsurance solutions challenging the primacy of buy-out as the gold standard solution for the endgame. This challenge is essential, for the sake of financial stability and member outcomes. 

Trustees and sponsors of larger pension plans should carefully weigh up the advantages and disadvantages of selling their liabilities to insurer solutions. With this, they should consider whether a strategy of continuing to operate the plan for the long term would prove a better option for all potential beneficiaries of the plan, including sponsoring employers and their employees.