The bulk annuity market is buoyant, with a record of £20bn of transactions completed in H2 2021, resulting in a 2021 total volume of almost £30bn. The demand for insurance de-risking from pension schemes is clear, and is expected to grow in future, with many commentators predicting in excess of £30bn of transactions in 2022. This is driven by corporates looking to remove legacy schemes from balance sheets, and trustees progressing schemes along long-term journey plans, many of which will ultimately be aiming for buy-out.
Set against this is a backdrop of significant global economic volatility - in particular, since the start of the calendar year. Just as we emerged from the pandemic, and the global economy was finding its feet, the outbreak of war in Ukraine sent shockwaves through markets.
Here we consider what impact the recent economic environment has had on insurance pricing, and on the affordability of an insurance transaction for pension schemes.
Economic environment
The impact of the Russia-Ukraine conflict and high levels of inflation have dominated economic markets over recent months. The net impact on pension scheme buy-out funding levels will vary materially for schemes in different circumstances, predominantly driven by investment strategy, but for many schemes, recent economic conditions may provide an opportunity to step closer towards their full buy-out end goal.
Rising Inflation
The rising cost of living has been headline news, with price rises being driven from increasing energy and fuel costs, and a resurgence of demand for services following a hiatus during the COVID-19 pandemic. Short term inflation as measured by the Consumer Prices Index reached 9% over the year to April 2022.
Of greater relevance to pension schemes is the expectation for long-term levels of inflation.
The spot rate of market implied breakeven inflation on 15-year gilts increased markedly, increasing by c0.5% to c4.2% over the year to April 2022. All else equal, higher inflation leads to higher liabilities for pension schemes, however the impact may be less severe than first thought:
- Schemes with a material level of benefits which are fixed in nature will have a limited exposure to increasing levels of future inflation expectations.
- Many schemes have benefits which are linked to inflation, but capped at a certain level. For example, pension increases in line with inflation subject to an annual maximum of 5% or 2.5%.
Both of these features provide pension schemes with protection against escalating levels of inflation.
The net impact rising inflation has on a particular scheme’s funding level will also be heavily influenced by the level of inflation hedging adopted within the investment strategy. Schemes with greater levels of inflation hedging will have seen corresponding increases in their inflation-linked asset valuations to offset the increase in liabilities. In certain instances, for example those with a high level of inflation hedging and capped inflation linked benefits, the recent increase in long-term inflation may even have led to an increase in funding level, as the inflation-linked assets may not be subject to the same caps which apply to the liabilities.
Market volatility
Tightening of monetary policy as central banks have raised interest rates has fuelled more market volatility and economic instability. Global equities have been volatile since the start of the year, with many regions posting large losses. Whilst the UK equity market has rebounded since the immediate aftermath of the outbreak of the Russia-Ukraine conflict (primarily due to its larger exposure to commodities and energy stocks), many global equities (such as US equities) have seen much of the gains built up over 2021 lost since the start of the calendar year. However, insurer pricing is unlikely to be directly linked to equity returns, and many schemes with a de-risked investment strategy will have had a limited exposure to these losses.
The economic uncertainty has also resulted in credit yields (and credit spreads over gilt yields) increasing. Insurer bulk annuity pricing is traditionally related to yields on credit-linked assets, and increasing credit spreads are likely to make buy-out pricing more attractive to a pension scheme which may predominantly be holding gilts.
As an illustration, the Pension Protection Fund (PPF) 7800 index for April 2022 estimates that the aggregate section 179 funding level for the defined benefit pension schemes potentially eligible for entry to the PPF was 114%. This compares with 107.7% for December 2021 and 103.1% for April 2021. This reflects PPF compensation and so is likely to overstate the equivalent funding level based on scheme benefits; but it does give an indication that the overall impact on solvency funding levels of the economic landscape in recent times has been positive.
Other considerations on affordability of insurance
There are also regulatory developments in the pipeline which could have an impact on bulk annuity pricing. Potential reforms to Solvency II (the regulatory regime overseeing the EU and UK insurance market) are currently being consulted on. If implemented, these could give UK insurers more capital and investment freedom, potentially leading to more competitive bulk annuity pricing.
However, many bulk annuity transactions are dependent on a top-up contribution being paid from the sponsor, to bridge any remaining gap to full buy-out funding. The current environment means that the medium-term economic outlook remains particularly uncertain for many employers, and corporate boards may decide to err on the side of caution and bolster company reserves in place of funding schemes above agreed recovery plan levels. This may delay schemes reaching their end game.
Opportunities for some
Whilst there has been significant economic turmoil in recent times, for some schemes this can present as an opportunity. Trustees and sponsors should continue to monitor their solvency funding levels and ensure their investment strategy remains appropriate for their objectives in light of the current economic environment. Well prepared schemes, and those with resilient investment strategies, can act quickly to capitalise on these opportunities when they arise.