For many schemes, this will involve transferring the assets and pension liabilities to an insurance company. There are several areas of preparation, including scheme data, insurer selection and pre-buyout investment strategy.
In this article we highlight the importance of considering your investments ahead of buyout. We also explain how to optimise your strategy to hedge buyout pricing.
Time to revisit your hedging strategy
Traditionally, schemes have used liability-driven investment (LDI) strategies to hedge their technical provisions or long-term basis, to minimise volatility in the funding level.
A buyout target has different characteristics
As a buyout target has different characteristics, it makes sense to revisit the scheme’s hedging strategy. Aligning the scheme’s assets to mirror the interest rate, inflation and credit sensitivity within buyout pricing can help reduce the volatility in the scheme’s buyout funding level.
This can help prevent a scenario where changes in market conditions result in a scheme no longer being able to afford a buyout.
Insurer pricing
Buyout pricing is a complex calculation influenced by several key factors, including long-term interest rates, inflation expectations, and credit market conditions.
Insurers’ pricing methods are driven by stringent UK regulatory requirements.
While each insurer’s approach to pricing is different, all insurers’ pricing methods are driven by stringent UK regulatory requirements.
Additionally, the maturity of the pension scheme will play a significant role in determining the buyout cost. Understanding this element is crucial for schemes aiming to optimise their hedging strategy.
It’s important to acknowledge that there are elements of buyout pricing that cannot be hedged effectively through the investment strategy, for example, changes in supply/demand dynamics in the market.
The buyout hedging target
Using data from insurers for a number of example pension schemes with different characteristics, we can understand the level of interest rate, inflation and credit sensitivity in the discount rate used by the insurer to price different pension scheme liabilities.
For overall interest rate sensitivity and credit spread sensitivity, Chart 1 summarises results of data received from an insurer. This information can be used to infer an appropriate hedging basis for the interest rate sensitivity and the proportion of this interest rate exposure which should be held through corporate bonds rather than government bonds.
Chart 1: Interest rate and inflation sensitivity of example pension schemes based on insurance data
Chart 2: Credit sensitivity of example pension schemes based on insurance data
Two key takeaways from the data are:
- The appropriate buyout hedging targets are dependent on the maturity of the scheme, for example, a lower target credit allocation for schemes that are more immature i.e. longer duration.
- The hedging target changes over time with changes in market conditions. In particular, when credit spreads tighten, the optimal credit allocation reduces, reflecting changes in the insurer’s investment strategy.
The sensitivity to inflation will be scheme-specific, based on the unique mix of inflation-linked benefits the scheme has promised to pay. Insurers’ inflation models may differ from the approach currently used by the actuary for the pension scheme valuation.
Investing to hedge buyout pricing
Once the scheme-specific buyout hedging target has been calibrated, the investment strategy can be reviewed to achieve the target sensitivities.
Chart 3: Implementing a new investment solution
Source: abrdn, 31 May 2023
Depending on the size of the scheme, a segregated portfolio or combination of pooled funds can be used to implement the new investment solution.
Other considerations
Once the solution is implemented it’s important to review two aspects regularly:
- Does the solution continue to meet the scheme-specific buyout hedging targets?
- Are the scheme-specific buyout hedging targets still appropriate given up-to-date information on insurer pricing?
As well as helping to protect the funding level of the scheme on a proxy buyout basis, implementing a bespoke buyout hedging solution can provide additional benefits including:
- Increased engagement and interest from insurers, as the investment strategy demonstrates the scheme’s desire to transact.
- Insurers may be prepared to provide a price lock based on the scheme’s assets, protecting the scheme from changes in market conditions in the final stages of the transaction.
Conclusion
In conclusion, as DB pension schemes approach a buyout, optimising the investment strategy to hedge buyout pricing becomes paramount. By understanding the factors influencing insurer pricing and tailoring investments accordingly, schemes can better manage the financial risks associated with a buyout. Regular reviews and the potential use of price locks further enhance this approach, providing schemes with a robust framework to achieve a successful and cost-effective buyout.
Next steps
If you would like to find out more about our Buyout Ready investment solutions visit our website or contact us at ukinstitutionalall@abrdn.com.
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