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There is a comfortable consensus in the UK pensions business that pension schemes’ funding has recently improved so much that they can safely move towards a so-called endgame.
This happens in two ways. One is by transferring risk to an insurer via a buy-in, or bulk annuity purchase, where a pension scheme takes out an insurance policy that pays out all commitments to its members. The other is a buyout, where the scheme transfers all its liabilities to the insurer.
The risk transfer market is hot. Actuarial consultants WTW forecast earlier this year that 2024 would be the busiest year ever, with £60bn of bulk annuity transactions. Yet this boom is paradoxical.
The psychology is admittedly understandable after years in which sponsoring employers poured billions into their pension funds to meet burgeoning deficits. Passing on the risk of future deficits is a way of locking in a favourable funding position. Longevity risk is also transferred to the insurer.
Yet there is a real question as to whether sponsoring companies and trustees have connived in what William McGrath, chief executive of C-Suite Pension Strategies, calls a damaging de-risking overshoot.
According to the Pension Protection Fund, pension schemes were in surplus in March 2023 to the tune of £359bn with their liabilities valued at benefit levels equivalent to those of the PPF. That was a funding ratio of 134 per cent. More than 80 per cent of schemes were in surplus. On the tougher valuation basis in line with buyout market pricing, the surplus was still a sizeable £149.5bn, or 111.9 per cent.
Note, too, that past deficits were arguably a fiction — the freakish product of ultra-low interest rates after the financial crisis. This caused the value of future pension liabilities to balloon as they were discounted by lower rates. Given rates are normalising, a transfer of risk to insurers would now preclude benefits such as paying discretionary increases to scheme members and reducing company contributions.
In particular, if pension funds continue to retain responsibility for meeting pension liabilities — a so-called “run on” — any surpluses could be recycled into threadbare defined contribution schemes.
At the same time, a run-on allows pensions to be financed with a healthier risk appetite across a wider range of asset categories than insurers tolerate. That highlights the broader economic consequences of transferring risk to insurers.
Graham Pearce and John O’Brien of consultants Mercer point out that the risk transfer transaction process is inefficient and costly. Most plans have to overhaul their investments in advance to satisfy the insurers’ demand for a highly liquid, low-risk fixed income portfolio — only for insurers to potentially reinvest in illiquid fixed income after the transaction. Pension plans are thus denied the opportunity to earn an illiquidity premium for some time. Insurers, they say, need to add the cost of delays in reinvesting the assets into their upfront premium pricing.
Such risk transfers reinforce the bias in the UK financial system against equity. For good measure, the Prudential Regulation Authority has been concerned that the insurance sector may have absorbed too many assets too quickly, giving rise to financial stability risks. The concentration among just nine insurers in the business also points to the risk of one-way markets.
Whether buyouts and buy-ins have offered value for money is hard to answer because the market lacks transparency. What is clear, though, is that the dramatic surge in demand is causing capacity constraints. This creates an adverse pricing environment for pension funds.
Turning the Page, a public policy focused think-tank created recently by Michael Tory, a founder of Ondra Partners, estimates that the realised profit from total risk transfers to date by defined benefit pension funds amounts to £12bn-£15bn. These profits, incidentally, include those from buy-ins by big insurers’ own pension schemes.
This is a very handsome reward for such a low-risk business. Given that just four players are reckoned by industry sources to account for close to 80 per cent of the market there is a clear case for the Competition and Markets Authority to cast an eye. And McGrath argues that the government should adopt a windfall profit tax on the insurers.
Windfall taxes often amount to bad economics. But in this instance a tiny oligopolistic group of insurers are operating in a highly distorted market where their actions have implications for the wider economy. This should surely give chancellor Rachel Reeves pause for thought.