Run-on vs buy-out? Key considerations for defined benefit pensions

UK defined benefit pension schemes that have found themselves in a surplus since mid-2022 are considering alternative options over the traditional buy-out with insurers. We explore the key factors pension schemes should consider in their decision making process.

Larger, well-funded, defined benefit pension schemes are increasingly debating run-on vs buy-out. There are schemes for which buy-out is currently affordable, in theory, based on their funding level, but for whom there may be near-term road blocks in terms of illiquid assets, data quality, market capacity, or sponsor willingness to pay an insurer’s profit margin. There may also be a desire to generate upside over an extended period in order to be able to ‘share profits’, e.g. enhance member benefits, fund defined contribution (DC) schemes etc.

Although there has been much discussion about why defined benefit schemes shouldn’t buy-out, we have seen very little debate on whether run-on actually makes commercial sense. By the time regulatory concerns and constraints are addressed, is the scheme going to be able to do much more than cover its costs? This is a key question for schemes and sponsors, and we need to cut through the noise created by the obviously conflicted advisors and address the actual underlying question. The key focus should be whether or not ‘run-on’ will actually benefit members.

“Larger, well-funded, defined benefit pension schemes are increasingly debating run-on vs buy-out.”

A key concern for trustees choosing to run-on is the ‘regret risk’ of missing the opportunity to buy-out when they could, but why is that the case?

Firstly, since pension schemes will be paying benefits to members for a long time (50 years+), there is a material probability of any scheme sponsor – unless you are a Local Government Pension Scheme (LGPS), for example – defaulting during the scheme’s remaining life.

Secondly, times of sponsor distress or default are highly correlated with general market downturns. Let’s assume that a scheme currently operates with a small surplus on a proxy buy-out basis, that the sponsor is reasonably strong, and trustees decide to run-on with a view to generating and distributing surplus to sponsor and members. But then in 10 years the sponsor finds itself in financial distress due to market conditions that mean the scheme is in deficit. This is wrong way risk for the scheme and its members – the weak sponsor can’t afford any additional contributions, and trustees wish they had bought out when they had the chance.

The above risk is not to be taken lightly. Trustees have a fiduciary duty to scheme members, and failure to act in their best interests has serious consequences. We think that most trustees will only really get comfortable with the potential regret risk if they feel that the investment strategy pursued in run-off has a high probability of maintaining (and of course growing) the buy-out surplus position and therefore benefitting the members.

We will come back to this idea of investing in order to maintain (hedge) the buy-out position later. However, there is another problem – the difference between an actuary’s estimate of buy-out price vs a transactable price of the liabilities. Unless a scheme has directly approached the buy-out market or done detailed preparatory work with a broker, in run-off it will need to allow a margin for error in its estimation of the buy-out price. There are plenty of examples of significant data and retrospective benefit rectification issues arising within schemes as they approach the buy-out market. Occasionally, the longevity assumptions adopted by the scheme actuary are simply not in line with those of reinsurers. This additional prudence needs to be funded, and can’t be distributed to members or the sponsor.

Not only does a scheme need to be able to generate and retain an initial ‘prudent surplus’ to cover the above risks/uncertainties, it needs to be able to maintain this surplus on an ongoing basis to be able to achieve the key aim of run-on – sharing upside between members and sponsor.

Three considerations on surplus extraction

These above considerations were mirrored in the DWP consultation on surplus extraction, where the three core requirements were:

• Surplus should only be extracted when member benefits are deemed safe.
• Trustees are ultimately responsible for managing the scheme funding levels.
• Surplus extraction should not be contingent on a specific use of the surplus.

In order for a pension scheme to maintain a healthy buy-out surplus in run-off – so trustees can feel comfortable in their decision to run-on – the value of its assets needs to move broadly in line with buy-out pricing. This means investing in the types of long-dated cash-flow matching assets that insurers use to back their liabilities and to price their deals. However, not all these assets are insurer-friendly, so corporate bonds and gilts may be the best choice as these are assets that most insurers will accept in-specie.

Since most insurers have very small allocations to gilts, having a larger allocation to corporate credit should provide a better buy-out hedge for pension schemes. Having a higher allocation to credit also generates more upside for pension schemes, which is the whole point of run-on.

Comparing pension scheme and insurer approach

Pension schemes who choose to run-on need to hedge their buy-out funding level. This greatly constrains their investment strategy. However, if they broadly replicate an annuity writer’s asset allocation then it reduces risk. This should also generate additional surplus over time (since we all know that insurers make good returns for their shareholders).

However, there is a problem. Schemes typically can’t actually replicate insurers’ asset allocation. Many are held tight in the grip of Liability Driven Investment LDI and can’t break free.

For example:

• A typical UK pension scheme has c.50% of its assets held in cash and gilts in order to provide collateral for its LDI strategy. 
• Despite the above, the scheme is still exposed to liquidity risk in the event of large interest rate moves.
• The scheme can’t increase its allocation to long-dated cash-flow matching credit, even though this would also provide an interest rate hedge (and generate more upside), because it also needs to put in place inflation hedges, and it can’t post corporate bonds as collateral for inflation derivatives unlike insurers.
• This means the other c. 50% of assets typically end up invested in short-dated corporate bonds. 
• These typically don’t pay as much as longer dated bonds, and since they only provide cash flow certainty for maybe 5 to 10 years, it is difficult for trustees to answer the basic question: “Will we have enough cash flow to pay pensioners in the future?”

If this is the best that a pension scheme can do in terms of a run-off strategy that broadly hedges buy-out pricing (an important part of which is hedging its interest rate and inflation risk), then it is not a very compelling commercial proposition in our view.

At present, medium duration corporate credit is yielding c. gilts+120bps*. Let’s assume expected losses due to defaults and downgrades are 30bps p.a., buy and maintain asset management fees are 5bps, LDI fees are 3 bps, and scheme running costs are £3 million per year. The breakeven minimum size for a pension scheme to begin considering running on is then £700 million. What would make a huge difference to this commercial assessment, is if pension schemes were able to more closely replicate insurer asset allocation – i.e. a higher allocation to credit, and incorporating high quality illiquid assets. Even without incorporating illiquid assets and assuming a strategy of 80% credit, the minimum size for a pension scheme to consider running on reduces to £400 million.

*market conditions as at 31/07/2024

A viable solution for DB pension schemes?

M&G’s Cashflow Driven Investing (CDI)+ Liquidity solution allows pension schemes to achieve this insurer-like cashflow matching investment strategy, while also incorporating insurer-friendly illiquid assets (at the scheme’s discretion).

The combination of insurer-friendly illiquid assets with long-dated corporate bonds allows schemes to reduce their reliance on LDI. Defined benefit pension schemes are able to take advantage of an insurance company’s favourable liquidity agreements with banks, enabling schemes to post credit against inflation swaps to provide inflation protection. A collateral backstop provided by M&G Life allows schemes to maintain target hedge levels even through times of extreme market stress. This results in a portfolio with reduced liquidity risk and a strategy that provides a natural hedge to buy-out pricing. 

“The combination of insurer friendly illiquid assets with long dated corporate bonds allows schemes to reduce their reliance on liability-driven investment.”

The solution can be for either all of part of a pension scheme. M&G, as both life insurer and investment manager, is relatively unbiased between schemes choosing run-on or buy-out. We do, however, believe that proper insurer-style asset management is a very sensible way to manage pension liabilities. Our focus is bringing solutions to the market that allow schemes to benefit from our expertise in this area.

M&G’s CDI+ Liquidity solution offers pension schemes the opportunity to partner with an insurance company during run-on, taking advantage of our expertise in managing our internal run-on annuity portfolios, and helping deliver a better commercial outcome for members and sponsors.

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