Changing with the times

10.04.08

 

This article was written by Jason Coates, partner in Wragge & Co LLP's Pensions group and published in Professional Pensions in May 2008.

Introduction

The more things change, the more they stay the same. This is certainly true of pensions these days. No longer is it the sleepy backwater of the financial world, but it continues to be high profile with new developments worthy of leading articles in the press on a daily basis.

The "buy out" market is one aspect of this development. The rise of Paternoster to challenge L&G and the Prudential with deals such as those done with Emap and P&O; the involvement of the investment banks such as Citi (Thomson Newspapers) and Goldman Sachs (Rank); and the introduction of the "corporate" buy out by Pensions Corporation (Telent, Thorn). These have all hit the headlines.

But is it new, will there be more of it, how do you make it work well and, perhaps most importantly, is it a good thing?

Is it new?

Yes and no.

Is it new for insurance companies to run pension schemes? Certainly not. Companies have passed on the risk to insurance companies before and indeed many schemes were run on an "insured basis" from the start. Some of my SPC colleagues have suggested that we are really at a point in a cycle, which is favouring outsourcing the risks.

However, the scale of the buy out seems to be changing and the methodology is developing. Some of the new arrangements seek to reduce the traditional cost of buy outs by using one or all of (i) regulatory arbitrage, (ii) enhanced transfer exercises, (iii) non-cost neutral commutation factors and (iv) sharing of mortality gain experience as part of the "package".

We are also seeing more interest in "partial buy out" solutions, where company capital is applied for specific groups of benefits (e.g. the pensioner group).

Will there be more?

Yes, almost certainly.

The increasing "pressure" on corporate accounting for pensions and the fact that the defined benefit schemes are essentially financial legacies rather than important HR tools mean that the off-loading of schemes to third parties will continue. With the buy out costs coming down due to competition, the numbers are making more sense to finance directors. If the price is right, it will happen quite quickly in certain situations.

I would certainly expect the market for "event-led buy outs" to continue to grow, particularly where the scheme (and its deficit) is relatively small compared to the corporate (and the transaction price). The pension scheme can be a distraction to the deal and, for private equity investors, the price chip they want is invariably linked to a much stronger test than the simple ongoing deficit anyway.

What about the "strategy-led buy out" market? If Solvency II was to be applied to pension schemes such that UK plc would have to reserve for pension liabilities as if it were an insurance company then I could see this type of buy out taking off apace. But, recent announcements suggest that this is less likely now. On the other hand, recent ASB proposals only push the accounting liabilities upwards (in essence, a requirement to use gilt yields rather than corporate bonds for the purposes of liability calculation) and close the gap on the buy out cost.

But for any finance director, the real question is whether applying capital for the buy out is the best use of the company's finance? When this question is coupled with the incentives for the FD himself or herself (usually short-term), the reaction of the markets (still not clear or necessarily logical), and the in-house investment expertise, the buy out may still not be the "right" thing for many companies.

I think that we are certainly likely to see the "partial buy out" approach grow as corporate pension strategy becomes more sophisticated and the market starts to breaks up into "specialists". It is only a matter of time for certain players and their solutions to look to specialise both to differentiate themselves and to focus their business models and risks better. The partial buy out approach can also work well for the corporate by breaking down into pieces something which otherwise just looks too difficult and costly to deal with. Collaboration between buy out players will be important as a means of reducing cost and spreading risk for everyone involved.

However, we can not focus the answer to this question solely on the demand side. There may be supply side restrictions which impose themselves on the market. This could be in the form of a lack of cheap capital in the markets generally, as we have now as a result of the credit crunch. Or, it might arise as a result of mortality risk concentration when providers decide that they simply have enough of that risk on their books. Much will depend on how the mortality re-insurance market develops.

The other supply side issue will be the security offered by the providers. What if an insurer or investment bank involved in the buy out market crumbled as a result of the credit crunch or other such future difficulty in financial markets? The loss of confidence could be huge and it would take a long time for pension trustees to get over that.

How do you make it work well?

In short, preparation, preparation and preparation.

I mentioned earlier the importance of corporate strategy in pensions. The buy out solution will normally be lead by the corporate sponsor (although it doesn't have to be in my view – despite contrary opinion, there is nothing wrong in my book with trustees proposing that a buy out is looked at). The most important thing is to plan and involve the trustees from the earliest stage. The trustees will need convincing about the buy out and they will (sometimes perversely) need a great deal of reassurance that the new "provider" is a "safer" place than the current sponsor who is facing tighter margins as the global economy overtakes it. Corporates, investment banks and other financial institutions must remember where trustees are coming from: it may sometimes seem illogical, but it is the reality. The buy out is not just a financial process, but it is essentially very human and it is important for everyone involved to remember that.

Early engagement with the trustees, on a very open basis, is crucial. This will enable data issues to be dealt with, facilitate training for the trustees on key concepts and perhaps, most significantly in these times of turbulent markets, allow quick execution when the right time comes. I think it is also helpful for the corporate to encourage the trustees to get expert corporate finance advice. Rather than seeing this as a threat, the corporate is better having a well-informed and well-advised counter party. This becomes particularly acute in a partial buy out situation where the trustees will be facing a conundrum about how to split the fund and what amount of capital value going out of the corporate sponsor in respect of one group of members only is acceptable.

My personal view is that auction process is rarely a good way forward for the buy out process: it is just too important to be driven by price alone.

And finally...the really important question...

Is it a good thing?

Yes, from an economic point of view, if it is a sensible allocation of resources.

The buy out solution is good for corporate Britain where the economic price for passing on risk is right. Furthermore, it allows companies to focus on their core business. But, if the price is not right then they may be allocating too many resources to the risk transfer at the cost of alternative investment which would create wealth.

There must also be some truth in the proposition that the collecting of assets within organisations that have skilled in-house investment experts is a good thing. This enables economies of scale in investment as well as an ability to move quickly to take advantage of market positions, something which trustees (and/or their investment advisers) are sometimes criticised for. But, shouldn't sophisticated corporates be able to work with trustees to manage their schemes without needing to contribute towards the insurers' profits or the capital reserving requirements?

And what about managing mortality risk? There must be strength in the argument that the buy out providers are best placed to cope with the mortality risk, both by aggregation and by being at the leading edge of new products aimed at spreading the risk.

But there is one reservation as we move into a new period of transferring pension risk to financial institutions with no history in the scheme or its people. There is a risk of the "commoditisation of pensioners". Do we risk seeing the packaging up of pension risk and the creation of complex derivative mortality products which could lead to its own sub-prime crisis in the future? And do we risk putting all our pension futures in financial institutions which seem so strong, but can become so weak so quickly?

Conclusion

The buy out of pension scheme liabilities will continue to be a feature of the pension landscape for many years.

The thing we should all remember is that they are not complex financial transactions which allow advisers and providers to make money. They are about the futures of thousands of people, who will depend on their success.

We should all welcome the buy out solution as one of the options available for providing promised pensions. However, we should guard against the simple commoditisation of pensions and pensioners. As the credit crunch has shown, the creation of financial products and derivative risk products can, when combined with greed, have very serious consequences.

For further information about this published article, contact Kathryn Hobbs on +44 (0)121 685 2785, Rebecca Davies on +44 (0)121 685 3819, Gayle Redding on +44 (0)121 685 2708 or Rebecca Lum on +44 (0)121 260 9973

This published article may contain information of general interest about current legal issues, but does not give legal advice.