Buy-out market shows dramatic surge

New players have entered a market of over €3bn in the past couple of years, finds Nina Röhrbein

The UK buy-out market grew 80% in the second quarter of 2008, reaching a value of £2.7bn (€3.4bn), according to research by Aon Consulting published last month.

Market insiders are implying that partial pensioners-only buy-in is the flavour of the moment - and of the past 12 months.

In both a buy-in and a buy-out, trustees pay a premium to a Financial Services Authority (FSA) regulated insurance company in exchange for bulk annuity contracts that guarantee to pay a set of defined benefits. In a buy-out, the trustees fully discharge their liabilities, while the scheme ultimately winds up and individual members receive an annuity policy from the insurer. A buy-in is an asset of the scheme, with the trustees owning the bulk annuity policy and the beneficiaries remaining members of the pension scheme.

“FSA regulations clearly affect the amount of capital that insurers need to hold,” agrees Ian Maybury, senior actuary at Redington Partners. “But as far as buyouts are concerned it is the Pensions Regulator that has had a greater impact. The new scheme-specific funding requirements and its consultations on the longevity assumptions have created at least the perception of greater risks that may have led schemes to consider buy-outs or buy-ins. This has been reinforced by consultations from the accounting standards bodies suggesting more onerous assumptions for determining pension scheme liabilities.”

“The buy-out market has really developed over the last couple of years,” explains Matthew Furniss, senior consultant at Punter Southall. “It has gone from the two big insurers, Legal & General and Prudential, who used to pick up the majority of wind-up business, to around 15 players in the market as more schemes are using buy-out to derisk.” Among them are Aegon, AIG, Legal & General, Lucida, Met Life, Norwich Union, Paternoster, Pension Insurance Corporation, Prudential, Rothesay Life and Swiss Re.

Total written business for the market grew from £1.7bn in 2006 to £3bn in 2007, with some industry insiders expecting it to exceed £10bn by end-2008, says Mark Wood, chief executive at Paternoster. “This is due to more tailored and cost-effective propositions, greater trustee awareness of the options available to them to secure pensions and companies becoming increasingly keen to remove this volatile liability from their balance sheet.”

According to Matt Gore, chief administration officer at Pension Corporation, two years ago, every financial institution wanted to win business in the buy-out market. “But some interested parties have drifted away resulting in a core nucleus of companies offering those solutions,” he says.

“As not all of the market players can survive, consolidation between them is becoming more important,” notes Kevin Wesbroom, (pictured right) UK lead, global risk services at Hewitt. “Synesis Life, for example, came and went, never having written any business.”

“Large pension funds are increasingly able to negotiate bespoke solutions with providers,” says Mike Rogers, senior investment consultant at Watson Wyatt. “However, strong demand is making it harder for small pension schemes to obtain quotes, with some buy-out companies even raising their minimum quotes.”

Most pension schemes look predominantly at plain vanilla buy-ins or buy-outs despite the emergence of new innovative forms such as non-insured buy-out solutions or buy-outs with profit shares, according to Furniss.

“Recent transactions have included some element of recoverability - the ring-fencing of assets, which recovers the assets in the event of insurer insolvency - and it is likely that now trustees are aware it is available, they will be looking to negotiate for similar clauses in their own agreements,” says Maybury. “Staged payment mechanisms are of particular interest to those who are keen to buy-out but unable to afford the price initially agreed upon.”

The pension schemes involved in buy-outs are getting bigger. “Over the last eight to 10 months, we have seen some deals involving large pension schemes such as Rank with £700m of liabilities and the Delta pension plan with £450m worth of liabilities being bought out,” says Gore. “And we are now in discussions with schemes above the £1bn mark. However, for some transactions that size, conversations are taking place in the industry about a syndication approach where more than one insurer collaboratively provides insurance to a pension scheme.

“Because there are significant amounts of funds tied up in final salary pension schemes it is an attractive market for us. We believe that by pooling them we can manage those assets and liabilities more efficiently than pension schemes,” he adds.

“With such big demand for buy-ins and buy-outs, we are moving from a buyers’ to a sellers’ market, as insurers can be more selective now as to whom they will sell,” adds David Ellis, (pictured left) principal at Mercer.

But while insurers ultimately look at making a profit, some have been underpricing this year to get a foot in the market, says Rogers. “We saw some very low prices earlier this year which might suggest that pressure to grab market share was more important than making money on those transactions for some providers. But it is unclear how long this pressure on providers to build up critical mass will continue.”

“Prices came down at the end of 2007 on the back of the rising number of insurers looking for business as well as the high spreads of corporate bonds and swaps following the credit crunch,” agrees Furniss. “As the spreads increased, the liabilities lowered in value which in turn dampened prices. However, it is difficult to see what happens next, as the high spreads currently observed depend to some extent on how long the credit crunch will last.”

“Prices are drifting up again now, also because insurers are in need for more money from their internal or external backers in this capital-intensive business,” says Ellis. “And the backers will push for higher interest on the money lent.”

However, annuitisation is just one tool in a vast array of risk management techniques. “Often we find that while the initial focus is on buy-ins or buy-outs, trustees and sponsors quickly ask whether there are other ways to manage their risk and return more effectively, for example using swaps, options, term based policies and other diversifying assets,” says Rogers. 

Wesbroom sees plenty of interest for a longevity swap combined with an LDI investment, also called a synthetic buy-in or buy-out. “This is very much the leading edge and more flexible than a real buy-out or buy-in,” he says. “I expect to see at least one transaction before the end of the year.”

“Different schemes have different objectives,” explains Gore. “For a larger pension scheme the longevity swap may be a more attractive proposition than a full buy-out because it is likely to already have sophisticated investment teams with inflation and interest rate hedging strategies in place. The one risk these schemes find more challenging to remove is longevity, which makes products like longevity swaps such a complementary solution to their existing strategy.”

“The vast majority of pension schemes are not able to afford the level of expertise necessary to do the evaluation work and so a buy-out represents a very practical solution to securing the pensions,” adds Wood.

Currently buy-out expertise is predominantly with UK-based companies. However, Wood identifies some similarities between the UK and the Canadian and US markets, adding that Paternoster may look at those in the future.

“Over the medium term we see great opportunities across Europe and the US but at the moment there probably is not a huge need to look overseas,” notes Gore.

And the consensus is that he is right because despite its sharp growth over recent months, with up to £1trn worth of liabilities believed to be held in UK DB pension schemes no end is in sight for the buy-out and buy-in market.