Defined Benefit Pensions: Overcoming the Obstacles to Buyout
by David Norgrove, Chairman, Long Acre Life
In recent years, full scale pension buyouts have been rare despite an increasing corporate focus on the pensions ‘endgame’. Yet innovative new approaches to buyout may prove more tempting for treasurers and CFOs.
Over the past decade there has been a substantial increase in the cost of defined benefit (DB) pension schemes as a result of rising longevity, a more demanding regulatory environment, and the combination of falling equity prices and lower interest rates. The result is that DB schemes are now entering their own phase of retirement and, although the death of DB may not be upon us quite yet, it is clear that the end-game has fast risen to the top of the agendas of many treasurers and CFOs of companies with significant pension obligations.
In search of a solution, some sponsoring companies have turned towards benefit re-design, while an increasing number are closing their schemes completely. Recently, Shell – one of the last bastions of DB provision within the FTSE 100 – announced that it too was to close its scheme to new members. Yet closing a scheme does not end a company’s obligation to pay its previously accrued liabilities – which means that the risk management burden remains. Certainly, there are serious implications of unmanaged DB pension risk, which can impact the sponsoring company’s core business – affecting its credit rating, share-price, ability to attract capital and even its contracts with clients — with significant knock-on effects for shareholders and scheme members.
In the worst case, DB pension liabilities may be so large and volatile that they endanger the entire financial viability of sponsoring companies. One only needs to look at the FTSE 100, where no fewer than 10 companies now have pension liabilities greater than their market capitalisation, to realise that this is a very real threat.
It is here that pension buyouts — which enable sponsoring companies to pass their pension risk over to an insurance company, at a cost — could potentially offer a way out. Yet, despite the theoretical benefits of a buyout, very few have been completed in the market to date, as insurance companies struggle to persuade treasurers and CFOs of their value. In this respect, the emergence of a new approach to pension buyouts – aimed at making transactions more affordable for sponsoring companies – may help.
Five key barriers to buyout
Given treasurers and CFOs’ anxiety about the impact that DB pension risk may have upon the financial viability of their company, the actual number of buyout transactions since 2007 (when they seemed to be taking off) has been minimal. Indeed, since then, the market has witnessed only £25bn of business — the equivalent of roughly 2.5% of the total value of DB liabilities sitting alongside the balance sheets of private UK companies — and that figure includes buy-ins (bulk annuities).