1. How Does Buy-In Pricing Work?
This blog begins a new series of articles from Aadarsh Gautam, Associate at Redington, tackling technical topics from the pensions investment world, to make the information as accessible as possible.
The pension world is jargon-filled and technical. I remember 3 years ago, in my first real full-time job, not having a clue what was being said to me.
Perhaps you’re used to sitting in Trustee board meetings, being talked at by advisors and investment managers and feeling similarly perplexed. If so, this is the blog for you.
By the end of this blog you’ll know:
i. How buy-in pricing works
ii. How to know if pricing is good or bad
Setting the context
For pension schemes, the light at the end of the tunnel is in sight. It’s come into view far quicker than expected, and travelling at this speed, everything might look like a blur.
When I first joined Redington, only a small amount of time was dedicated to teaching new graduates on buy-ins/buy-outs. Fast forward three years, the world has changed and our new graduates are learning about this topic a lot earlier than I did.
How did we get here?
A combination of strong investment returns and a decline in mortality improvement rates[i] have propelled pension schemes to improved funding positions[ii], and some are having discussions with insurers that would’ve been the stuff of dreams in the past few years. How can the scheme implement a transaction to transfer its liabilities to an insurer (buy-out)? Can the scheme insure a portion of its liabilities (buy-in)?
Now for a second, imagine being in a Trustee board meeting and an actuary says something along the lines of ‘currently buy-in pricing is favourable relative to current Gilt yields.’ Potentially you know exactly what this means and you understand how buy-in pricing works – in which case, no need to read ahead!
Alternatively, you might be like me, and this way of describing pricing isn’t immediately intuitive. Why isn’t the price quoted like any other thing I can buy i.e. with a pound value?
How can a Trustee evaluate whether a buy-in is a good deal for its members, if the way it’s priced isn’t clear?
Hopefully, by the end of this blog this will be much clearer, helping to smooth your drive to the end of the ‘pension scheme life-cycle’ tunnel.
How does pricing work?
At its core, a buy-in is like any other insurance contract – I pay a premium to insure something I have responsibility for, let’s say my car. The complication is that rather than a tangible entity today (a car), I’m insuring a series of cashflows (i.e. pension payments) that extend far into the future.
To do this, an insurer needs to create a portfolio of assets that very closely match the portion of liabilities being considered for a buy-in.
So rather than quoting a pound amount to express how much the insurance costs, the quote is in terms of an expected return on the insurance policy.
Let’s say I have two buy-in quotes for the same buy-in, Gilts + 50bps and Gilts + 70bps. Which one is more favourable?
The answer is Gilts + 70bps – this essentially means that I am paying the same pound amount for either buy-in and getting more expected return. It’s like saying I get a more comprehensive car insurance for the same pound amount.
Is pricing good or bad right now?
To answer this question, let’s take a step back. The point of a buy-in is to match a portion of the scheme’s liabilities by owning an asset that moves in line with liabilities. The most liquid, easily available instrument to achieve that investment objective is Gilts.
If I have an asset that can achieve the same function as my Gilts (i.e. generates cashflows that match my liabilities and help me ensure I can pay pensioners over a long period of time) but gives me a better return, then clearly that’s a great thing.
At current market levels, that is exactly what schemes can do – schemes can exchange Gilts for a buy-in policy, maintaining or improving the return on the overall asset portfolio.[iii] As well as this the buy-in covers off the risk of people living longer, which a Gilts portfolio would not.
Buy-now, think later!
If pricing is so favourable, why doesn’t every scheme transact now?
Alas, if it only it were that simple – a buy-in is a complex transaction, which means that price is not the only factor that determines whether it makes sense to transact or not.
A buy-in is an illiquid asset – this means that once a scheme has transacted a buy-in, those assets are no longer available for a scheme to rebalance the overall portfolio. A lot of work therefore needs to be done to make sure that the transaction is affordable for a scheme from an investment strategy perspective. The scheme also needs to make sure that insuring the liabilities of one set of members, does not adversely affect its ability to meet its obligation to the remaining members.
If you’d like to know more about what factors a Trustee board needs to consider before transacting a buy-in, keep an eye out for the next blog which will cover exactly that.
What are the key takeaways?
Buy-in pricing is expressed as an expected return. The higher the expected return, the more favourable the pricing – the scheme is paying a certain amount for an asset that matches a portion of its portfolio and getting greater returns.
At current buy-in pricing levels, transacting a buy-in (by paying with Gilts, which is typically what insurers look for) means a scheme can maintain or improve its overall expected return and obtain an asset that perfectly matches its liabilities.
Buy-ins are complex transactions and pricing is one of many variables to consider.