A Guide to Risk
Navigating the settlement market to find a solution that best meets an investor’s needs is a challenge that continues to plague the market
In association with Aon
Chapter Three - Trends in UK mortality and why it is a risk worth hedging
Chapter Four - The benefits of giving members more options for retirement
Chapter Two - Bridging the gap – you may be closer to buy-out than you think
Chapter One - What is a bulk annuity and how can you de-risk your pension scheme at the right price
Navigating the settlement market to find a solution that best meets an investor’s needs is a challenge that continues to plague the market.
It is no surprise therefore that the transfer of risk to an insurer is regularly appearing at the top of trustee and corporate agendas – especially given the buoyant settlement markets offering pension schemes a terrific chance to de-risk.
The articles shared here offer an introduction to how pension stakeholders can capitalise on these opportunities and be in the best position to achieve optimum value when settling risk.
Senior Partner & Head of Risk Settlement, Aon Hewitt
What is a bulk annuity?
Optimising opportunities in the annuities market
Source: Aon Hewitt Bulk Annuity Market Monitor
What should trustees do?
Aon's Compass platform has been designed to simplify the process leading to a bulk annuity purchase, and make it as efficient as possible. A combination of effective monitoring of both the scheme’s financials and bulk annuity terms is essential. The use of a broking platform to allow insurers to provide regular transactable pricing updates allows you to optimise the opportunity to improve security for the members’ benefits while substantially reducing risk.
As more schemes become legacy arrangements, it is very important that trustees and sponsors are clear about their 'endgame' intentions, and agree at which stage investing in bulk annuities may be a desirable option for their scheme. Schemes that are nimble enough to capitalise on pricing opportunities along their journey can effectively use buy-ins to accelerate and stabilise this journey.
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How safe are bulk annuities?
Investing in bulk annuities will typically increase security for the benefits covered under the policy. Insurers are subjected to a strict regulatory regime – they need to regularly demonstrate financial strength and resilience in order to be authorised. Insurers are required to hold additional capital reserves to reflect uncertainty, plus an additional buffer to cover extreme experience (defined as a '1 in 200 years' event). The Financial Services Compensation Scheme provides further support to the insurance regime.
For larger schemes, the availability of surrender terms or ring-fenced, collateralised policies can add even further security.
Entering into a significant transaction with a third party should never be taken lightly, with due diligence essential, but trustees can take particular comfort from the dual support of the insurance regime and sponsor during a buy-in.
How to assess the price of a bulk annuity
Market opportunities can and do arise from time to time, resulting in particularly beneficial pricing. This is generally linked to insurers sourcing good quality higher yielding assets which can be used to support pricing. As an example, this year Aon negotiated pricing in respect of pensioner members equivalent to a yield of gilts + 0.7% p.a. Timely preparation will ensure that a scheme maximises the chance to be exposed to such pricing opportunities.
The most logical way to assess whether a bulk annuity is good value is by considering the yield available on the policy against the yield on the assets used to fund the purchase. This assessment should be made in the context of the additional risk reduction achieved, and particularly understanding the longevity risk removed. The chart below shows that schemes can obtain a yield in excess of government bonds for pensioner members.
Who provides bulk annuities?
The players in the bulk annuity market are a mixture of large multi-line insurance companies (such as Legal & General and Aviva) and specialist mono-line insurers set up specifically to serve this market (such as Pension Insurance Corporation and Rothesay Life). With 8 insurers actively participating and each favouring a different market segment, all schemes can now be confident that they can obtain a competitive quotation.
Why do schemes invest in bulk annuities?
Most pension schemes invest at least some of their funds in assets such as gilts and bonds, as these assets are generally secure and can generate an income stream which is a good match for the scheme’s outgoings. In addition, the scheme’s funding position will typically be more stable as a result.
A bulk annuity is a better matching asset than either gilts or bonds, providing a perfect financial match and also protecting against the risk of changes in life expectancy for the scheme members. On this basis, it is surprising that not all schemes hold bulk annuities! The reason that this isn’t the case is that the guarantee implicit in the contract comes at a cost, specifically a lower expected yield than some of the other asset classes that might be needed to repair deficits.
Under a buy-in contract the policy is an asset of the scheme and member benefits are not transferred away from the scheme. The insurer commits a monthly amount to the scheme, with the trustees retaining responsibility for pension payments to members.
The policy can be turned into a buy-out at the trustees’ request, where each member becomes a policyholder of the insurer and is no longer a member of the scheme.
A bulk annuity policy is a contract in which, in exchange for an initial premium, an insurer commits to fund the benefits payable to scheme members (all of them, or a section of the membership), calculated according to the scheme rules.
To view the Aon Risk Settlement website please click here
If you would like to discuss any aspect of Bulk Annuities or find value in a face to face meeting with one of our experts, please contact us or your usual Aon representative.
Bridging the gap
Chapter 2 will be fully available to read on 30th October
Transaction price monitoring. Where the target price is not met immediately, our Compass platform is used to monitor the transaction price. This allows schemes to capitalise on short-term pricing opportunities that can arise due to market or political events, such as the EU referendum result, or asset opportunities flagged by insurers
Enter the market at the right time. By tracking asset and funding information on Aon's Risk Analyzer and tracking pricing through our bulk annuity pricing platform, Compass, we monitor the feasibility of transactions for clients. This allows us to pick opportune times to launch an annuity auction. Negotiation and appropriate structuring of the transaction can lead to significant savings, especially where clients are able to be flexible and ready to make quick decisions
Rethinking cheque-writing distance
Coming back to the original question – you may be much closer to being able to afford to buy-out than you thought! Particularly as annuity pricing has improved recently, so you may get a pleasant surprise if you haven’t considered the deficit lately.
It’s well worth considering how you may bridge your buy-out deficit, and agreeing your insurance strategy sooner rather than later.
Optimising your insurance strategy
Our deficit bridge tool also allows us to see the savings that could be achieved by optimising your insurance strategy.
Buy-out deficit estimates may not represent the most favourable pricing that can be achieved:
Integrate with member options
The purple bars in the chart to the right represent the potential impact of these exercises. Risk Analyzer allows us to illustrate the potential savings interactively by varying the assumed savings and take-up rates from each member option exercise. This helps to prioritise actions from the agreed shortlist based upon financial impact, along with forming an initial strawman proposal for the offer to be made to members.
These exercises can each take a few months and planning the timing and order in which each is implemented is important.
There are a number of member options available that could either reduce the size of liabilities with the scheme, or reshape liabilities so that they are easier or better value to secure with an insurer.
Allowing for what has already been agreed
In the example shown, a solvency (buy-out) deficit of £54m is expected to fall to £38m by the end of 2023, reflecting:
If we focus in on the left hand side of the chart below, we can see the impact of simply letting the Scheme run on in line with its existing funding and asset strategies.
Get the full picture
The 'recovery plan'
contributions that the
Company will pay to address a funding deficit (which also reduce the buy-out deficit), plus any other contributions the Company is willing to make to achieve buy-out
The maturing of the Scheme membership, in particular members retiring, which makes them cheaper to insure
Expected asset returns in excess of those assumed in bulk annuity pricing
You could also expect some savings on headline insurance pricing, if you are willing to be flexible
Member options, such as transfer values or pension increase exchange, can reduce the size of scheme liabilities, and make your scheme easier to secure
Contributions that are already committed, along with expected asset returns, will help to fill some of the buy-out deficit
The deficit bridge within Aon's Risk Analyzer, our interactive desktop application, is a great way for us to illustrate these potential impacts.
As a first step, make sure you are looking at the complete picture:
Many schemes may be much closer to reaching buy-out than it first appears. And there are significant merits in considering actions to bridge your buy-out deficit now, rather than waiting.
“The solvency deficit reported by our Scheme Actuary is much bigger than the Company can afford. It’s not worth us thinking about buy-out now…is it?”
Scheme Maturity Savings
Start deficit at
Longevity trends in the market
Chapter 3 will be fully available to read on 6th November
Sometimes the prevailing best estimate view differs from the view reinsurers are using for setting their pricing.
This can happen when there is uncertainty over which approach or model to use, and reinsurers act cautiously in adopting the new paradigm.
In these circumstances, reinsurance pricing does not fairly reflect best estimate and prices are said to be ‘dislocated’.
Insurance market dislocation
Longevity market dislocation
Structures continue to evolve to meet the needs of pension schemes aiming to maximise the efficiency of their longevity insurance arrangements
(0.7% per year)
(3.1% per year)
(1.8% per year)
(0.7% per year)
Calculations by Aon Hewitt using ONS and CMI data. Standard population is the European standard 2013 population ages 50 to 89 inclusive.
Longevity risk has not gone away. If anything, the past five years have indicated how potentially volatile longevity projections actually are
A competitive pricing process does not by itself guarantee value for money. Pension schemes that chose to defer longevity swap transactions from 2016 to 2017 saw price reductions of up to 2% of liabilities, which is certainly material when premiums are around 5%
The longevity market is robust and adapts quickly. Not only has pricing shifted to take account of the emerging lower improvement trend, but market capacity continues to increase to meet demand and structures continue to evolve to meet the needs of pension schemes aiming to maximise the efficiency of their longevity insurance arrangements.
Changes in available structures
Pension schemes choose longevity swaps because they want to hedge their longevity risk while retaining ownership and control of their assets. Pricing is driven by the global reinsurance market, but has to be accessed via an insurance company (because schemes cannot enter into reinsurance contracts themselves). Recently, some insurers have started to offer a ‘pass through’ structure whereby the scheme looks directly through to the reinsurer, including taking on the reinsurer credit risk, in return for the insurer charging a lower intermediation fee. The recent £800m Scottish Hydro-Electric Pension Schemes deal is an example of this. Efficient access to the global market is positive for schemes.
Despite the perennial suggestions in some quarters that the longevity reinsurance market capacity is close to its limit, capacity continues to increase. One of the concerns has been that pension schemes now have to compete with insurance companies looking to hedge the longevity risk in their back-books, driven by the new Solvency II insurance regime which makes the retention of longevity risk by UK insurers capital intensive. The good news is that market capacity continues to grow: existing providers have extended their capacity and new reinsurers continue to enter the market, partly as a result of the global search for high quality long-term investment yield.
Over the past 12 months, reinsurers have progressively reviewed and revised their life expectancy assumptions, driven in part by emerging data continuing to indicate that longevity improvements are not returning to their previous high levels. It seems that pricing is back in sync and dislocation is no longer a major concern.
There are some important lessons here:
Log standardised mortality rates for England & Wales males
What does this mean for longevity insurance pricing?
The cost of longevity reinsurance is the key driver of the cost of both longevity swaps and bulk annuity premiums. When the data on lower longevity trends started to emerge, reinsurers took a cautious stance on pricing. This is understandable – if you were a long-term risk-taker then you too would want to be confident that the prevailing longevity trend had genuinely changed before reducing prices.
However, this pause to reappraise caused a serious dislocation in longevity reinsurance markets. At Aon Hewitt, we were vocal in calling out the dislocation and advised clients transacting of the need to test their pricing and possibly walk away from proposed deals.
The causes are not well understood, although the timing indicates the global 2008 financial crisis may be to blame, alongside the subsequent curtailment of the huge year-on-year real increases in health and welfare spending seen over the previous decade.
The pressures on health and welfare spending seem unlikely to abate in the near future. It is easy to find negative indicators such as slower improvements from prevention and treatment of heart disease, slower falls in cessation of smoking and growing levels of obesity. All else being equal, lower improvement rates seem likely to be the ‘new norm’ in the medium term.
The debate has moved on from ‘is this really happening’ to ‘does this apply equally to everyone?’ Analysis of Aon Hewitt’s longevity databank and Office for National Statistics (ONS) data suggests that the better off and, in particular, members of defined benefit pension schemes were less impacted compared with the national population. However, most of the population will ultimately be affected by health and welfare services, especially at older ages.
Until a few years ago, the narrative that accompanied the word ‘longevity’ was considered obvious and largely unquestioned. It was, quite simply, that we are going to ‘live longer than expected’.
Improvements continued to accelerate and the historically high improvements of 1.5% to 2% per year from 1975 to 2000 were surpassed in the first decade of this century, when male improvements topped 3% per year.
But this narrative has now collapsed. National longevity improvements executed the statistical equivalent of a hand-brake turn in 2011 and have since been less than 0.75% per year.
How are longevity trends impacting the market?
Pension Increase Exchange
Pension increase exchange ('PIE') allows members to swap their increasing pension for a higher fixed pension. In the early years the member will receive more pension income which may better suit their circumstances. Naturally, over time the increasing pension gradually catches up with the higher fixed pension, and this effect reverses. However many individuals place greater value on higher pension income earlier in their retirement and so the flat pension provides a better outcome.
From a company and trustee perspective, exchanging pension increases which are expensive or difficult to hedge for a higher flat pension allows the purchase of more accurately matching assets, which again delivers greater funding level stability and improved bulk annuity pricing.
Companies - shrink the pension liability sitting on the corporate balance sheet
Trustees - reduce the volatility of the pension scheme’s funding level and accelerate the journey to buy-out
Members - obtain the freedom to shape their pension to suit their needs
Why would trustees and companies offer these options?
Trustees are frequently considering offering more member options to provide greater flexibility to members when drawing their retirement income. It is important to Trustees that these options are clearly communicated and their pension fund members make informed choices about their pension. This drives a successful member options exercise for the member, the trustee and the company.
Companies similarly have an interest in providing greater flexibility to members. However, they also often have a focus on managing their pension risk. Member options exercises allow the alignment of greater freedom for members with risk reduction and improved insurer pricing for the sponsor by reshaping/shrinking the sponsor’s pension liability resulting in a win:win for all parties.
We expect member options exercises to continue to flourish as members benefit from increased freedom in shaping their retirement incomes.
As with ETVs, PIE offers are typically accompanied with financial advice to ensure the members make informed choices and often result in 35% of members accepting the PIE offer.
Enhanced Transfer Values
Transfer value payments are typically calculated as the best estimate cost of providing the member’s pension benefits. However an increasing theme is for companies to offer higher transfer values to members. These higher payments reflect a view about (a) the uncertainty in the cost of providing the benefits and (b) a desire to remove pension liabilities from the corporate balance sheet which in turn reduces the cost of buying out the pension scheme’s liabilities.
Enhanced transfer values ('ETVs') are typically accompanied by financial advice to ensure the member understands the implications of the option being made available. The exercises are carefully communicated ensuring individuals make informed choices and often result in 25% of members electing to transfer.
Source: Aon Hewitt
Example PIE offer for a male member aged 60
Transfer values taken near/at retirement are the most popular
Record transfer value amounts continue in 2017
Flexible Retirement Options
Manage their tax position
Gain a higher pension via income drawdown (albeit potentially with greater investment risk)
Access the greater lump sum freedoms now available (which may not be provided through their defined benefit pension scheme)
Paying transfer values also helps trustees and companies by shrinking the size of the pension scheme’s liabilities which materially reduces both future funding volatility and bulk annuity premiums.
Trustees and companies are focussed on highlighting pensions options to members. Flexible retirement options set out all of the options available to a member at retirement. Traditionally this was just early retirement and commuting pension for a lump sum, but now individuals are being informed about their transfer value options as well.
Many members choose to take transfer values at retirement to:
Transfer values – increasing individual amounts and increasing overall volumes
In recent times the transfer values offered to members for their pension benefits have increased due to a number of factors, including lower assumed future investment returns (which increases the cost of providing pension benefits). This has driven a huge increase in the number of transfer values paid from defined benefit pension funds into defined contribution pots. In 2017 Aon saw a six-fold increase in the amount of transfer values paid from pension schemes.
The first option a pension scheme member typically receives during their pension scheme journey is the option to transfer their benefits out of their pension scheme. Historically individuals have often moved their pension benefits from a former employer’s pension fund to a new employer’s pension fund to keep all their benefits in one place.
Member options (commutation, early retirement, late retirement, etc) have existed for many years, but in 2014 the UK Government introduced Freedom and Choice in Pensions. This big bang moment changed the face of pensions flexibility for members. Instantly members could take their entire pension as a lump sum and they no longer had to buy an annuity with their DC account. This change drove innovation in member options.
So what are flexible retirement options, enhanced transfer values and pension increase exchange freedoms, why are Trustees and Companies making them available to pension scheme members and how do they help pension schemes on their journey to buy-out?
Member options provide a win:win opportunity for all stakeholders involved in a pension scheme
Your current pension is higher than the PIE pension
PIE pension is higher
than your current pension