The Day After the Buyout…

Picture the scene: The financial director and chair of the pension trustee board have just arrived at the insurer’s office to sign a piece of paper that will make everyone’s life easier.

With the dash of a pen, hundreds of millions of dollars/pounds/euros’ worth of worries will be lifted. Thousands of pension fund members will be able to sleep at night, knowing their benefits have been assured—and shareholders will no longer hold their breath while looking at the “actuarial gains/losses” section of the company’s accounts.

Sounds great, right? The asset owners and insurer alike should retire to the nearest watering hole and toast an achievement—but they’d do well to limit their intake, as tomorrow the real work begins.

Before going any further, let’s look at the two options to fully de-risk a pension. First, a buy-in: Plan sponsors can purchase a single insurance policy that exactly matches their pension liabilities. Many see it as an asset that still requires attention and managing but also a route to total de-risking. Which brings us to the buyout: An insurer can issue a separate policy to every member, rendering the pension team obsolete. No managing the policy, no benefit administration, and—most importantly—no funding volatility.

Put like that it seems simple, but getting a pension fund ready for transferring its liabilities to a third party is like moving from one house to another. On the surface, the process appears tidy and well managed: Pack, carry, unpack, done. But remember that drawer you have been meaning to sort out, or the cupboard under the stairs you haven’t seen the back of in years? These—and so much more—need addressing before the moving trucks will take your stuff.

“A buy-in deal is signed on the basis of liability information given to the insurer a few months before,” says Bryan Elliston, former group financial controller at metals firm Cookson. “The insurer then makes assumptions about what the full data are going to tell it. It has to verify this assessment to confirm the pricing of the deal, which normally takes place six to nine months after signing. In the first few weeks after Cookson’s deal was signed, the scheme was providing information and dealing with questions.”

(Art by Jing Wei)

In 2012, Cookson underwent a demerger, creating ceramics firm Vesuvius and shifting swathes of its pension liabilities to London-based Pension Insurance Corporation (PIC) in two tranches. Elliston was in charge of the group’s finances and had been instrumental in the move to de-risk the pension since 2004. He and the trustees considered the alternatives—and the work and costs involved—before joining the growing number of firms opting to hand over responsibility to someone else.

“Pension liabilities are legacy debts and are not a central concern to the sponsor as a part of ongoing operations; they’re something the company would prefer not to have to worry about or manage,” Elliston says, echoing the sentiments of many financial controllers. But sponsors do have to manage the transition—and this can be more onerous than many suspect.

“After the initial work has been done to prepare for and announce the deal, all parties look to getting the deal done,” says Ari Jacobs, global retirement solutions leader at Aon Hewitt. In the nascent North American mega-buyout market, Jacobs has more experience than most, having advised both General Motors and Verizon on their record-breaking deals.

“This work includes ensuring that all the assets are in place, making sure the data are all present, including benefit calculations, census data, certificates of insurance, contractual requirements for the sponsor company and those with the fiduciary duty, along with other administrative tasks,” Jacobs says. “There will also be a series of dry runs, if there is the opportunity to do so. Then there will be more questions, including from the Pension Benefit Guaranty Corporation.”

Finding and cleansing the data within the allotted timeframe can be something of a challenge, says Matt Gore, chief administration officer at PIC. “Most haven’t done this as a matter of course. But they don’t want to see market conditions change, and lose the opportunity to transact, so they agree to a deal based on known data. Then they spend the next 12 months sorting out their member records.” Normally, pension schemes don’t hold details of the amounts payable to every spouse and dependent, he says, “and no insurer wants to take a guess on what they don’t know.”

When the trustees of the UK’s Merchant Navy Officers Pension Fund (MNOPF) decided to insure the old section of the scheme, which had £1.3 billion ($2.1 billion) in assets and 40,000 members, they set sail on a daunting journey.

“As part of the preparation for buyout, we undertook a £3 million admin project that took 18 months and even involved going back and collecting member data that were stored on microfiche dating back to 1937,” says Andy Waring, chief executive of Ensign Pensions, a third party administrator owned by the MNOPF (more on that later). “We recruited 18 people to sort the data over these 18 months.”

After the buyout deal was signed, as the fund had no clear—or even, in some cases, existing—covenant to write checks, trustees had to hold back enough assets to cover administration, litigation, and any other outstanding fees. What was left was handed back to Rothesay Life—which carried out the fund’s second buy-in—and used as a one-off 2% benefit increase for members.

“There is a ‘final pricing’ done at the end of data cleaning when all the details are clarified,” says Gore. “If it turns out that there are vastly more liabilities than had been thought and the scheme and sponsor can’t meet the cost, it’s likely the scheme will hold the insurance policy as a buy-in and do some de-risking of the portfolio, and then wait until they can complete the buyout. It’s very rare that this happens, although it is even rarer that there isn’t some correction after the data have been clarified.”

While all the data are being cleansed and final prices are being settled, the assets are also in transition. They too have to be put in order, as an insurer won’t take just any old portfolio. “Smaller transactions—those of less than $1 billion—are usually settled with cash,” says Jacobs, “whereas the larger deals are transferred in high-quality corporate bonds or other assets used by insurance companies.”

“In principle, insurers will take anything you have. But they will give you a price for what they will pay—for example, the equity bid price minus a percentage for potential volatility,” says Clive Gilchrist, deputy chairman of independent trustee firm BesTrustees. “There is very little reason for a pension scheme to go forward like this.” Gilchrist was chairman of trustees at the EMI pension, which broke records in 2013 with a £1.5 billion buyout with PIC that included deferred members and retirees. “EMI had sold its equity and property funds before transferring its assets,” he says. “There might have been a discount, perhaps as high as 10%, applied if we had handed over these assets.”

But it is not (usually) the insurance company being picky about what it will and will not accept. The industry has strong regulation governing what it can hold as an investment and no sponsor to ask for a cash injection should its bets turn sour.

“Under Solvency II, insurers need to hold risk capital, and a lot less capital is needed for bonds than for higher-risk investments,” says Mark Gull, PIC’s co-head of asset and liability management. “If we were to just take on the investment strategy of a pension fund, we would need to hold much more capital, as their strategies are generally not as accurately matched against liabilities as insurers’.”

And the reason these insurers prefer to take the assets in specie, according to Tom Ground, head of bulk annuities and longevity insurance for Legal & General (L&G), is to have them better aligned with the new liabilities and get the assets working immediately.

“The assets become ours as soon as they are transferred,” says Ground. “We have £40 billion in our annuity book, and we match our liabilities across all of it.”

Amy Kessler, head of longevity risk reinsurance at Prudential Financial—which has carried out some of the largest deals in the US—says the company prefers to work out a solution for transacting the client assets rather than hurry along a deal. Like many insurers, Prudential won’t take cash for large transactions, as the market risk of buying up billions of assets straight after the transfer would be too great. So taking liquid, high-grade assets means it can start fashioning its portfolio exactly as it wishes, without signalling to the market it is on the hunt for securities.

Additionally, insurers with various business lines can create assets that closely match their newly assumed liabilities. For example, Prudential Capital offers financing to middle-market companies, including mezzanine debt and fixed-rate private placements, according to its website. Holding the other side of a loan your own actuaries have scoped out and priced might be seen as a win-win for the company—and the pension members whose benefits are being insured.

“Prudential has the ability to create illiquid fixed-income products, including mortgages and private placement loans, that match our liabilities,” says Kessler. “Our first line of defense is to have the right portfolio. We have some hedging overlays, but they are not our first line. We also have trillions of dollars in life insurance liabilities, which are a great approximation for pension-risk transfers.”

But what about those players that do not have a world-beating insurance arm to ask to create policies, or the size to address all prospects? How do they deploy these assets?

 “We really just want to earn the illiquidity premium and take minimal credit risk,” says Guy Freeman, who works in business development for Rothesay Life. “Once the liabilities are transferred over, there is no need for us to hold substantial liquidity. Liquidity is what most people need—we don’t.”

Rothesay Life, which was born of Goldman Sachs and then partly sold to Blackstone, Singapore’s GIC, and MassMutual, also does clever things with other assets. “We do some secured lending, that is, we take large amounts of good quality collateral backing our investments,” Freeman says. “We avoid—and often hedge out—credit risk.” The company, as its heritage would suggest, does more besides but is not willing to spill the beans to its competitors.

“The vast majority of our portfolio is ‘boring old bonds,’” says PIC’s Gull. “We are cash flow investors, and so we have more than 90% in bonds. Around 40% of our assets are classed as ‘risk free.’” But the company has been leading the charge in buying more esoteric assets, such as private and infrastructure debt as banks have been moving out of these markets. And for good reason: The longest liabilities PIC holds last upwards of 70 years. The longest-dated bond issued by the UK government is 50 years.

So, the assets are transferred, the admin is all in line—what is left to do? Look after the members.

At Prudential, the largest staff group in its pension-risk transfer division is the one servicing schemes post-trade, Kessler says.

“Members don’t like the idea of being handed over to an insurer,” according to Waring at MNOPF-owned Ensign. “There is a certain amount of distrust. But we explained that the legal responsibility to pay their pensions was being handed over.”

“We used two different providers for the buy-ins—Lucida (now L&G) for the first and Rothesay Life for the second—as we were able to get better pricing this way,” Waring continues. “It would have made it difficult for members if we had left them with two insurance companies and two different payments for their one pension. So we consolidated the service and managed the admin transition ourselves.”

Ensign Pensions is one company that runs the whole shebang and now looks after 40 UK pension funds.

L&G, for its part, is investing in its post-buyout services, says Ground, as the buyout trend shows no sign of slowing and members will become ever more numerous. In the UK, last year’s £7.5 billion transaction record is already out of date, according to consultants LCP, and insiders say the US pipeline is also filling up.

So the additional work is done and the handover is complete—now what?

“In a buyout, once the policy is issued, there is unlikely to be a relationship on a corporate level between the insurer and the sponsor,” says Gore at PIC. “The trustees step down on wind up of the scheme, and the company is able to focus on its core operations.”

For those hanging on with a buy-in, the company and trustees are invited to “kick the tires” and make certain the insurer is still on steady footing as they retain fiduciary responsibility. Furthermore, many will shortly be at work on a complete buyout.

We’ve talked about everyone but the CIO: What is he or shet left with?

“Some CIOs might think they can run the plan more cost efficiently than transferring the assets and liabilities to a third party, but it is not in their mandate to decide whether to settle,” says Aon Hewitt’s Jacobs. “That is generally a company decision and the CIO/fiduciary will implement that direction.”

Kessler from Prudential points out that a CIO might be really good at liability-driven investing and have some great managers and overlays, so getting to 70% or 80% funded is fine. But after that, the fund has to function a bit like an insurer if it is to avoid having to ask for more money from the sponsor. If it’s not comfortable with longevity swaps and illiquid fixed income, it’s better off with a buy-in/out.

So if you are considering a total de-risk, start clearing out your closets and aligning your portfolios now. And if you bring your CIO along on the big day, pitch in for that first round of congratulatory/leaving drinks.