LCP Pension Buyouts Report 2009 · For further information about pension buyouts, longevity hedging...

Lane Clark & Peacock LLP

Pension Buyouts 2009

For further information about pension buyouts, longevity

hedging and LCP’s specialist de-risking services please

contact Clive Wellsteed, Charlie Finch, Jill Ampleford,

Jerome Melcer, Michael Berg or Ken Hardman in our

London office or David Stewart in our Winchester office,

or the partner who normally advises you.

For further copies of the report, please download a copy

from our website www.lcp.uk.com or contact

Mark Roberts on +44 (0) 20 7439 2266 or email

[email protected].

This report may be reproduced in whole or in part, without

permission, provided prominent acknowledgement of the

source is given. Although every effort is made to ensure that

the information in this report is accurate, Lane Clark &

Peacock LLP accepts no responsibility whatsoever for any

errors, or the actions of third parties.

The purpose of the report is to highlight the recent changes

and developments within the buyout market. This report and

the information it contains should not be relied upon as

advice from LCP or a recommendation as to the

appropriateness either of proceeding with a buyout, buy-in or

longevity hedge or of any particular insurance company or

provider. Specific professional advice should be sought to

reflect an individual plan's circumstances.

© Lane Clark & Peacock LLP May 2009

This is the second edition of the

Lane Clark & Peacock LLP Pension Buyouts

report. It provides an in-depth analysis of

pension buyout and longevity transactions

in the UK.

Lane Clark & Peacock LLP (LCP) is a leading

actuarial consultancy at the forefront of

advising companies and trustees on buyout

and longevity hedging opportunities. LCP has

developed the expertise and specialist skills

needed to successfully negotiate and

implement a pension plan buyout, buy-in

or longevity hedge, combined with a wider

understanding of how de-risking options fit

into corporate and trustee strategy.

UK Professional Pensions Awards

FT Business Pensions &Investment Provider Awards

Corporate Adviser Awards

Actuarial Consultancy of the Year 2005 | 2006 | 2007Investment Consultancy of the Year 2007

Actuarial Consulting 2007 | 2008Investment Consulting 2007 | 2008

Best Member Communication Strategy 2008Best use of Technology by a Corporate Adviser 2008

Best Strategy for Investment Advice on Pensions 2009



The UK pension buyout market currently comprises:

• insurance companies competing to take investment and longevity risks from pension plans inreturn for a premium; and

• financial institutions competing to take on longevity risk from pension plans, with the trusteesretaining control of the investment of the plan assets.

Lane Clark & Peacock (LCP) has worked with the main players in the market to create the industry’smost comprehensive database of:

• completed transactions since January 2008; and

• potential pipeline deals currently being considered by pension plans.

We are grateful to the following institutions who have contributed to this report: AEGON, AIG Life,Aviva (formerly Norwich Union), Legal & General, Lucida, MetLife, Paternoster, Pension InsuranceCorporation, Prudential and Rothesay Life (Goldman Sachs).

Page 2

Page 4

Page 6

Page 12

Page 16

Page 19

CONTENTS

1

Page 27Page 280Page 32

Introduction

Market development

Market drivers

Preparing for a transaction

Market outlook

Business written

Security arrangements

Longevity hedging

Appendices

1 Protections2 Insurance reserving3 Longevity hedging4 Transactions

De-risking glossary

Page 14

Page 34

Page 22


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INTRODUCTION

Key conclusions

• The September 2008 financial crisis marked the start of a new chapter in the UK pensionbuyout market, requiring pension plans and insurance companies to adapt tounprecedented global events.

• Insurance companies responded through stronger reserving and more cautious pricing.Paternoster has gone one step further and agreedwith the FSA that it will not, for the timebeing, write any new business.

• Despite these challenges, over £900 million of buyout business was closed in the firstquarter of 2009. Going into the second quarter, investment market conditions –particularly in the swaps market – are beginning to improve which will help pricing.

• The longevity market is now in a similar position to the pension buyout market two yearsago – prices have come down and the first deal has now been announced. However, weanticipate slower initial growth in the longevity market due to the more sophisticatednature and larger sizes of these deals.

• Buy-ins and longevity swaps are both effective forms of de-risking – however their relativeattractionswill change over time as pension plansmove towards their eventual end game.For longevity swaps it is important to consider the exit strategy for when the timeeventually comes to buyout and wind-up in full.

• Access to capital and stronger reserving requirements are likely to be the main drivers forfuture consolidation in the pension buyout market. One established route is the transferof business between insurance companies – for example Prudential has acquired around£5 billion of individual annuities in insurer-to-insurer transfers since 2004.

• Therewill be a steady andgrowingdemand for viable de-risking options as definedbenefitpension plans continue to mature. We expect the emergence of insurance companiesfrom the financial crisis to reinforce pension buyouts as sensible and effective means ofsecuring pension promises to members.

LCP is at the forefront of advising companies and trustees on buyout opportunities:

• We designed and implemented the first of the new-style pensioner buy-ins at thestart of 2007 and since have completed 10 further buy-ins over £50 million.

• We advised on two out of the three significant buy-in deals which have includedbespoke protections to provide additional security to pension plan trustees.

• In an article by Financial News in January 2009, we were recognised as one of theleading buyout advisers over 2008, having advised on more medium or large buyoutdeals than any other adviser. This followed LCP’s market leading position in 2007,where we advised on 50% of all medium or large buyout deals.

• We are currently working with a range of major organisations and their pension plans toassess buyout and longevity swap opportunities.

2


INTRODUCTION


3

Market statistics

• Total buyout business volumes for 2008 were £7.9 billion and several landmarkdeals were struck such as the first £1 billion deal between Cable & Wireless andPrudential. Business volumes in 2007 were £2.9 billion.

• Legal & General and Pension Insurance Corporation dominated the buyoutmarket in 2008 and continued to do so in the first quarter of 2009. Conversely,Paternoster, who had a 50% market share in 2007, has not written any new dealssince September 2008.

• Volumes of buyout business reduced to £900 million in the first quarter of 2009 –the lowest quarterly volume since 2007.

• 2008 was characterised by insurance companies producing high volumes ofquotations, many of which did not go on to complete. Data provided by insurancecompanies shows that less than 20% of quotations led to a completed deal in2008.

• Data provided by insurance companies shows that buyout quotation volumes aredown 60% in the past 12 months. However, a much higher proportion ofquotations are at an advanced stage, including a number of pension plans indetailed negotiations. We expect 2009 to be characterised by a “lower quantity,higher quality” buyout pipeline.

• There is continued evidence that companies are recognising the cost of increasedlongevity. Over the last three years, FTSE 100 companies have added an extrayear every year to pensioner life expectancy. This is likely to increase the demandfor buyout and longevity hedging options.

Business written in the insured buyout market

0

500

1,000

1,500

2,000

2,500

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1

£m

illio

n

2007 2008 2009

MARKETDEVELO

PMENT Pension Buyouts 2009

View a full list of our services at www.lcp.uk.com4

Market development

2006 and 2007 saw dramatic growth in the buyout market as an explosion of new andestablished providers developed buyout offerings. In contrast, the past 12 months hasseen both new entrants and departures.

Synesis Life exited the buyout market in 2008 after failing to secure any transactions.Pension Insurance Corporation subsequently acquired assets and some key membersof Synesis Life’s team. Swiss Re entered the market with a range of de-risking optionsbut is now focusing on longevity-only transactions. A number of financial institutionscontinue to watch the buyout market closely with a view to getting more activelyinvolved, although this is set against a backdrop of difficulties in raising new capital.Paternoster has agreed with the FSA that it will not, for the time being, write anynew business.

Longevity hedging for pension plans is presently available from a range of providers, primarilyinvestment banks and insurance companies. The major players not listed above include:

Insurer Date of entry

1986

1997

April 2006

May 2006

June 2006

October 2006

January 2007

July 2007

July 2007

November 2007

Offers longevity-onlyhedging?

Institution Type of entity

Investment bank

Investment bank

Investment bank

Reinsurer

�

�

�

�

�

�

�

�

�

�

Correct as at May 2009


MARKETDEVELO

PMENT


5

Types of buyout

This report covers buyouts by UK defined benefit pension plans with insurancecompanies that are authorised and regulated in the UK by the Financial ServicesAuthority (FSA). It also covers longevity hedging options available from insurancecompanies and the capital markets.

Full definitions of the different types of buyouts are set out in the Glossary. The keytypes are as follows:

This report does not cover “non-insured” buyouts. In 2007 there were four such deals(telent, Thorn, Thomson Regional Newspapers and Thresher) whereby liabilitieswere transferred to institutions that were not FSA authorised insurance companies.Since then we have not seen any further deals. However, in May 2009, Bridge Pointe– a Bermudan based captive insurance company – has announced its entry to themarket, offering a non-UK insurance-based “stepping stone” to full buyout.

This report also excludes insurer-to-insurer transactions such as the £300 milliondeal between Rothesay Life and Prudential to reinsure the pensioners of the Rankpension plan.

The process whereby a pension plan’s liabilities are transferred to aninsurance company and the obligation for the pension plan to providethose benefits is ceased. Usually this covers all of the liabilities of thepension plan as a full buyout and is followed by the wind-up of thepension plan.

Examples: Rank, Thorn, M-Real Corporation

The purchase of an annuity contract with an insurance company as aninvestment to match some or all of a pension plan’s liabilities, andtherefore reduce risk. Crucially the liabilities remain in the pension planand the trustees retain responsibility for them. Commonly this coversthe pensioner liabilities as a pensioner buy-in but there have beenseveral buy-ins of non-pensioner liabilities or a sub-set of pensionerliabilities.

Examples: Cable & Wireless, TI Group, Friends Provident

The purchase of an investment to remove or reduce the risk of pensionplan members living longer than expected.

Examples: Babcock International*

Buyout

Buy-in

Long

evity

hedge

* Babcock International announced on 12th May 2009 that it had agreed in principle with two of its pensionplans to enter into longevity hedges with an unnamed counterparty.

see page 34for the Glossary ofde-risking terms

MARKETDRIVERS



Market drivers

The fifteen month period covered by this report can be divided into the periods beforeand after the collapse of Lehman Brothers in September 2008.

January to September 2008

In the first part of 2008, buy-in prices for pensioners were frequently lower than thefunding reserves being agreed between trustees and companies in their actuarial fundingvaluations – the lowest point was reached in March 2008. This provided an opportunityfor pension plans to transfer investment and longevity risk to an insurance companywithout increasing their funding deficits or requiring accelerated cash contributions to bepaid into the pension plan. This can clearly be seen from the chart on page 9.

Many of the deals were pensioner buy-ins, reflecting the fact that most pension planshad funding deficits and could not afford a full buyout. In addition, trustees andcompanies had a greater awareness of new options available in the market such aspensioner buy-ins.

The deals over this period covered a wide spectrum of companies: from FTSE 100companies (such as Cable & Wireless) to engineering companies (such as BBA andPowell Duffryn) to non-governmental public organisations (such as Ofcom) and, in thecase of Friends Provident, a life insurance company choosing to transfer pension riskto another life insurance company.

Major deals in January to September 2008 include:

Friends Provident

A £360 million pensioner buy-in with Aviva (formerly Norwich Union). This was the first

deal to include a security arrangement where a portion of the premium is held in a

segregated premium account.

TI Group

TI Group’s pension plan undertook two £250 million buy-ins, the first with Legal &

General in March and the second with Paternoster in September, covering different

segments of their pensioner population.

Delta

A £450 million pensioner buyout with Pension Insurance Corporation. This was the only

significant pension buyout in 2008 (all other significant pensioner deals were buy-ins).

Delta plc paid £50 million to achieve a complete transfer of the liabilities through a

buyout.

Cable & Wireless

The largest buy-in ever at £1,050 million with Prudential. The deal included an additional

security arrangement. A £10 million cash payment was made by the sponsor to facilitate

the transaction.

see page 19for further informationon additional security

arrangements

Majorbuyout

andbuy-intransactions

7

Fina

ncialcrisis


MARKETDRIVERS



Post September 2008

The collapse of Lehman Brothers signalled some dramatic changes to the market –both to the practicalities of completing a buyout and in the attitudes of trustees andcompanies towards them. The key changes included:

• insurance companies adopted more cautious pricing and reserving assumptions– in particular many insurance companies increased their assumed default rates oncorporate bonds backing their annuity portfolios to reflect a gloomier economic outlook;

• many key investment markets became significantly less liquid – this impededasset transfers from pension plans to insurance companies as market prices forcertain assets were distorted, thereby making accurate valuation difficult; and

• confidence in financial institutions was eroded – as evidenced by investorsheavily marking down insurance company share prices. Trustees of larger pensionplans increasingly sought additional protections as part of buy-in contracts.

Each of these factors is explored in the sections below. We then look at the outlookfor the buyout market in 2009 and beyond.

Pricing and reserving

Following the collapse of Lehman Brothers in September 2008, there was a sharpincrease in buyout prices, both in absolute terms and relative to funding andaccounting valuations.

Lehman’s collapse also represented a step-change in attitude towards the likelihoodof financial institutions defaulting. This is significant as the financial sector is a majorissuer of the corporate bonds held by many insurance companies to back their annuityportfolios.

The level of increase in buyout prices since September 2008 has varied widely,reflecting differing outlooks for defaults on corporate bonds. Many insurancecompanies also moved away from investing in debt issued by the financial sector.

Insurance companies’ underlying investment strategies are also relevant. For example,many insurance companies link their pricing to the market prices of the swaps andother derivatives they plan to invest in after taking on new business. Thin tradingvolumes in the inflation swaps market have led to distorted pricing since September2008 and this has fed directly into higher prices.

see page 29for further details onthe challenges facinginsurance companies

Major deals since September 2008 include:

Thorn

The largest buyout ever at £1,100m. This was previously a non-insured buyout in 2007. As

part of the buyout a 5% uplift was provided to members’ pensions from surplus funds.

see page 29for commentary on

insurance companies’allowances fordefaults on theircorporate bond

portfolios


MARKETDRIVERS


9

The divergence in pricing between different insurance companies is clearly shown inthe chart below:

The divergence in pricing has two key implications for pension plans:

• it is more difficult to gauge what prices will be in advance of obtaining detailedbuyout or buy-in quotations; and

• it is even more important to understand how insurance companies are pricing andto carefully consider the asset implications – both on how to invest to match theinsurance companies’ pricing and the strategy for transitioning assets.

Most pension plans are likely to conclude that there is a modest immediate increaseto the valuation deficit if they proceed with a pensioner buy-in. The challenge forpension plans is to consider what level of increase is acceptable in return for the riskreduction achieved by the transaction.

Financial crisis

Lehman Brothers’insolvency

Divergence inbuy-in pricing

Investment conditionsbegan to improve in

April 2009 – particularlyin the swaps market –and we expect this tohave a beneficialimpact on pricing

Buy-in premium equals 100 at 31st December 2007

Confidence in financial institutions

The wider deterioration in the UK and global economy over late 2008 and early 2009has impacted on attitudes towards insurance companies – both from investors andpension plan trustees. This led many pension plans to adopt a “wait-and-see”approach to buyout with completed deal volumes falling as a result. The reduction ininvestor confidence can clearly be seen from the chart of insurance company shareprices below.

In line with most financial stocks, the share prices of insurance companies weremarked down heavily in early 2009. This reflected market concerns that furthershareholder capital would be needed to strengthen policyholder reserves. Sincethen, there has been a rebound in sentiment as confidence grows that insurancecompany reserves are adequate to meet the challenges of the next few years.However, share prices are likely to remain volatile until greater certainty emerges on theeconomic outlook.

MARKETDRIVERS



see page 27for policyholderprotections

Despite … negative factors, we continue to view

favourably the strength of [life insurance] regulation in

the U.K., improvements in risk management across the

[life insurance] sector, the long-term fundamental

strengths of the U.K. economy, and the size and

diversity of the U.K. life market.

Standard & Poor’s25th February 2009

“”VIEWPOINT



Practical steps to prepare for a pension buyout or buy-in

The implementation of a pension buyout or buy-in is a significant exercise and thereare a number of steps that companies and trustees can take now to ensure they canact quickly to take advantage of attractive pricing when market conditions are right.

Set up a trigger-based approach

A buy-in is essentially an investment decision. Therefore it is helpful to set up a framework for

assessing whether a buy-in price represents an attractive investment. By monitoring pricing

closely, pension plans can identify when the price is within their target zone and work quickly to

execute and achieve the desired risk reduction before the opportunity goes away.

Possible action: Agree a trigger for assessing whether buy-in is attractive (eg relative to

technical provisions) so that when price triggers are met the transaction can be executed

rapidly.

Review your data

Whether trustees are aware of them or not, most pension plans have a range of issues with their

data (from untraced members to key data not being held electronically). This can significantly

delay transactions. If insurance companies are concerned about data quality they may add

margins to their prices, or even refuse to quote at all.

Possible action: A data audit in advance of a buyout process can speed up negotiation and

implementation, as well as providing keener and more certain pricing. It can also improve the

ongoing governance of a pension plan.

Review your investments

Transitioning significant amounts of assets can be challenging in volatile financial markets and this

has been a significant hurdle in recent transactions. By reviewing the marketability and liquidity of

the pension plan’s investments in advance of any deal, work can be undertaken to prepare asset

portfolios to allow a buyout transaction to be executed more rapidly. Some pension plans may

also wish to adjust their investment strategies to better match their position against buyout or

buy-in pricing.

Possible action: Consider transitioning your assets into a form acceptable to insurance

companies whilst ensuring they remain marketable and liquid to retain flexibility.

Review the insurance companies

One of the most difficult decisions for trustees is the ultimate selection of the insurance company

to place the business with. This decision can be made easier by spending time now

understanding who the insurance companies are and what they can offer. Assessing the

insurance companies’ strengths and weaknesses, understanding the UK insurance regime and

considering potential selection criteria will allow the final decision on selection to be made much

more quickly when the time comes.

Possible action: Meet the insurance companies to understand who they are and what they

can offer.

PREPA

RINGFO

RATRANSACTION

12

In our experience, careful preparation pays dividends

for companies and trustees when executing a buyout –

better insurance company engagement, keener

pricing and being able to move quickly when the time

comes – these are the key ingredients to achieving a

successful deal.

Clive Wellsteed, Partner, LCP

“

”LCPINSIGHT

MARKETOUTLO

OK



Insurance company pipelines – quality rather than quantity?

The dynamics within the buyout market have changed markedly and this can clearlybe seen by examining the insurance companies’ pipelines:

• The demand for pension buyouts has reduced in the past year. For example, oneof the leading insurance companies has seen the number of pension plans seekingquotations fall by nearly 60%.

• On the other hand, the “quality” of the pipeline has improved. One leadinginsurance company states that over 50% of current deals in their pipeline arebeyond the initial quotation stage which compares to around 20% a year ago.

• The completion rate in 2008 was low. One insurance company states that less thanone in five quotations that they issued went on to complete, either with them oranother insurance company.

This paints a picture of a maturing and more orderly market than the initial rush in thesummer and autumn of 2008. We are also seeing a greater level of sophistication inthe deals that go through as trustees develop their requirements and insurancecompanies develop the features they are able to offer.

Demand for buyout from pension plans in 2009 onwards

Whilst attractive pricing has been available from a small number of insurance companiesin early 2009, most insurance companies have now strengthened their pricing bases.Some pension plans, particularly those who value the risk reduction achieved from abuyout, are proceeding nonetheless and the insurance companies retain a core “quality”pipeline. However, many pension plans have taken a “wait-and-see” approach given thecurrent financial turmoil.

We expect that buyout quotation activity will pick up over the next few months asconfidence begins to return to financial markets. After all, the demand for de-riskingremains high – the financial turmoil has been an effective demonstration of the level ofrisk that is being run by UK defined benefit pension plans and their sponsoringcompanies.

In the short-term, depressed pension plan funding levels mean there is limitedaffordability for full buyouts and so a continued stream of pensioner-only deals is themost likely prospect.

Over the medium term there is significant demand for risk reduction, and the recent trendfor companies to cut back pension provision and even close pension plans to futurebenefit accrual will only serve to accelerate this. The pace at which pension plans movetowards ultimate buyout depend on investment markets and available cash withinsponsoring companies.

We expect thebuyout market in 2009

and 2010 to becharacterised by qualityrather than quantity

MARKETOUTLO

OK

15View a full list of our services at www.lcp.uk.com


How will the buyout market develop?

The table below sets out three possible scenarios for investment markets over the next couple of years and theimplications for the buyout market.

Insolvent companies – a source of new deals?

The insolvency of companies with defined benefit pension plans (such as Lehman Brothers and Woolworths) isanother source of potential activity for the buyout market. Under UK legislation these pension plans will aim to securepensions with an insurance company, subject to a minimum level of compensation being provided by the PensionProtection Fund for less well-funded plans. These transactions are generally quite difficult due to the complexlegislative requirements and so it may be 2010 before some of these deals start to come through.

We may also see some “compromise” deals where pension plans are bought out as part of a company restructuringor rescue deal. Such deals will involve many different parties, generally including the Pensions Regulator.

Economic scenario Impact

Estimatedvolumes

2009 2010

Optimistic

Fiscal stimuli and quantitative easingprove successful

Markets rebound over 2009 and 2010

Inflationary pressures potentially grow

Pension funding levels recover from lows in early 2009

Buyout market volumes increase as pension plans decideconditions support further de-risking and locking-in ofgains through buy-ins and buyouts

£7billion

£12billion

Middle of the road

Economies struggle throughout 2009

Deflationary pressure through 2009

Unprecedented government bondissuance potentially leading to:

• fiscal tightening• inflationary pressures• currency devaluations

Steady stream of buyout transactions

Initially pensioner-only transactions as they are mostaffordable

Increasing number of full buyouts over the medium term

£4billion

£8billion

Gloomy

Serious further deterioration inmarkets

Bank of England initiatives proveunsuccessful with resulting debt andfiscal burden

Solvency positions of insurancecompanies become stretched

Pension funding levels remain very low

Limited buyouts due to concerns over insurancecompany solvency

Most buyouts arise from the wind-up of pension planswhere the sponsoring company is insolvent but the planis funded above the level for entry to the PensionProtection Fund

£2billion

£4billion

2008 calendar year

2008 saw buyout volumes hit £7.9 billion, a rise of over 150% on 2007 volumes. Thefollowing chart shows the market share of each insurance company over 2008 by valueof transactions written.

Whilst 2007 was split between Legal & General and Paternoster with over 90% ofbusiness between them, in 2008 the business was much more evenly splitdemonstrating the greater maturity of the market. Six insurance companies now makeup over 90% of the market. Legal & General’s and Paternoster’s shares have reducedsince 2007, but they are shares of a much larger market.

Legal & General had the highest volumes at £1.9 billion – up from £1.4 billion in 2007– and replacing Paternoster in first place. Conversely, Paternoster pulled back fromthe market in the fourth quarter. This allowed Prudential to push them into fourth placewith their £60 million deal with the Thomson Regional Newspapers pension plan inDecember.

Pension Insurance Corporation was perhaps the surprise entrant in 2008. Havingwritten no insured buyouts in 2007 or in the first four months of 2008 they wrote fivedeals before the end of 2008 totalling £1.7 billion. This put them in second place witha market share of 21%, only marginally behind Legal & General.

Lucida and Prudential also separately struck deals with Bank of Ireland Life andRothesay Life. As these deals were not with UK defined benefit pension plans they areexcluded from the figures in this report.

BUSINESSWRITTEN



All significanttransactions in 2008and the first quarter of2009 are listed on

page 32

For all insurancecompanies, there is adelicate trade-offbetween achievingmarket share andreturn on capital

Insurance company market share over 2008 by transaction value



17

2009 quarter one

The first quarter of 2009 saw over £900 million of business written. The followingchart shows the market share of each insurance company over the first quarter of2009 by value of transactions written.

Legal & General carried on their success into the first quarter of 2009, writing justover £500 million and giving them the leading market share. Pension InsuranceCorporation also continued to be successful writing £226 million of business.

Paternoster remained out of the market in 2009 citing that the current regulatory andfinancial uncertainties are making pricing difficult and that their primary obligation isthe security of policyholders. At the current time they are not accepting furtherliabilities.

AIG Life wrote its largest buyout yet of £29 million at the end of March 2009 showingthat whilst its parent company in the US has had highly public difficulties there is stillconfidence in the UK insurance business as a continuing entity.

BUSINESSWRITTEN

The volume ofbusiness written byeach insurance

company is set outon page 33

Insurance company market share over Q1 2009 by transaction value

A well structured security arrangement, available at a

proportionate price and with a clear understanding of

the limitations, can provide additional protection and

comfort to members, trustees and sponsoring

companies.

Charlie Finch, Partner, LCP

“

”LCPINSIGHT

Security arrangements for buy-ins

In 2008, some larger pension plans began to seek additional security arrangementsas part of buy-in contracts and this trend is likely to continue into 2009, certainly forlarger transactions. The protections available aim to reduce the impact on the pensionplan of insurance company default.

The key challenge for trustees and sponsoring companies is to balance the cost ofany security arrangement against the additional security it provides. In ourexperience, a proportionate approach is vital. This should take into account thefinancial strength of the insurance company and the sponsoring employer and analysethe extent to which the security arrangement enhances the basic protections of theUK insurance regime.

Arrangements to provide additional security generally offer pension plans a surrendervalue or collateral or both. Trustees and sponsors should be aware that there will beongoing costs to operate and monitor a security arrangement.

Surrender values

A surrender value gives trustees the right to take back a level of assets should certaintriggers be met. In practice, there is no certainty that the surrender value wouldactually be obtainable in a distressed situation. For this reason it is common to seeksome form of collateral.


SECURITYARRANGEMENTS


19

Since August 2008LCP has advised ontwo major completedbuy-ins involvingadditional securityarrangements and

three without



Basic collateral arrangement

There are a number of ways of structuring a collateral arrangement but the basicconcept can be summarised as:

• the insurance company places an amount of money in a fund separated from theinsurance company’s other assets; and

• if certain trigger mechanisms are breached, then the trustees are entitled to takeback the segregated assets.

The segregated fund can either be within the insurance company’s legal groupstructure, within a separate standalone vehicle or within the pension plan’s legalstructure.

Collateral arrangements only exist for buy-ins – once converted to individual memberpolicies the collateral arrangement ceases, as it is impractical to manage across a largenumber of policies.

Whilst Aviva’s (formerly Norwich Union) collateral arrangement is being marketed forbuy-ins above £100 million, most of the collateral arrangements being offered in themarket are only being made available for buy-ins of £500 million or more.

Some of the key questions for trustees to consider when assessing the value of acollateral arrangement are:

• how much and what type of collateral is being posted?

• under what circumstances can trustees gain access to the collateral?

• where does the pension plan rank relative to the other creditors?


Operation of a basic collateral arrangement

View a full list of our services at www.lcp.uk.com 21

How much collateral is being posted?

The amount of collateral that an insurance company will post is critical, and can varysignificantly. Ideally trustees would wish the collateral posted to be at least thereplacement value of the insurance policy. However, this potentially open-ended levelof commitment can be an expensive option.

Conversely, if collateral is set at too low a level then it may not pay out any more thanthe trustees would have received in any case in an insolvency situation.

It is also important to ensure the level of collateral posted is updated frequently totake account of market movements, as extreme events can happen very quickly.

What type of collateral is posted?

When setting up a collateral arrangement it is important to remember that the mostlikely time for it to be exercised is in a period of severe economic stress. Under sucha scenario the types of assets included in the arrangement are vital, as many assetclasses are likely to be both difficult to price and difficult to sell.

Trustees and corporate sponsors should look for marketable, transparently valuedassets that are likely to hold their value in an economic downturn. If not, they couldfind that the value of their collateral reduces at precisely the time when it is mostneeded.

Under what circumstances can trustees gain access to the collateral?

The level of trustee access to the collateral will depend on the type of arrangement.However, it is key that the trustees would be able to access the collateral at anappropriate time. If the collateral cannot be obtained before an insurance companybecomes insolvent it may be too late. Typically, a collateral agreement will have agreed“trigger points” which, if breached, will allow the trustees to take full control of thecollateral. Examples are:

• the insurance company breaches specific statutory solvency levels;

• the insurance company suffers a “credit event” such as missing a repayment on abond; or

• the insurance company’s credit rating is downgraded below a certain level.

Where does the pension plan rank relative to the other creditors?

Trustees should consider where they rank in the event of the insurance company’sinsolvency. By seeking a fixed or floating charge over the insurance company’s assetsthey may be able to improve their ranking.

If an insurance company is to provide a high level of good quality collateral, this is likelyto come with an additional cost. This is because the insurance company will have topost additional funds into the collateral arrangement, and under the FSA’s “treatingcustomers fairly” guidelines it will not want to disadvantage existing policyholders.Trustees will need to take a view on how much collateral, if any, they want included inthe contract.


see page 27for a detailed summaryof the protections inplace in the UKinsurance regime


LONGEVITYHEDGING



Longevity hedging

A longevity hedge allows a pension plan to remove the risk that members live longerthan expected but, unlike a buyout or buy-in, there is no transfer of the underlyingassets and the associated investment risks.

There is an established UK and overseas market for the transfer of longevity risk betweenfinancial institutions. Interest from UK pension plans has lagged behind the institutionalmarket, but has been building up steadily over the last 12months. During this time, two of theleading longevity hedge providers have priced hedges on £30 billion of pension liabilities,spanning over 50 pension plans. Several individual cases have been over £1 billion, with atleast six FTSE100 companies exploring longevity pricing.

This growth in interest culminated inMay 2009when Babcock International announced thatan agreement had been reached in principle for two of the group’s pension plans to enterinto a bespoke longevity hedge – the first UK pension plans to do so. We expect that anumber of other plans will follow, now that “proof of concept” has been established.

When is longevity hedging most attractive?

Whilst many pension plans have considered pensioner buy-ins, longevity hedging can bean attractive alternative de-risking option for larger plans where:

• there is an appetite to retain investment control and gain exposure to future returns onthe underlying assets;

• there is a desire to reduce counterparty risk, for examplewith a single insurance company;

• a buy-in or buyout is difficult to execute, for example due to a shortfall in pension planfunding, difficult investment market conditions, or where pension liabilities are very large;or

see page 30for a description ofhow a longevityhedge works in

practice

Comparison of risks transferred under a buy-in and longevity hedge

• there is a preference to deal separately with longevity and investment risk withinthe pension plan.

Longevity pricing: are we there yet?

As with the buyout market, pricing is likely to be the main driver of growth. Pensionplans typically evaluate longevity pricing compared to:

• the expected longevity of plan members built into the trustees’ funding reserve;and

• the cost of a buy-in – the main alternative for a pension plan seeking to transferlongevity risk.

We have seen longevity pricing become more competitive on both measures, in recentmonths, as providers seek to kick-start the market. The analysis below explores thisin more detail.

Expected longevity of plan members

The last decade has seen pension plans move toward ever-higher longevityallowances, driven by unfolding experience and new research. The chart below showsthe impact for a typical pension plan over the last three valuation cycles, comparedwith actual longevity swap pricing today.

Any increase to a pension plan’s funding reserve from taking out a longevity swap cangenerally be spread over a number of years, so the actual cash cost is usually modest.


LONGEVITYHEDGING


23

Longevity hedgingoffers a way for financedirectors to close outthe cost of increasinglongevity expectations



DIY buyout: longevity hedging versus pensioner buy-in

Pension plans can now create their own “DIY buyout” strategies by hedging individualrisks seperately within the pension plan – but how do you compare this with apensioner buy-in? One of the best comparisons is to calculate the “breakeven”investment return that needs to be achieved on the asset portfolio underlying thelongevity hedge in order to “beat” the pensioner buy-in price.

The following chart shows how this breakeven investment return has fallen significantlysince Autumn 2008. In this case, the underlying assets would have needed to earn5.5% pa in Autumn 2008, but this had reduced to 3.7% pa by Spring 2009. In practicethe actual breakeven investment return will vary according to financial conditions andplan specific factors.

Many pension plans back their pensioner liabilities with a mixture of gilts and corporatebonds. So, another way of looking at a DIY buyout is to consider the proportion ofcorporate bonds that would be needed to achieve the breakeven investment return. Ascan be seen, this proportion has also fallen significantly in recent months and is nowmuch more in line with typical pension plan investment strategies for backingpensioner liabilities.

For larger pension plans willing to accept a limited amount of investment risk for theassets backing the pensioner liabilities, there is now a strong case for establishing theprice of a longevity hedge.

LONGEVITYHEDGING

24

The combination ofchanges in investmentconditions and lowerlongevity pricing has

made longevityhedging an

increasingly viablede-risking solution



What are the challenges facing longevity hedging?

The challenges facing longevity hedging include:

• Whether a longevity hedge would complicate an eventual buyout and wind-up.Pension plans should consider whether a longevity hedge will be an attractiveasset for buyout providers to take on as part of a buyout. Trustees shouldnegotiate terms to ensure they ultimately get value for money for any longevityhedge they take out.

• How to quantify the benefit of the longevity risk removed. Pension plans willwant to be convinced that the risk reduction justifies the cost of the longevityhedge.

• Ongoing management costs including regular valuations, posting of collateral,and additional administration.

Of these challenges, the impact on a future buyout is in our view the most material,and we expect this issue to come to the fore in the coming months.

The future for longevity swaps

In our view the development of the longevity swaps market is a welcome additionaloption for pension plans looking to de-risk.

• We see conditions today as especially fertile for this fledgling market. With buyoutprices trending up, and pension plans adopting more cautious longevityallowances, longevity hedge pricing is now more attractive than ever before.

• With an increasing number of plan sponsors focussing on the removal of pensionrisks from the corporate balance sheet, a key challenge for the longevity market isto persuade pension plans that a longevity hedge is viable as a “stepping stone”to buyout in the longer term.

• The first trade by Babcock International is a milestone, providing “proof ofconcept”. However, it is not yet clear whether this will signal a rapid growth inactivity (akin to the insured buyout market of 2007/2008) or an exceptional event(similar to the short-lived success of the non-insured buyout market in 2007).

LONGEVITYHEDGING

25

Protections for pension buyouts

In entering into any significant insurance transaction it is important to understand the structure and security ofthe insurance company and the protections in place. Multiple layers of protection exist for policyholders whopurchase bulk annuity products from FSA-authorised insurance companies in the UK.

Protections of the UK insurance regime include:

• prudent reserving;

• regulatory solvency capital – on top of their prudent reserves insurance companies have to holdadditional buffer capital under two key measures:

• Pillar I – typically for pension annuity business this is an additional buffer of at least 4% ofreserves; and

• Pillar II – under the Individual Capital Assessment framework each insurance company has tohold capital to ensure there is at least a 99.5% probability of it being sufficient for the next 12 months.

• potential support from shareholders or other lines of business if capital levels fall;

• statutory mechanisms to transfer pension annuity business to another ongoing insurance companyto provide continuity of cover if the insurance companies’ capital position is particularly weak;

• in the event of actual insolvency, policyholders, in general, rank above shareholders and unsecuredbondholders and creditors (but behind expenses, secured and preferred creditors); and

• ultimately the Financial Services Compensation Scheme (FSCS) exists to provide compensationto policyholders.

These protections are intended to provide long-term security – extremely important for pension buyoutbusiness where the pensions may be in payment for 50 years or more. With perhaps a few exceptions, the UKinsurance regime is likely to be more secure than long-term dependence on the financial strength of a pensionplan sponsor.

With that said, the insurance regime is not designed to be a zero-failure regime. We are yet to witness the failureof a significant life insurance company but the risk of failure needs to be assessed and understood beforeentering into a buyout or buy-in.


Appendix 1: Pension Buyouts 2009APPENDIX

1

27

Insurance company reserving

Insurance companies calculate their reserves using assumptions chosen to reflect the characteristics of theirassets and liabilities.

Two key reserving assumptions are:

• The mortality assumptions for individuals in the insurance company’s annuity book; and

• The allowance for defaults on corporate bonds in the insurance company’s investment portfolio.

Mortality assumptions

The following chart shows the range of life expectancies underlying insurance company reserving for bulkannuity business. The mortality assumptions reflect the underlying demographics of the individuals eachinsurance company has insured. Therefore inevitably the underlying life expectancies will vary betweeninsurance companies. This will be particularly noticeable for the newer insurance companies as they growtheir business.

Each additional year of life expectancy typically adds around 3% to the insurance company’s reserves.

APPENDIX

2Appendix 2: Pension Buyouts 2009


Source: Insurance company FSA returns and LCP 2008 Accounting for Pensions

Appendix 2: Pension Buyouts 2009

Corporate bond default assumptions

The table below shows the allowances made by three insurance companies in their reserves for futurecorporate bonds defaults. This area came under particular scrutiny in early 2009. In each case the default rateis expressed as a reduction in the interest rate used to set the reserves – the higher the reduction, the moreprudent the reserves.

The allowance made for defaults can have a significant impact on the disclosed solvency position. Forexample, Legal & General increased their allowance for defaults over the next four years in their 2008 year endresults. This increased their reserves by £650 million.

All of the default allowances are high compared to historic levels of default over the last 70 years – thechallenge is judging a prudent level going forwards. Each insurance company’s allowance will reflect the levelof prudence in their reserves and the credit quality of the corporate bonds held within their annuity investmentportfolios.

Each 0.1% reduction in the interest rate adds around 1% to 2% to the insurance company’s reserves.

APPENDIX

2

29

Challenges for insurance companies in 2009

Capital is scarce

Many financial institutions are facing weakened balance sheets. In an environment of scarce capital,insurance companies may require a higher return on capital on capital intensive products such as pensionbuyouts. This is likely to translate into higher prices. For example, in their year-end announcement inMarch2009, Legal & General stated “Balance sheet strength remains our priority in 2009… We will be selectiveabout sales growth and are reducing new business capital strain…”

Tougher reserving

At the year-end several insurance companies tightened their reserving allowance for defaults on theircorporate bond portfolios. A review of financial regulation in light of the banking crisis is likely which couldlead to further reserving pressure. Higher reserves will, in principle, mean greater security but will also meanhigher prices.

New reporting standards

From the end of 2009many large European insurance companies will report under a newMarket ConsistentEmbedded Value (MCEV) approach. In effect this requires them to mark their liabilities to market using arisk-free discount rate. This is bad news for insurance companies who invest in corporate bonds aspreviously they have taken credit for some of the additional return expected from corporate bonds. Forexample, Aviva reported a £885 million loss in 2008 under international standards but under MCEV thisloss increased to £7,710 million. Recently there have been reports that the introduction of MCEV maybe delayed.


1.30% reduction for fouryears, 0.30% reduction

thereafter

0.82% reduction0.67% reduction

but some allowanceis made for recoveries

on defaults


3

30

Longevity hedging mechanisms – an overview

Longevity hedging solutions have developed along two distinct paths: bespoke and index-based hedging.

A bespoke longevity hedge transfers longevity risk for the members covered to the hedge provider. The provideragrees to meet the actual payments to pension plan members regardless of how long they live – this is calledthe “floating leg” of the hedge. In exchange, the pension plan meets a fixed schedule of payments to the provider –this called the “fixed leg” of the hedge.

With a bespoke longevity hedge in place, a pension plan is no longer exposed to the risk that members live longerthan projected.

Whilst highly effective, bespoke longevity hedges are normally only available for relatively large pension plan populations,as the hedge provider will look for enough member data to price the hedge efficiently. Competitive hedge pricing isavailable to pension planswith pensioner liabilities over £100million – this is significantly above the entry level for buyout.Also, providers will typically offer bespoke hedging for pensioners only, or “pensioner-rich” memberships.

An index-based longevity hedge provides protection against future increases in longevity, but only based on the generalpopulation and not the specific pension plan membership. This allows the provider to assess an efficient price for thehedge, regardless of the size of the pension plan.

However, index-based hedges have two main disadvantages:

• The pension plan is left holding an uncertain and indeterminable risk: that movements in pension plan memberlongevity are not in line with those of the index population; and

• Such hedges typically only offer protection for a relatively limited period (usually between 10 and 30 years)whereas pension plans are often more concerned about longer-term risks.

These uncertainties present a substantial challenge to providers seeking to develop a market for index-based hedginginstruments with pension plans. As a result, bespoke hedging is often seen as the more attractive option by pensionplans seeking to transfer longevity risk. By contrast, financial institutions generally view index-based hedging morefavourably as a means of trading longevity risk between institutions. The flexibility of an index-based hedge is attractiveto them and, with large pools of lives on their books, they expect their pensioner longevity experience to closely matchthat of the index population.

00 10 20 30 40 50

Time (years)

Paym

ents

(£pa

) Fixed leg The pension plan pays this regardless of how long members live

Floating leg

The hedge provider pays pensions due to memberswhich could be greater orless than the fixed leg


Annual pension plan payments with and without a longevity hedge

Regulation of longevity hedges: insurance regime versus capital market regime

Longevity hedging for pension plans is presently available from a range of providers, primarily investment banks andinsurance companies.

Unlike the buyout market, where the focus has been on FSA-regulated insurance vehicles, some of the key providersof longevity hedging do so through a capital market solution – typically a swap. The key difference between the twocompeting frameworks is the management of counterparty risk:

• Capital market providers put collateral arrangements in place, whereby the two parties (ie pension plan andprovider) stake assets to protect the other against any financial loss expected to arise from a default.

• Insurance companies are not required to put collateral arrangements in place. Instead they have thestronger capital reserving requirements of the FSA insurance regime, with the option of putting collateralarrangements in place where desired.

Regulation in the longevity market may develop differently from the buyout market, with room for both capital marketand insurance solutions to prove successful. As a precedent for this, interest rate swaps and inflation swaps are inwidespread use by pension plans under the capital market route.

One reason why capital market solutions may succeed here is the level of counterparty exposure under a longevityhedge compared to buyout. The following chart shows the maximum potential loss a pension plan would face (on£1 billion of pensioner liabilities) were a provider to default on its contractual obligations under a longevity swap anda buy-in respectively. In practice, any compensation from the Financial Services Compensation Scheme wouldsignificantly reduce the counterparty exposure under a buy-in.

As can be seen, there is only limited counterparty exposure under a longevity hedge, compared with buy-in. Further,a longevity hedge is symmetric with either party potentially exposed to counterparty risk, depending on whethermembers live longer or shorter than expected.

We see strong benefits from the development in parallel of longevity solutions from both insurance and capital marketproviders. We expect competition between the two frameworks to drive further innovation and possibly pricing,as providers seek to neutralise any disadvantages (perceived or real) arising from the particular framework in whichthey operate.


3

31View a full list of our services at www.lcp.uk.com

Level of counterparty exposure under a pensions buy-in and longevity hedge

Pub

licallyan

noun

cedtran

sactions

inexce

ssof£100

millionover2008

andQ12009


Nam

eVa

lue

£milion

Sector

Insurer

Date

Type

Tho

rn1,100

Eng

ineering

PensionInsuranceCorporatio

nDecem

ber

2008

Fullb

uyout

Cab

le&Wireless

1,050

Communications

Prudential

Sep

tember

2008

Pensionerbuy-in

Rank

700

Leisure

Rothesay

Life

(Goldman

Sachs)

Feb

ruary2008

Fullrisktransfer

Delta

450

Eng

ineering


nJune

2008

Pensionerbuyout

PowellD

uffryn

/PDPensionPlan

400

Eng

ineering

Paterno

ster

March

2008

Fullb

uyout

FriendsProvident

360

FinancialServices

Aviva

(form

erlyNorwichUnion)

April2008

Pensionerbuy-in

BBA

270

Aviation

Legal&General

April2008

Pensionerbuy-in

TIG

roup

250

Eng

ineering

Legal&General

March

2008

Pensionerbuy-in

TIG

roup

250

Eng

ineering

Paterno

ster

Sep

tember

2008

Pensionerbuy-in

LeylandDAF

230

VehicleManufacturing


nJanu

ary2009

Fullb

uyout

Pensions

Trust

225

Charities

Paterno

ster

July2008

Pensionerbuy-in

M-RealC

orporatio

n180

Pap

erManufacturing

Legal&General

March

2008

Fullb

uyout

Morgan

Crucible

160

Eng

ineering

Lucida

March

2008

Pensionerbuy-in

Ofcom

150

Pub

licLegal&General

July2008

Pensionerbuy-in

Dairy

Crest

150

FoodProducer

Legal&General

Decem

ber

2008

Pensionerbuy-in

Vivendi

130

Communications

MetLife

November

2008

Pensionerbuy-in

WestFerry

Printers

130

Printing

Aviva

(form

erlyNorwichUnion)

Sep

tember

2008

Pensionerbuy-inAPPENDIX

4

32

Sou

rce:

LCPresearch

2009

33

Totalsizeoftransactions

(£million)

Insurer

Dateofentry

Q1

Q2

Q3

Q4

Q1

Total

MarketShare

ve2008

2008

2008

2008

2009

2008

&2009

Q1

Businesswritten

byinsurers


Lega

land

Gen

eral

1986

720

660

250

310

504

2,44

428

%

Pen

sion

Insuranc

eCorporation

Octob

er20

060

524

421,11

022

61,90

221

%

Pruden

tial

1997

10

1,06

460

–1,12

513

%

Paterno

ster

June

2006

509

7847

40

01,06

112

%

Aviva

(form

erlyNorwichUnion

)May

2006

3336

918

124

365

891

10%

Rothe

sayLife

(Goldman

Sac

hs)

July20

0770

00

00

070

08%

MetLife

July20

0742

250

164

4427

53%

AEGON

Janu

ary20

0730

3247

1552

176

2%

Lucida

Novem

ber

2007

165

00

00

165

2%

AIG

Life

April

2006

817

140

3978

1%

Total

2,20

81,70

52,07

21,90

293

08,81

7

APPENDIX

4

33

Note:P

rude

ntia

ldid

not

prov

ide

any

figur

esfo

rth

eir

2009

quar

ter

one

busi

ness

volu

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Sou

rce:

LCPresearch

2009

All risks transferA full buyout transactionwhere the insurance company assumes responsibility forall the risks borne by the pension plan – such as incorrect data risk, GMPequalisation risk and other legislative risks.

Auction processA competitive process where insurance companies bid to enter into exclusivenegotiations with the trustees for a buyout or buy-in contract.

Bespoke longevity swapA swap which is linked to the longevity experience of the actual pension planmembership. The counterparty will pay the additional pension payroll if theunderlying members live longer than expected; the pension plan will pay theadditional pension payroll if the underlying members die sooner than expected.

Bulk annuityDescribes a contract between a pension plan and an insurance company,whereby an insurance company insures some or all of the liabilities of the pensionplan. Depending onwhether the short-term intention is to transfer policies into thenames of individual pension plan members, bulk annuity contracts are referred toas buyouts or buy-ins.

Buy-inThe purchase of a bulk annuity contract with an insurance company as aninvestment tomatch someor all of a pensionplan’s liabilities, and therefore reducerisk. Crucially the liabilities remain in the pension plan and the trustees retainresponsibility for them. Commonly this covers the pensioner liabilities as apensioner buy-in but there have been several buy-ins of non-pensioner liabilitiesor a sub-set of pensioner liabilities.

BuyoutThe process whereby a pension plan’s liabilities are transferred to an insurancecompany using a bulk annuity contract and the obligation for the pension plan toprovide those benefits is ceased. Usually this covers the full liabilities of thepension plan as a full buyout and is followed by the wind-up of the pension plan.

Buyout marketA term to encompass the range of solutions available to transfer risk from apension plan to another institution, usually an FSA regulated insurance company.Risk transfer is typically achieved through a bulk annuity contract (see buyout andbuy-in) or a longevity swap contract. The term is sometimes taken to include non-insured buyouts.

ClosureAn action to restrict the future build up of liabilities in a pension plan. It could berestricted to closing the pensionplan to newmembers or be extended to stoppingaccrual. Stopping accrual usually means that current active members becomedeferred members, sometimes with a link to future increases in their salary.

CollateralAssets specifically set aside or earmarked to reimburse one party for the default ofa counterparty (eg an insurance company or bank). Collateral is sometimes builtinto the structure of larger buy-in contracts and swaps to provide additionalprotection to the trustees.

Counterparty riskThe risk for a given party that the other party (eg an insurance company or bank)defaults on its obligations. Mechanisms such as posting collateral can sometimesbe negotiated to reduce the potential impact of this risk.

DIY buyoutThe process whereby a pension plan purchases inflation, interest rate andlongevity swaps to achieve similar levels of risk transfer to a buy-in or buyout. It issometimes called a synthetic buyout.

Financial Services Compensation Scheme (FSCS)A statutory compensation arrangement funded on a “pay-as-you-go” basis by anannual levy on the financial services industry. It is expected to provide broadly90% compensation on annuity contracts in the event of an insurance companydefaulting.

Full buyoutA buyout contract covering all known liabilities in a pension plan, usually followedby the pension plan winding-up.

The definitions listed below focus specifically on pension plande-risking terminology.

This guide and the information it contains should not beconstrued as being advice from LCP and should not be reliedupon as such. Specific professional advice should be sought

to reflect individual circumstances.

Glossary: Pension Buyouts 2009

GLO

SSARY

Glossary: Pension Buyouts 2009

35

GMP equalisationThe process of adjusting pension plan benefits to allow for theinequality in the definition of GuaranteedMinimumPensions (GMPs)between males and females. The practicalities of this can becomplex. Some insurance companies will provide an indemnityagainst a future legal requirement to equalise GMPs as part of a bulkannuity transaction.

HedgingPurchasing assets that have similar characteristics to the pensionplan’s liabilities, so that if the value of the liabilities rises/falls this ismatched by a similar rise/fall in the value of the assets.

Index-based longevity swapA swap where the actual payout is linked to a standard population.For example, the counterpartymay pay out to the pension plan if thelongevity of the standard population improves faster thananticipated. Index-based swaps are flexible, but provide only partiallongevity protection against actual pension plan experience.

In-specie asset transferThe transfer of some or all of the pension plan’s assets directly to theinsurance company to pay the premium for the buy-in or buyoutcontract. This can sometimes provide a saving compared to payingthe premium in cash owing to the reduced transaction costsinvolved.

Liability Driven Investment (LDI)A specialised investment (usually made up of cash and swaps)designed to have a similar cashflow profile to a pension plan’sliabilities. So, if the value of the liabilities increases the value of theinvestment also increases. This is a type of hedging.

Liability managementThe process of taking active steps to manage the risk involved witha pension plan’s liabilities. Practical examples include transfer valueexercises, pension plan closure or conducting a trivial commutationexercise.

Longevity hedgeThe purchase of an investment to remove the risk of pension planmembers living longer than expected. The main way of hedginglongevity risk, other than buying annuities, is to use a longevity swap.

Longevity swapA tool to enable pension plans to transfer the risk of members livinglonger than expected to a third party (the counterparty), whilstretaining direct control of the assets. The twomain types of longevityswap are a bespoke longevity swap or an index-based longevityswap.

Mono-line insurance companyAn insurance company offering products within a single businessline, such as bulk annuities.

Multi-line insurance companyAn insurance company that writes business across a range of linesof business (eg investment management and other insuranceproducts).

Non-insured buyoutA transaction that transfers riskbychanging the relationshipbetweenthe pension plan and the current sponsoring company. Non-insuredbuyouts do not involve insurance companies and so do not benefitfrom the associated protections of the insurance regime. Due tolower capital requirements they can be more affordable than a bulkannuity or longevity swap.

Partial buy-in / buyoutA buy-in or buyout covering only a proportion of a pension plan’sliabilities. The most common type is a pensioner buy-in.

Pensioner buy-inA buy-in which covers payments to current pensioners and theirdependants.

Pensioner existence exerciseAn exercise to ensure that all the people the pension plan is payingpensions to are still alive. This can either be done by writing tomembers or through a specialist agency.

Pricing basisThe basis used by insurance companies to price buy-ins or buyouts.Contrast to reserving basis.

Profit shareA provision in a bulk annuity contact for the insurance company tomake payments to the trustees, or to an agreed third party, if theexperience under the contract is better than anticipated in theinsurance company’s pricing.

Progressive or staged risk transferA buyout or buy-in transaction which is completed in several stages,often as part of a pre-determined premium payment plan based onasset performance. This allows risk to be transferred when thepension plan can afford to do so.

Reserving basisThe basis used by insurance companies to calculate the reservesthey must hold. These will generally be based on prudentassumptions and will have regard to FSA rules. It will generally bemuch more prudent than the pricing basis.

Residual longevity riskThe risk of members living longer than expected that is not coveredby an index-based longevity swap. The residual risk is due todifferences between the pension planmembership and the standardpopulation.

Ring-fencingA type of security arrangement under a buy-in, where certain assetsbacking a pension plan’s liabilities are only available for the benefit ofthat pension plan rather than other policyholders.

Solvency capitalThe additional capital that an insurance company must set aside, inaddition to the premium paid, when writing a buyout or buy-in. Thisprovides a buffer against adverse future experience.

Standard populationThe underlying population used to determine the payouts under anindex-based longevity swap – for example the population of EnglandandWales.

SwapAn agreement with a counterparty (often an investment bank) to‘swap’ types of liability exposure. For example, under an inflationswap a pension plan pays the bank if inflation falls compared toexpectations, but the bank pays the pension plan money if inflationrises. This hedges the pension plan’s inflation risk.

Synthetic buyoutSee DIY buyout.

Transfer value exerciseAn exercise where deferred members (and sometimes also activemembers) are given the opportunity to transfer their benefits out ofthe pension plan. An enhancement is often offered above thepension plan’s standard transfer terms, either to the transfer valueitself or as a cash payment outside the pension plan, tomake itmoreattractive for members to transfer.

Trivial commutation exerciseAn exercise to commute small pensions in the pension plan for acash lump sum. This can both reduce risk and save on futureadministration costs.

For a full list of our services seewww.lcp.uk.com



Notes

*

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All rights to this document are reserved to Lane Clark & Peacock LLP. This report may be reproduced in whole or in part, without permission, provided prominent acknowledgement of the source is given.LCP is a limited liability partnership registered in England and Wales with registered number OC301436. LCP is a registered trademark in the UK (Regd. TM No 2315442) and in the EU (Regd. TM No 02935583).All partners are members of Lane Clark & Peacock LLP. A list of members’ names is available for inspection at 30 Old Burlington Street W1S 3NN, the firm’s principal place of business and registered office.The firm is regulated by the Institute of Actuaries in respect of a range of investment business activities. LCP is part of the Alexander Forbes group of companies, employing over 4000 people internationally.

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LCP Pension Buyouts Report 2009 · For further information about pension buyouts, longevity hedging...

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Transcript of LCP Pension Buyouts Report 2009 · For further information about pension buyouts, longevity hedging...