The pension fund transfer business needs an urgent review

Unlock Editor’s Digest for free

FT editor Roula Khalaf selects her favorite stories in this weekly newsletter.

There is a comfortable consensus in UK pensions that the funding of pension schemes has recently improved so much that they can safely head for the so-called bottom line.

This happens in two ways. One is the transfer of risk to an insurer through a buy-in or bulk annuity purchase, where a pension scheme takes out an insurance policy that pays all of its members’ commitments. The other is a buy-in, where the scheme transfers all its liabilities to the insurer.

The risk transfer market is hot. Actuarial consultants WTW predicted earlier this year that 2024 would be the busiest year on record, with £60bn of bulk annuity transactions. However, this boom is paradoxical.

The psychology is understandable after years of employer sponsors pouring billions into their pension funds to cover growing deficits. Passing on the risk of future shortfalls is one way of locking in a favorable financing position. Longevity risk is also transferred to the insurer.

However, there is a real question as to whether sponsoring companies and trustees have colluded in what William McGrath, chief executive of C-Suite Pension Strategies, calls a damaging overreach of risk reduction.

According to the Pension Protection Fund, pension schemes were in surplus in March 2023, worth £359 billion, with liabilities assessed at benefit levels equivalent to those of the PPF. This was a funding ratio of 134%. More than 80 percent of the schemes were in surplus. On the tougher valuation basis, in line with market prices, the surplus was still £149.5bn, or 111.9 per cent.

Note, too, that past deficits were arguably a fiction—the freak product of ultra-low interest rates after the financial crisis. This caused the value of future pension liabilities to increase as they were discounted by lower rates. As rates normalize, a transfer of risk to insurers would now preclude benefits such as paying discretionary increases to scheme members and reducing company contributions.

In particular, if pension funds continue to retain responsibility for meeting pension obligations – the so-called “operation” – any surplus could be recycled into worn-out defined contribution schemes.

At the same time, a run-on allows pensions to be funded with a healthier appetite for risk across a wider range of asset classes than insurers tolerate. This highlights the wider economic consequences of shifting risk to insurers.

Graham Pearce and John O’Brien of consultants Mercer point out that the risk transfer transaction process is inefficient and expensive. Most plans must revise their investments up front to meet insurers’ demand for a highly liquid, low-risk fixed income portfolio – only for insurers to potentially reinvest in illiquid fixed income after the deal. Pension plans are thus denied the opportunity to earn an illiquidity premium for some time. Insurers, they say, must add the cost of delays in reinvesting assets into their original premium price.

Such risk transfers reinforce the bias of the UK financial system against equity. For good measure, the Prudential Regulation Authority was concerned that the insurance sector could have absorbed too many assets too quickly, giving rise to financial stability risks. The concentration of only nine insurers in the business also indicates the risk of one-way markets.

Whether acquisitions and buy-ins have provided value for money is difficult to answer as the market lacks transparency. What is clear, however, is that the dramatic increase in demand is causing capacity constraints. This creates an adverse pricing environment for pension funds.

Turning the Page, a public policy think-tank recently created by Michael Tory, a founder of Ondra Partners, estimates that the profit realized from total risk transfers to date by defined benefit pension funds is 12 billion pounds sterling – 15 billion pounds. These profits, by the way, also include those from purchases by the large insurers’ own pension systems.

This is a very nice reward for such a low risk business. With industry sources estimating that just four players account for nearly 80% of the market, there is a clear case for the Competition and Markets Authority to take a look. And McGrath argues the government should introduce a windfall tax on insurers.

One-off fees are often bad economics. But in this case, a small oligopolistic group of insurers operates in a highly distorted market where their actions have implications for the wider economy. This should certainly give Chancellor Rachel Reeves pause for thought.

[email protected]