BAC Briefing

June 2020

Getting buyout ready

2019 was a record year for bulk annuity insurers and the message to schemes could not have been clearer – pricing is very attractive. Covid-19 has created many challenges for DB schemes but, for those ready to transact in 2020, it may have created even more favourable market conditions for a buyout.

The problem is that most schemes, even those which have come a long way on the journey to de-risk their assets, are not there yet. It will be the schemes that can get “deal ready” in the next year or two that are likely to achieve the best outcome for their members and their sponsor.
 
In this BAC Briefing we look at what being “deal ready” actually means and what work it will involve. Essentially it breaks down into two parts:
  • ensuring the transaction is financially viable, which is where Covid-19 will have an impact
  • precisely defining the liabilities which are being transferred from the scheme to the insurer.
The first stage is critical in all transactions, but the second is less critical when agreeing a buy-in deal that is not intended to convert to a buyout quickly. This is because any questions which arise about the liabilities that have been contractually transferred can be addressed following buy-in and corrected before the scheme ultimately winds up. However, in the case of a short buy-in to buyout period, it is essential that the correct liabilities are transferred at the time of the transaction, as the scheme will simply not exist in the future to address any mistakes that have been made.

Ensuring the finances work

Once a scheme has sufficient funds to transact with an insurer, it needs to be able to maximise its hedged position, relative to insurer pricing, as quickly as possible. This is easier said than done, as different insurers have different pricing models, which are best matched with subtly different investment strategies. The best that can usually be achieved, prior to going exclusive with one insurer, is a hybrid strategy which will typically achieve a 95%+ hedge against interest rate and inflation risks.
 
Part of the detailed deliberations are concerned with how a scheme’s current hedging, usually via some form of liability driven investment (LDI), can be transitioned to a structure that is attractive to insurers, without placing a strain on the collateral which the scheme needs to hold for its LDI. 
 
In order to target good returns over the long term, many schemes have invested in a range of illiquid asset classes. Whilst this can be a very sensible approach, it does require a good understanding of precisely how illiquid these investments might prove to be. Some schemes have been caught out by not fully understanding the small print and finding out that lock-in periods do not work as they thought or that approval from third parties is required before the asset can be sold.
 
In the run up to a transaction, trustees and sponsors need training on these investment areas. They should also agree an investment protocol so that, when close to being able to do a transaction, decisions can be made quickly, thereby ensuring that markets do not move against the scheme’s funding position.

Impact of Covid-19

Of course, the impact of Covid-19 on investment markets may mean that some schemes which were targeting a bulk annuity deal in 2020 are now too far away (at least without a significant extra contribution from the sponsor). Indeed capacity within the bulk annuity market at the present time is quite low – aside from deals which are already included within insurers’ new business pipelines, there is probably only capacity for deals of up to £500 million each over the remainder of 2020.
 
However, it is also possible that, for schemes which had already hedged almost all of their interest rate and inflation risk relative to gilts and are already included within insurers’ pipelines, the terms which insurers may offer over the second-half of 2020 could prove even more attractive (at least for pensions in payment). This is because of the increased credit spread provided by corporate bonds, which is likely to more than offset the increased risk of defaults and downgrades on those bonds and additional reserving requirements for insurers. Having said that, insurers are being very selective about which corporate bonds they are willing to hold, so there is no certainty that terms have improved due to increased credit spreads, plus the credit spreads themselves have been volatile over the months of March, April and May 2020.
 
Mortality is the other key factor which Covid-19 will be changing, but it is too early to assess what this will mean for bulk annuities. In the short term, it is likely to mean additional deaths and so will remove some of a scheme’s liabilities before a transaction is priced. However, these additional deaths are likely to be older pensioners with existing health conditions, so insurers will be cautious about a possible selection effect for mortality rates looking forward. Initially, after the first wave of deaths from Covid-19, they are likely to assume higher future mortality improvements. There is a separate question about whether Covid-19 outbreaks will become an annual occurrence, like the winter flu.

Defining the liabilities

This stage involves:
  • performing detailed data cleansing
  • auditing administration benefit calculations
  • reviewing all the scheme’s legal documentation (historic and current) to ensure the rules have been correctly administered.
Clearly this is a time-consuming stage and, unless a scheme is very fortunate, it is likely that such a detailed audit will reveal some legacy issues. Advice will be needed on how to address any such issues. Often there is more than one legitimate way of dealing with such problems, with corresponding advantages and disadvantages. In such situations it is entirely possible that the trustees, the sponsor and the insurer(s) all have different views on what corrective action needs to be taken.
 
Schemes which are getting close to transacting need to give serious thought and planning to this audit stage. Completing some or all of this before engaging with insurers can be a significant help in convincing insurers that the scheme is serious about transacting.

Getting your governance right

A large-scale transaction requires excellent communication between the trustees, sponsor and insurer (and of course their advisers). If not, the quality of decision-making and the process itself will suffer – indeed we have heard of one major transaction that did not take place because of poor communication between the trustees and the sponsor.
 
The quality of the governance framework is something which insurers are very concerned about, again as a sign of how serious the scheme stakeholders are about getting a deal done.
 
A joint company/trustee working party can be an effective tool to ensure there is sufficient focus on the transaction and efficient communication about issues as they arise. Terms of reference for the working party can spell out the remit of the group and be clear on what decisions need to be escalated upwards. Ideally, this working party will be set up long before the insurers are approached.
 
Its first jobs should be to develop and implement the investment changes required and also to push ahead with the data and benefit audit. The role of the different advisers and how they work together also needs to be agreed and documented.
 
Whilst it is not unusual for one firm to carry out the bulk annuity broking process, it is not possible for that one firm to advise both the trustees and the sponsor. This is because, as we have already explained, there is usually more than one legitimate way of dealing with (often non-trivial) legacy issues that emerge as part of a bulk annuity process. For larger transactions, it has become increasingly common to have the trustees’ and company’s advisers working together on the broking.

Resources and project management

Very few schemes have sufficient internal resource to embark on a large-scale transaction without careful planning. Schemes will require dedicated resource and specialist project management for a significant number of months. Issues to consider include:
  • who will provide this resource?
  • who does this resource report to and does that create any potential conflicts of interest?
  • what is the role of advisers in meeting any resource needs (again this can create conflicts that need managing).
It is important that the trustees and sponsor work through these issues before they get too far into the transaction process.
 
BAC has direct experience of working alongside other advisers, as the lead corporate adviser responsible for the governance and project management for a £4 billion buy-in/buyout transaction. If you would like to discuss any aspects of getting buyout ready, please contact us.

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