Captives for defined benefit pensions
Defined benefit pension risk is back in the headlines as a result of some high-profile company failures, including those of Carillion and BHS. Unsurprisingly, most defined benefit schemes are now closed to new members. However, there remain concerns about the ability of the employer’s covenant to make up any shortfall in legacy scheme funding.
Over the last decade or so, in a changing economic environment with low interest rates, defined benefit pension schemes have become a millstone for many employers and are quite simply unaffordable for some. What was seen as an acceptable part of an employee’s package is now perceived as “gold-plated” and is often a major contributor to material additional debt on the balance sheet.
Successful businesses in sectors such as manufacturing did not anticipate the impact of legislative change, lowering actuarial discount rates and the consequent level of long-term risk when these schemes were first established. Many are now exposed to material investment risk, interest risk, inflation risk and longevity risk.
This has led to a quest to find the most appropriate way to handle such risks, with many trustees looking to a buy-in or buy-out so that they are no longer bound by the employer’s covenant but instead reliant on an insurance policy and sponsors looking to remove the risk from their balance sheet and cash flow.
A buy-in is an investment by the scheme and mitigates risk, usually in relation to pensioners, by consolidating them into an insurance policy as a way of matching future pension payments while the sponsoring company retains overall responsibility for the liabilities and oversight.
In a buy-out all liabilities are sold on to an insurance company which then takes on the associated risk, discharging the company of any future obligation. However, buy-ins and buy-outs both carry an associated cost to cover the insurers’ risk premia plus the cost of capital and meeting the relevant regulatory requirements.
As a result in recent years captive insurance has come to play a greater part in the risk management of defined benefit schemes as an alternative to some of the more traditional solutions, especially when the relevant liabilities run into billions.
It was in 2011 that a captive was first widely acknowledged as an alternative risk management vehicle in these circumstances. A US parent company accumulated material pension liabilities across the UK and Ireland as a result of a succession of acquisitions over the years with each being a financially separate entity.
A Dublin-based captive was used to buy-in the existing schemes, creating significant efficiencies as the result of the pooling of investments between schemes as well as providing the sponsor more direct control and influence over the investments within the captive and the means to retain the upside of good investment returns or surplus, as opposed to these being retained within the scheme or by a third party insurer.
For some, reluctant or unable to meet the costs of a bulk annuity with an insurer, self-sufficiency often becomes the long-term target, whereby the scheme is deemed to have sufficient assets to match the liabilities and eliminate the majority of investment and inflation risks. For many of those heading on this trajectory longevity risk soon becomes the dominant and most material unhedged risk, hence the emergence of longevity-only risk transfers through longevity swaps.
In 2014 there was the first use of a captive to enter into a longevity swap, whereas previously investment banks or insurers had fronted these transactions, reinsuring the majority of the longevity risk themselves. The captive structure used incorporated cells which ensure a complete financial ring fence around each longevity swap, allowing further swaps to be executed in future when current deferred pensioners come into force.
Guernsey was chosen as the domicile for this transaction due to a combination of fit-for-purpose legislation and the Guernsey regulator’s being open to consider innovative new uses for captives. Captives have of course been used to access reinsurers in a variety of markets for a number of years but the innovation here was around pension trustees setting them up to directly access longevity reinsurers and removing the need for a third party fronting insurer.
In 2015 the first longevity swap was executed in Guernsey using a pension trustee-owned Incorporated Cell Company, followed by two similar transactions in 2017 and one earlier this year. One of the key attractions of this structure to trustees was confirmed when one of the earlier transactions converted from a longevity swap to a buy-in, one of the first occasions when this has been achieved. Crucially this confirmed that the theory underlying most longevity swap transactions—namely the contractual ability to novate the swap to a third party insurer in the event of a subsequent buy-in or buy-out—was confirmed in practice.
With a trustee-owned captive the renegotiation of the swap in these circumstances is vastly simplified by facilitating direct discussions between the trustee and the reinsurers.
As we head into 2019 there continues to be strong demand from pensions schemes for longevity swaps as well as buy-ins and buy-outs and it is expected that this practice will continue to evolve.
To date, where captives have been used, the economics and bespoke nature of many of the transactions has been seen as suitable for larger pension schemes. However, there are already moves to simplify and standardise documentation to encourage lower liability value transactions at least in the hundreds of millions.
In effect, this will increase the volume of longevity swaps by decreasing transactional size and make deals less complicated and more routine. Instead of having a longevity swap tailored to a particular risk it should be possible to take a majority-fit proxy. Naturally, this is likely to encourage a broader take-up and result in more employers having some form of longevity risk management, either as part of a self-sufficiency solution or for those on a longer-term path to ultimate buy-out.
This should be welcome news for trustees wanting to remove longevity risk and for fiduciary managers whose clients are seeking an alternative to what might be perceived as a relatively expensive buy-out with an insurer.