The pension risk transfer (PRT) market in the United Kingdom received a boost in November last year as the U.K. government announced proposals to relax some of the capital constraints for insurance companies under the Solvency II regulatory regime, which should provide insurance companies with additional room on their balance sheets to complete more PRT deals with defined benefit plan (DBP) sponsors.
It’s unclear when the proposed amendments to Solvency II will be passed by the UK government, but in the meantime, the country’s PRT market seems to be perfectly fine just the way it is; consulting firm WTW says that 2023 could be the best year ever for PRT deals in the UK with the firm forecasting approximately £40bn of deals this year, according to its recent Shifting up a gear; De-risking report 2023, which would be a record.
The bullishness stems from the robustness of current funding levels for U.K.-based DBPs. The rise in interest rates last year has had the knock-on effect of improving funding levels through higher liquid fixed income returns, and even if rates plateau this year, or fall in future, according to according to Louise Nash, a Director in WTW’s UK Pension Risk Transfer team, the generally stronger funding levels of DBP sponsors in the UK is sustainable.
“Stronger funding positions make it more affordable for pension schemes to come to insurers, of course, but then they look to try and hedge against interest rate risk. Once pension plans are in a strong position, they want to hold on to it – they’re very proactive in that way. I don’t see funding levels falling back and so I’d actually expect demand to continue to grow in coming years.”
Data produced by WTW suggests that historically, market activity in the second half of the year outstrips the first half. That’s true for 2022, but to a lesser extent; the £16bn of deals in the second half of last year was only £4bn higher than the £12bn observed in H1, the smallest gap in the past five years. Reasons for the trend include a more flexible price environment due to insurance companies needing to hit their full year targets, but Nash cautions plan sponsors that waiting for better pricing isn’t always the best strategy.
“A lot of insurance companies work on year end business targets and if they have not met volumes for the year, there can be more flexibility on price. But if they have met their targets, plan sponsors might miss the boat in terms of discounts, especially with those who care about half year reporting. Pricing and deal activity really does vary year by year so it’s important for plan sponsors to be aware of these business cycles and therefore when they are likely going to get the best deal for them.”
It’s not a completely rosy picture, of course. The UK’s ‘mini budget’, announced in October 2022 by then Chancellor of the Exchequer Kwasi Kwarteng, had the effect of sending the country’s pensions market into something of a frenzy, as many plans rushed to liquidate assets to meet margin calls on derivatives exposures in the wake of surging gilt yields. Pension plans that were previously looking at the partial buy-in option – a common type of PRT transaction for schemes that aren’t candidates for a full buy-out but that still want to de-risk some of their book – might find themselves in a more difficult spot.
“Risk is more at the front of pensions’ minds as a consequence of what happened in the autumn; they’re looking to hold more liquid assets. But buy-ins are illiquid, and many plans are trying to square the circle of having enough assets to support their hedging program, and enough to provide a good enough return to get them closer to fully funded. There are some schemes where buy-ins still make sense and we’ve seen some strong pricing in the last few months. But many others will have to think a lot harder about pursuing a partial buy-in because the effectiveness of the transaction will be diminished,” said Nash.
Also, even for those that are good candidates for a full buy-out or buy-in, it’s not as simple as hiring an advisor and knocking on an insurance company’ door. Illiquid investments such as third party pooled funds need to be liquidated, and exiting via the secondary market can often mean accepting a discount, which then changes the funding profile of a plan. Other routes to exiting illiquid investments, including a loan from the sponsor and transferring the assets to the provider, exist; but each has their own challenges, including sponsor willingness to take the risk in the former, and investment strategy alignment in the latter. And then there’s the pension data issue, which is a big one.
“Pension scheme data can lack quality and so there are lots of projects that need to be undertaken to make sure the data is correct. Insurers need accurate data to work out what the liabilities are so they can price the deal correctly. Having accurate data is a critical part of the de-risking journey,” said Nash.
Whether WTW’s £40bn prediction ends up being correct remains to be seen. But for Nash, the bottom line is that the world’s most active PRT market is almost certain to get even busier.
“There are around £1.5trn of defined benefit pension plan liabilities in the UK, and most of that hasn’t been touched yet,” she said. “There are new insurers coming to market and more talking about it. Obviously, it’s hard to predict the future, but there’s no reason to think that activity is going to fall off. There’s a lot more to come down the path.”