It Pays to Be Prepared
Four Opportunities to De-risk a Pension Fund
We recently witnessed the end of a very important moment when U.S., U.K. and Canadian pension funds were simultaneously at the best funded status they had experienced in ten years. At the same time, all three markets had new entrants in pension insurance and reinsurance with ample insurer capacity, vibrant price competition and attractive buy-in and buy-out pricing.
Pension Funding Has Peaked and Market Conditions Are Beginning to Soften
US Source: Milliman 100 Pension Funding Index; the 100 largest U.S. corporate pension plans, September 30, 2019 (85.4%).
Canada: Aon’s Median Solvency Ratio, Canadian DB Plans as of June 30, 2019 (99.3%).
UK FTSE 100: Aon Hewitt, “Aon Hewitt Global Pension Risk Tracker,” as of September 30, 2019 (99.7%).
https://PensionRiskTracker.aon.com, accessed October 7, 2019. Funding ratio (cumulative assets/liabilities) of all pension schemes in the FTSE 100 index on the accounting basis.
Additionally, seven years of lower than expected longevity improvements meant the lowest liability pricing from insurers and reinsurers in over ten years. In this very favorable market environment in 2018 and the first half of 2019, we saw more transactions in the U.S., U.K. and Canada than ever before. Only once before have we seen market conditions this favorable—in the run up to the financial crisis—and of course that market did not last. Markets in which all factors are positive are anomalies, and once again, favorable market conditions like these have proven to be fleeting. Market volatility is on the rise.
It pays to look for opportunities to reduce or transfer risk
Volatile markets often bring opportunity, so it pays to be prepared. While there are several options to reduce or transfer risk, we will focus on four key opportunities.
1. Low Rates
Low rates mean “borrow to fund” strategies are back in favor. With low rates, many highly rated sponsors can issue corporate debt at attractive yields and deposit the proceeds into the pension fund to improve funded status. Since the pension deficit is already considered debt of the corporation, this debt-for-debt exchange is likely to be considered credit neutral by rating agencies and stakeholders, though it can be credit positive if it allows the sponsor to take meaningful steps to de-risk the plan. For U.S. plans it also eliminates variable Pension Benefit Guaranty Corporation (PBGC) premiums, making borrowing to fund a very attractive potential opportunity for plan sponsors.
2. Widening Credit Spreads
Another opportunity arises when falling risk-free rates are combined with widening credit spreads. These market conditions often mean the economy is in distress, but for pension funds holding a cash flow- or key-rate duration matched portfolio of high-quality bonds, the interest rate risk is largely hedged. Gilts, treasuries and other high-grade bonds will likely appreciate if rates fall, and if, at the same time, the economy is in trouble and credit spreads widen, there is a real opportunity to transfer risk as buy-ins are backed by spread-bearing assets. Buy-in pricing is favorable when it has an implied return above gilts or treasuries, and when credit spreads widen, buy-in pricing improves. It is an excellent relative value trade for a pension fund to use freshly appreciated government bonds to pay for a buy-in that returns risk free plus a wide spread. This trade locks in the spread to government bonds implied in the buy-in price. This locked-in gain increases funded status after the buy-in is complete and transfers all risk to the insurer.
As a case study, Marks & Spencer took advantage of the favorable market conditions over the past year and a half, acting when buy-in pricing was particularly attractive to complete a series of transactions with multiple insurers. It turned in high-grade bonds for buy-ins when buy-in spreads were favorable.
Case Study: Marks & Spencer (2018-2019)
"We're pleased to announce the purchase of these...buy-in policies, which provide an important contribution to the Trustee's ongoing objective of reducing the longevity risk in the scheme to increase the security of all members' pensions."Chair of Marks & Spencer Pension Trust. Graham Qakley
SIZE: £2.8 billion ($3.6 billion)
WHY: Capitalized on excellent market conditions in 2018 and 2019 to transfer risk
UNIQUE FEATURES: Series of transactions with multiple insurers
3. Weakening Currencies
It can be very cost effective for a multinational plan sponsor to plug a pension deficit in a country with a weakening currency. Using the U.K. as an example, a multinational company headquartered outside of the U.K. that has a U.K. pension plan can more easily close a funding gap in the plan after the pound (£) depreciates. Since the first Brexit vote, the cost for a U.S. parent to plug a deficit in a U.K. plan has gone down by roughly 20%1. The same logic holds for funding risk transfer premia. Today, a U.S. parent with a U.K. plan can fund a buy-in premium for roughly 20% less than in early 2016.
4. Mortality Volatility
From 2011 until 2018, we have seen very low longevity improvements. In fact, during this period, life expectancy hardly improved at all, and each year the liability charges from insurers and reinsurers fell. As a result, many U.K. pension schemes are bringing longevity swaps to market. The chart below shows the aggregate base mortality for retirees in the U.K. since 2010. When the line moves down, mortality is falling and longevity is improving. Over a seven-year period from 2011 through 2018, there was only a modest 2.5% improvement. The dashed line shows how quickly mortality fell in 2019. We are expecting longevity improvement in the general population data of 4% in 2019. However, it is important to note that improvements have been higher among pensioner populations.
U.K. Pension Schemes Are Bringing Longevity Swaps to Market Today Because of a Recent Acceleration in Longevity Improvement
Source: ONS (Office of National Statistics) general population data.
 Aggregate base mortality (70% Male, 30% Female) based on expected death benefits by age for a typical U.K. longevity risk transfer transaction.
 U.K. 2019 Qx prediction based on estimated 2019 mortality improvement of 4% based on ages 65+ U.K. ONS provisional weekly death data (male + female combined) through 12/31/2019. Actual Qx may vary based on final U.K. 2019 mortality experience to be released in second half of 2020.
It's too early to tell if 2019 represents an anomaly, an increase in volatility or a trend shift, and market pricing is holding steady for the moment. In the meantime, pension funds are pouring into the longevity market to take advantage of today’s attractive prices.
One pension fund that took advantage of this opportunity was the HSBC Bank U.K. Pension Scheme. In 2019, HSBC completed the second largest longevity risk transfer transaction ever in the market at £7 billion ($8.7 billion) with The Prudential Insurance Company of America (PICA). The arrangement is scalable and repeatable.
Fortune favors the prepared
In today's market, with the continuing possibility of low interest rates, widening credit spreads, weakening currencies and mortality volatility, we believe that sponsors should set a realistic price target and continually monitor funded status and insurer pricing. They should then be prepared to pull the trigger to transact on short notice when their price target is met. Pension de-risking is the ultimate chess game where thinking three moves ahead is necessary in order to be prepared for opportunities that present themselves. Marks & Spencer and HSBC prepared for many years to transact in the extraordinary market that 2019 offered and have proven that it pays to be prepared.