DB PENSION SCHEMES
2023 risk transfer report
Our 2023 report on the risk transfer market will support Defined Benefit (DB) pension scheme trustees and sponsoring employers in navigating their pensions journey. This research focuses on recent activity in the bulk annuity and wider risk transfer market, and looks at the de-risking objectives and outlook for schemes approaching potential transactions. We discuss the key considerations in planning for a future transaction, recognising the importance of planning holistically — highlighting the practical preparatory steps which are instrumental in successfully delivering the endgame.
A summary of what happened in 2022
The implications for 2023 and beyond
Focus on transaction preparations
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Alternative transaction options
During the first half of 2022, £12bn of buy-ins and buyouts were completed. This was in line with expectations for a strong pipeline for new business at the start of the year. It reflected heightened appetite among insurers to write new business early in the year, following a slower than expected start to 2021. Trustees have also made progress in improving transaction readiness to take advantage of improvements in schemes’ funding positions and more attractive insurer pricing.
The second half of 2022 was much busier, with higher volumes of business and many more schemes preparing to approach the market. Market volumes for 2022 are again expected to be of the order of £30bn, reflecting a broadly similar value of bulk annuity transactions relative to 2021. This is despite liability values falling over the year, particularly over Q3 2022, due to significant rises in nominal gilt yields. Had these gilt yield rises not occurred, the same deals may have equated to market volumes of around £40-45bn - much more than in the previous two years.
Nominal gilt yields rose steadily over the first half of 2022, but there was significant volatility over the latter part of 2022, especially in the wake of the Government’s ’mini-budget’. Nominal yields peaked at around 5% p.a. in mid-October, rising to their highest level in over 10 years. In particular, substantial rapid fluctuations in gilt yields led to heightened volatility in schemes’ liability values. The excess yield on corporate bonds over gilts (the ‘credit spread’) also rose over 2022, peaking at over 2% in mid-October. Insurer pricing is heavily influenced by credit spreads, and so this increase created opportunities for schemes to transact at attractive levels relative to gilt yields (albeit at a time of significant economic volatility).
This period of unprecedented volatility created significant challenges for schemes in the market for completing transactions. Insurers typically offer mechanisms to help stabilise affordability as a transaction gets close to completion, but these were tested during this period due to the extreme movements seen over a very short time period. We successfully completed several transactions during this period, allowing these schemes to lock into very attractive short-term pricing opportunities.
For well-hedged schemes whose portfolios were designed to broadly match these changes in market conditions, funding positions remained relatively stable over this period of market volatility. However, there still may have been improvements in schemes’ positions on a buyout basis if hedged on a less prudent funding basis.
Chart - Number and value of pension scheme bulk annuity transactions
The consequences for 2023 and beyond
Introduction
For schemes with more limited hedging against movements in gilt yields and inflation expectations, significant falls in scheme liabilities will not have been matched by a similar fall in assets, leading to a material improvement in the funding position over a very short period. For better hedged schemes, even though the funding level may not have changed so much, the £ amount of any shortfall will still generally have reduced, due to the reducing size of both the assets and liabilities. For some, this can put the deficit into the zone where the sponsor has both the appetite and ability to close the gap. This may have led to schemes being able to considerably accelerate their journey to securing benefits with an insurer, where this may not have appeared to be a feasible short-term objective at the start of 2022. These trustees should be proactive in de-risking the scheme’s investment strategy and improving transaction readiness to take advantage of the material improvement in such schemes’ financial positions.
In the ’alternative risk transfer‘ market (including superfunds and other capital-backed solutions) 2022 might be characterised as a year of unfulfilled expectations. Over a year since Clara-Pensions completed its regulatory assessment, it was disappointing to see the commercial consolidation market struggle to get off the ground with a first transaction. Some of this is undoubtedly due to the significant changes in financial markets during the summer and autumn, which have led to rapid changes in schemes’ funding levels and tougher conditions for consolidators to demonstrate that their proposals are consistent with TPR’s gateway principles. It remains to be seen in 2023 whether the slow progress to date is purely market-driven, or possibly symptomatic of any lack of trustee and sponsor appetite for such alternative risk transfer transactions.
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In reaching a funding position where a transaction is affordable, schemes need to act quickly in order to lock-in these improvements in scheme funding and protect against the potential for subsequent falls in yields over 2023. Failure to do so could mean the significant improvementsin funding levels seen over 2022 could, at least to some extent, be quickly reversed. This recognises that for most schemes, a transaction becoming affordable doesn’t mean being ’transaction-ready‘. In reality, it can take some time for schemes to prepare for a transaction, and so taking steps to protect the position in the interim is crucial. We discuss what schemes might do to become transaction-ready later in the report.
Insurer pricing is influenced by a variety of factors, including the insurer’s investments used to back bulk annuity policies, reserving requirements, reinsurance pricing and terms, and the cost of capital. Generally speaking, we have seen demand for bulk annuity transactions be sensitive to pricing offered, particularly for pensioner only transactions. In these circumstances, the pension scheme is buying the bulk annuity policy as an asset. As it is an entirely optional strategic move, the pricing must offer a suitable risk adjusted return above gilts.
Insurer pricing
Many more schemes are now expected to be in a position to fully secure their liabilities with an insurer, whether due to steady progression of their de-risking journey or unhedged positions leading to an unexpected funding improvement. The bulk annuity marketplace has been busy for the last few years with schemes needing to work with insurers to obtain their interest in a particular transaction. The stage is now set for extremely high demand from pension schemes looking to insure liabilities.
Scheme finances
Gilt crisis impact
There are also other options available to schemes keen to progress their de-risking journey.
Find out more about these options to help you achieve your de-risking endgame through our pension buyouts and buy-ins webpage. DB Navigator provides knowledge, structure and tools to guide schemes towards their pension endgame. Our member options content offers schemes information about flexible retirement benefits.
De-risking options
Market development
Resourcing constraints are likely to be a crucial limiting factor for insurers when choosing to engage with a scheme. Insurers usually target transactions based on transaction readiness, liability profile, size and required transaction features. We may begin to see a greater focus on more specific transaction characteristics, for example, liability profiles that suit the insurer’s available investment opportunities. Such selectivity will likely be informed by insurers’ views on which cases give them the best opportunities to successfully write business. We expect to see processes with fewer insurers involved overall, but with heightened levels of participant engagement. Given the outlook for a busy marketplace, schemes must prepare well and show that they are in a position to complete a transaction when they approach insurers. Those with suitably progressed data readiness, a comprehensive benefit specification and effective governance structure with a clear route to completion, will gain greatest insurer engagement and allow them to complete a transaction in a more robust and efficient manner. This is particularly important for medium and smaller schemes with assets up to £150 million. Despite the smaller size, these deals demand similar insurer resource requirements to a larger deal. These transactions represent around 80% of completed deals by number but only around 20% of premium volume. Standing out as an attractive opportunity is increasingly important.
During Q4 2022, HM Treasury unveiled plans to give insurers more flexibility regarding the assets held to back their obligations, along with signals for easements regarding certain reserving requirements under Solvency II.
These factors have the potential to provide bulk annuity insurers with greater choice regarding in investments and their approach for managing longevity risks, which could lead to price improvements and help support greater new business volumes. However, it is not clear on the degree to which the Prudential Regulatory Authority will permit any material reduction in reserving requirements. Initial messaging from insurers suggests that the potential impact of the expected changes is likely to be relatively minor and take time to materialise, recognising that the timescales for reform are currently unclear and not anticipated until late 2024 at the earliest.
Regulatory backdrop
While demand for transactions is set to be high, healthy insurer competition within the marketplace should help to continue to support attractive pricing.
Supply and demand
Not many schemes are likely to be in a rush to secure their liabilities immediately at any cost. We anticipate that insurers may have set new business targets for 2022 which equate to total market volumes of more than £30bn, suggesting their appetite for business may not have been sated last year. We expect insurers to have again set aggressive targets for 2023 new business aspirations, particularly given swelling transaction pipelines in late 2022. Given the fall in liability (and so premium) values due to much higher interest rates than in recent years, insurers will have to write even more business to reach their greater volume targets for the year. This may offset some of the concerns around pricing potentially becoming less competitive due to heightened demand.
Following a gradual improvement in pricing over the second half of 2021, pricing improved significantly in early 2022.
This reflected an increase in the additional yield available on corporate bonds compared to gilts resulting in a sustained period of very attractive pricing. Although credit spreads narrowed somewhat in the last few months of 2022 and into 2023, pricing remains attractive compared with historical levels. This is illustrated by the chart to the right, which approximately tracks the implied margin above gilts that was typically achievable when securing pensioner benefits with an insurer.
Developments over the last 18 months
Impact on schemes
Impact on insurers
Leveraged LDI (Liability Driven Investments) is a tool which uses leverage to manage interest rate and inflation risks to provide greater certainty in funding including in the run up to an insurer transaction. LDI was particularly challenged during the gilt market volatility over September/October last year. Rapidly falling gilt prices caused leverage levels to increase to the extent that additional collateral payments were needed at very short notice in order to maintain hedging levels. In some cases, hedging exposure had to be reduced, either at a scheme level because insufficient collateral was readily available or within the pooled funds themselves where there was not time for collateral to be called from investors to lower leverage levels. As a result, LDI managers took the decision to permanently reduce the leverage levels within both pooled LDI fund range and segregated mandates. This was in order to make the funds more robust in the event of future market volatility, taking into account communications from the regulators and considering market trends. This has implications for investment strategies going forwards, which in some cases will impact on the speed and certainty of a scheme’s journey to buyout. This is because schemes will now have to either: 1. invest more in LDI to achieve the same level of hedging and therefore less in return seeking assets (including credit which is typically invested in as a proxy match for the credit element of insurer portfolios). Doing so would prolong the expected timeframe to buyout; or 2. retain the same allocation to LDI but accept lower hedging levels, and therefore more volatility in funding position. Doing so would make the journey to buyout more uncertain than before these changes. The heightened volatility environment and changes to LDI fund leverage levels may also have affected the strategic rationale for partial buy-ins. Specifically, lower leverage levels in LDI funds may mean that a buy-in makes it harder to maintain the same liability hedge as before using the residual assets (as the assets that would be used for the buy-in premium could otherwise be used to support liability hedging across a greater portion of the scheme’s liabilities). Going forward, schemes should use leverage with caution when building a buyout-ready investment portfolio.
Given the differences between typical bulk annuity insurer and pension scheme investment strategies, insurers were not directly impacted by the LDI crisis. Insurers are required to invest in a buy and hold fashion, while accurately cashflow-matching their liabilities. As such, insurers are not able to significantly leverage their investments, which results in them being largely unimpacted by the LDI fund challenges. Insurers typically utilise reinsurance via collateralised longevity swaps to manage their longevity risks. Collateral requirements on such instruments are likely to fall in a rising rate environment. However, the extreme volatility experienced in Q3 2022 caused some significant shifts in the collateral required from day-to-day. However, this typically only reflects a very small proportion of their investment portfolio and insurers are required to suitably manage their liquidity, helped by not running significantly leveraged or derivative intensive strategies. In addition to the considerable increase in short to medium term activity (owing to the substantial improvement in funding position experienced by many schemes), the most notable impact on insurers is likely to have been navigating transactions and the receipt of premium payments during the period of significant market volatility.
We are expecting to see the market top £40bn in 2023. In absolute terms, this wouldn't break 2019's record for bulk annuity volumes. However, if adjusted for interest rate changes, this would represent transaction volumes far in excess of that seen in past years. In particular, the human resource to prepare for, complete and implement this volume is likely to drive significant expansion of teams across the risk transfer market.
There are also other options available to schemes keen to progress their de-risking journey. Find out more about these options to help you achieve your de-risking endgame through our pension buyouts and buy-ins webpage. DB Navigator provides knowledge, structure and tools to guide schemes towards their pension endgame. Our member options content offers schemes information about flexible retirement benefits.
During Q4 2022, HM Treasury unveiled plans to give insurers more flexibility regarding the assets held to back their obligations, along with signals for easements regarding certain reserving requirements under Solvency II. These factors have the potential to provide bulk annuity insurers with more flexibility, which could lead to price improvements and help support greater new business volumes. However, it is not clear on the degree to which the Prudential Regulatory Authority will permit any material reduction in reserving requirements. Initial messaging from insurers suggests that the potential impact of the expected changes is likely to be relatively minor and take time to materialise, recognising that the timescales for reform are currently unclear and not anticipated until late 2024 at the earliest.
While demand for transactions is set to be high, healthy insurer competition within the marketplace should help to continue to support attractive pricing. Not many schemes are likely to be in a rush to secure their liabilities immediately at any cost. We anticipate that insurers may have set new business targets for 2022 which equate to total market volumes of more than £30bn, suggesting their appetite for business may not have been sated last year. We expect insurers to have again set aggressive targets for 2023 new business aspirations, particularly given swelling transaction pipelines in late 2022. Given the fall in liability (and so premium) values due to much higher interest rates than in recent years, insurers will have to write even more business to reach their greater volume targets for the year. This may offset some of the concerns around pricing potentially becoming less competitive due to heightened demand.
Following a gradual improvement in pricing over the second half of 2021, pricing improved significantly in early 2022. This reflected an increase in the additional yield available on corporate bonds compared to gilts resulting in a sustained period of very attractive pricing. Although credit spreads narrowed somewhat in the last few months of 2022 and into 2023 pricing remains attractive compared with historical levels. This is illustrated by the chart to the right, which approximately tracks the implied margin above gilts that was typically achievable when securing pensioner benefits with an insurer.
There are emerging transaction options available to pension schemes outside of the insurance space. These are superfunds, which are effectively commercially run pension schemes, and other capital backed solutions, which are effectively structured investment strategies. We take a look at developments within the alternative transaction space in this section.
Superfunds
Other capital-backed solutions
Given the lack of transactions announced in 2022, this year the industry will be watching eagerly to see whether, after several years of waiting, the capital-backed consolidation vehicles, or ’superfunds‘, can get off the ground with their first transactions. With Clara-Pensions having completed its regulatory assessment in late 2021, there has in theory been no barrier to Clara carrying out transactions for the last year. However, the first deal is yet to be announced. This is not for want of trying – a large amount of work has been carried out ’behind the scenes‘ – but recent market movements have meant that schemes which initially engaged with Clara have quickly found themselves within reach of an insurance transaction instead. Despite these challenges, we can see merits in having non-insurance solutions offering risk transfer solutions where the mainstream routes are not viable. We understand that Clara remains optimistic of being able to announce its first deal in 2023, and hope that this will provide the ’proof of concept‘ required for the scheme to start to build scale. We anticipate that greater focus will be given to schemes with a sponsor-driven imperative to complete a transaction quickly (e.g. M&A activity or a risk of insolvency), or to schemes which were previously further behind in their journey planning and therefore have further work to complete before they are transaction-ready, particularly given the financial market changes having shifted the group of schemes which are likely to be in Clara’s ’target zone‘ for pricing. The industry will also be paying attention to the challenges faced by other providers in the consolidation market, in particular given the well-publicised failure by The Pension SuperFund (PSF) over a number of years to emerge from its own regulatory assessment process.
Similarly, 2023 will be a year in which we wait to see whether the market for other forms of capital-backed risk transfer will take off. Only one capital-backed journey plan (CBJP) transaction has been completed so far, in 2020, but since then several new providers have entered the market and commenced detailed discussions with scheme sponsors and trustees. CBJP structures differ from superfunds in that they operate within an existing pension scheme trust, with no pooling of assets or liabilities between schemes and no breaking of the link to the existing scheme sponsor. As such, CBJPs are primarily investment products, meaning that there are fewer regulatory barriers to each transaction being completed. The CBJP providers in the market are offering a variety of structures, with a range of potential ’destinations‘ and risks covered (including an insurance transaction, a superfund transaction or funding on a low-dependency basis) and flexibility in the period of time taken to reach the destination.We expect the CBJP providers’ detailed conversations with schemes to continue during 2023, with every possibility of further deals being announced. Key considerations will be schemes’ funding positions after the recent market volatility (with CBJPs open to schemes at a wider range of funding levels than the relatively narrow band which applies for superfund entry) and limitations placed on the amount of leverage that can be built into the providers’ hedging strategies in the wake of the gilt crisis discussed previously.
In the backdrop of a very busy marketplace, schemes must be suitably well-prepared for a transaction in order to secure an insurer’s appetite to quote. Clarity on a scheme’s data and benefits is crucial for a variety of other reasons, such as ensuring a smooth progression from buy-in to buyout with no post-transaction ’surprises‘. Supporting robust decision-making and ultimately ensuring the trustees are able to provide the necessary warranties around the quality of a scheme’s data and benefits to the selected insurer is equally important.
Data and benefits, governance
How schemes can ensure they are ready for a transaction
Many schemes will find themselves in a different position compared to this time last year. For some, the timeframe to a transaction will have been significantly shortened. For these schemes, it is important to have a plan for your investment strategy that facilitates a smooth transition of assets to an insurer or consolidator in a risk-controlled way. In this section, we will consider the key considerations that trustee boards should be making at this time.
Investments
Planning ahead
Bearing in mind that the investments required by insurers for a transaction will be largely low-risk assets such as gilts and corporate bonds, trustees should ensure a plan is in place to sell down any risky and/or illiquid assets – such as equities or property – allowing for potentially long notice periods. The aim should be to reduce risk gradually over time. For schemes that are now ahead of their journey plan, this step is vitally important. Consider what place illiquid assets have within an investment strategy, and when you expect to be invested solely in liquid assets.
Credit exposure
When increasing the allocation to credit, trustees should consider prevailing credit spreads in the market and look to implement any increases when it is attractive to do so. Credit spreads increased over the course of 2022, and schemes that had a plan to purchase credit when spreads were higher, and therefore the credit was cheaper, would have benefitted.
Hedging
Schemes should generally aim to be fully hedged against interest rate, inflation and currency risks at the time of a transaction. The hedging should normally be based on the scheme’s solvency liabilities because this estimate of the liabilities should move most closely in line with insurer prices. As mentioned previously, leverage should be used with caution when hedging liabilities. Therefore, trustees should have a sensible plan to achieve the desired level of hedging over time, without taking excessive risks. Setting triggers to take advantage of opportunities, such as rises in yields, could allow trustees to be opportunistic, and to move schemes closer to the position they want to be in.
Engage with key stakeholders
Trustees should ensure they have appointed a credible team of advisors, such as risk transfer specialists to advise on the transaction and lawyers to advise on the benefit specification and contractual terms. Trustees must also engage with other decision makers including the sponsoring employer to agree key transaction objectives.
Feasibility study
Given the time and resources required to provide a quote for a scheme, insurers will want to check during their initial engagement that there is a realistic prospect of a transaction being affordable. Trustees should consider affordability carefully with their advisers, including allowance for any post transaction costs and expenses, and potential additional financing from the employer.
Legally reviewed benefit specification
In order to provide a quote, the insurer will require a specification which clearly details the scheme’s benefits. This should be legally reviewed to ensure it is consistent with the scheme’s rules, but with any trustee or employer discretions appropriately codified. This document will also need to work alongside the clean and complete pricing data, to allow a premium to be determined.
Clean and complete data
Trustees should review the quality of the scheme’s membership and benefit data, so that material gaps or uncertainties can be addressed prior to issuing data extracts to an insurer. Transaction-ready data is important to provide insurers with comfort that the required preparatory work has been carried out and there will be minimal data cleansing required after the transaction.
Planning and governance
Insurers will look for engaged trustees and company representatives working together, who are knowledgeable on the transaction process and preparatory work required. Trustees should receive training from their specialist advisers.
Liability management exercises
Liability management exercises (such as Pension Increase Exchange and Enhanced Transfer Value exercises) may be beneficial in order to improve the affordability of a transaction. Ideally these will be completed pre-transaction, but if not, a clear strategy will be required in order to achieve suitably flexible buy-in terms.
Chart - iBoxx Corporate Bond index spread
Illiquid asset holdings can be something to navigate on the approach to transaction, which can influence the timing and structure of the risk transfer deal, if it's not possible for these to be sold (without adverse funding implications).
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Please contact your Barnett Waddingham consultant if you would like to discuss any of the above topics in more detail. Alternatively get in touch via the following:
risktransferteam@barnett-waddingham.co.uk
Rosie Fantom
Risk Transfer Partner
rosie.fantom@barnett-waddingham.co.uk
Andy Smith
Risk Transfer Principal
Chris Pritchard
Investment Associate
Danielle Markham
Principal and Head of LDI Research
Jack Sharman
Principal and Senior Consulting Actuary
Olivia Westwood
Actuarial and Risk Transfer Consultant
Tom Hill
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Head of Bulk Annuities and Risk Transfer Partner
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Simon Bramwell
Head of Longevity Risk Transactions and Risk Transfer Partner
Richard Gibson
Partner
Gavin Markham
Chris Hawley
Ian Mills
Partner and Head of DB Endgame Strategy
