Behind the headlines - LDI/GILTS/UK Pension Schemes and the impact on bulk annuity pricing

UK Pension Schemes have hit the front pages in the past week, with headlines citing a "crisis", markets “going into meltdown", and UK schemes “risking being wiped out”. But what happened, what does this mean for pension schemes and the question of bulk annuity pricing in the UK for schemes looking to secure their liabilities with an insurance company in the UK?

We’ve spoken to our insurer clients, Standard Life (part of the Phoenix Group) and Scottish Widows, to bring you insight direct from the source. The response is clear: despite the turmoil of the last week, there could be great pricing opportunities in the de-risking space for those schemes in a position to make the most of them.

What Happened?

Matt Wilmington, Head of Origination at Scottish Widows explains, “What we saw following the Chancellor’s statement on 23rd September was a sudden rise in interest rates. This was good news for unhedged schemes who would have been likely to see an improvement in funding levels. However, many defined benefit pension schemes which have not yet transferred risks through a bulk annuity, or have only done so partially, have protected themselves from movements in interest rates and inflation using swap derivatives.

Simply put: if interest rates fall (causing liabilities to increase) the swaps pay out to the scheme, and if they rise (causing liabilities to fall) the scheme pays to the swap provider. In either scenario the funding position of the scheme is unaffected by the interest rate move.

For those schemes using swaps to hedge their exposure to interest rates, their funding levels would be broadly unchanged. In other words, the swaps did exactly what they were supposed to and protected the scheme funding position.

The ‘headline’ problem which was faced by the hedged pension schemes was the sudden nature over which the interest rates rose. As I’ve noted, when interest rates rise, liabilities fall and payments (actual or in terms of collateral) flow from the pension scheme to the swap provider. Hedged pension schemes are prepared for this type of event and will hold pools of cash and gilts to pay over if needed, but the magnitude and speed of the increase in interest rates has caught many such schemes out and forced them to sell other assets such as corporate bonds, or even in some cases seek to dispose of less liquid assets quickly.

It is worth noting this is a real but very likely a short-term problem which has kept pension schemes and their advisers very busy and has generated a number of alarmist headlines. At the end of this process most pension schemes will likely be in either the same or even better funding position than they were before the significant volatility of the past week.

What does this mean for bulk annuity pricing?

Matt Richards, Senior Business Development Manager at Standard Life, part of Phoenix Group explained the impact this is having on schemes’ ability to pursue de-risking activity and on the pricing offered by insurers - and it could be good news for some schemes.

““While events of recent days have highlighted strains on DB schemes, the overall picture regarding their funding position and ability to de-risk is more nuanced and, in many cases, more positive than headlines might suggest”

“For schemes looking to de-risk, this week’s rising gilt yields have pushed insurance pricing down, but this has been accompanied by a fall in the value of their LDI funds. The extent to which these opposing trends impact on affordability for Schemes to undertake buy-in or buy-out activity will depend on the degree of matching between the assets that insurers use to back their quotations and scheme assets. Schemes are often under-hedged relative to insurer pricing portfolios, meaning this yield rise will be beneficial. However, once yields start moving the other way this will have the opposite effect.

“Over the past few days Schemes have been forced sellers of assets to meet margin requirements in cash. Liquidating gilts and credit would exacerbate any mismatch between insurer pricing and Scheme assets. While yields continue to rise this is not an issue, but Schemes will want to re-balance exposures when possible, and hopefully before rates begin to fall, or act to insure if they have benefited from short term market movements.”

Matt Wilmington gave a similar view regarding the positive impact on bulk annuity pricing, but schemes may need to act fast: “For schemes about to enter into a bulk annuity there could be good news. Increases in interest rates and the yields available on corporate bonds over the past few months has seen the cost of bulk annuities fall when compared to the value of gilts which pension schemes are typically holding to back some or all of their liability. However, questions remain as to how long this may be true as the same increases in interest rates and bond yields also reduce the supply (and increase the cost) of the illiquid assets used by insurers to back bulk annuities – it is likely that 2023 will see bulk annuity pricing increase, albeit to level which will still look very good value to many schemes.”

Conclusions

Once the dust has settled on last week’s events, schemes ready to transact in the bulk annuity space may find great pricing available. This once again highlights the need to be prepared and transaction ready, including being ready for opportunistic bulk annuity transactions as part of a scheme’s investment strategy.