Preparation creates opportunity
Being ready to transact can help schemes take opportunities presented by favourable market movements.
Whatever your views on Brexit, the only certain thing is that we are currently living through uncertain times. With uncertainty comes volatility, traditionally the enemy of pension schemes with sponsors looking for certainty over their cash contributions and accounting figures. Uncertainty, however, also comes with opportunity; but only if you are ready to take it.
Looking back to the start of the Brexit process, financial headlines following the EU referendum vote focused on plummeting sterling, stock market volatility and falling bond yields - rumours even of insurers closing their books. Amongst the economic turbulence and frenzied referendum coverage what you may have missed though was the increase in the UK gilt/credit spread.
Why is this important?
It is important, because pension schemes tend to fund on a gilt related metric, while insurers tend to price on a credit related basis. The widening of this spread following the referendum created a short window in which buy-in pricing became particularly attractive. This is just one example of how market conditions can change however we see short-lived opportunities present themselves frequently which serves to illustrate an important principle: how being ready to transact can help a scheme to capture pricing opportunities when they arise.
The ICI buy-ins
The £750m buy-in announced in July 2016 between the Trustee of the ICI Pension Fund and Legal & General is an excellent example of how, by being prepared, trustees of defined benefit pension schemes can move quickly to take advantage of volatility to benefit their members and their sponsoring companies.
As part of its ongoing de-risking journey, the Trustee had already completed more than £6bn of buy-ins with different insurers - of which over £4bn was with Legal & General spread across four separate transactions beginning in 2014. These transactions may never have happened were it not for the preparatory work done by the Trustee and their actuarial and legal advisers, LCP and Allen & Overy, to put their scheme into a position where it could transact in a way and at a time that best met its objectives. Four pieces of preparatory groundwork in particular paved the way for success.
First, by using an "umbrella" contract structure - effectively a master contract with much shorter, transaction-specific schedules - the execution process is much more streamlined than a normal process. This enabled Legal & General and the Trustee to focus on the issues which are important to getting each transaction completed, such as the premium payment assets and collateral arrangements, rather than getting bogged down in the legal minutiae and potentially missing favourable market conditions.
A second potential barrier to a speedy transaction is data. Ensuring data is maintained in a transaction ready format enabled Legal & General to focus on the issues which really matter to the premium - investment strategy, pricing assumptions and reinsurance strategy - rather than spending time finding and resolving data issues. In the case of ICI, data is cleansed and refreshed on an annual basis - that annual process allows Legal & General to have confidence in the data at each pricing point and to be able to price quickly and accurately in response to a rapidly changing economic and political environment.
An established, committed and targeted panel of insurers
Rather than approaching the whole insurance market the ICI Trustee has identified a reduced panel of insurers committed to pricing the remaining blocks of pensioner liability on a regular basis. Insurers enter the pricing process knowing that a transaction will be completed if the pricing is acceptable to the Trustee, and in turn the Trustee receives firm and committed pricing proposals that can be executed in a short timeframe.
Robust governance and clear pricing targets
The last, and arguably most important, factor allowing a quick reaction is the governance process. Too often opportunities can be missed as they do not fit within the Trustees regular quarterly meeting cycle. By delegating authority to smaller committees with well-defined responsibilities and price targets, trustee boards can position themselves to react much more quickly when buy-in pricing might move in their favour.
In the case of the July 2016 buy-in with Legal & General, the ICI Trustee Investment Committee were able to convene a meeting to agree the transaction at very short notice. Without that flexibility it is not difficult to see how favourable pricing could be quickly lost in market movements.
What does this mean for other pension schemes?
By taking some of the steps above, pension schemes throughout the UK (and wider) will put themselves in a very strong position to be nimble, reacting quickly whenever financial circumstance presents an opportunity.
Transactions like these are rarely easy; but to move from a Brexit vote to a signed contract in little over a week - taking the opportunity presented by favourable market movements significantly narrowing the gap between the funding basis and the buy-in premium - is testament to how being ready to transact will lead to the most favourable outcomes for pension schemes, their members and their sponsors.
We are authorised by Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Legal & General Assurance Society Limited. Registered in England and Wales No. 166055. Registered Office: One Coleman Street London EC2R 5AA.