Pension buy-outs in Europe: is Britain set to rule the buyout wave?

Emma Oakman looks at whether the rest of Europe is likely to follow in the UK’s pensions buyout footsteps

The pensions buyout market in the UK is reaching fever pitch as the credit crunch shines a spotlight on the risks of volatile pension liabilities and rapidly increasing life expectancy. The temptation for trustees and corporates to offload their risk to the plethora of specialist players is proving hard to resist, especially as wider credit spreads and fierce competition in an increasingly crowded market are driving prices downwards.

As the UK buyout market prepares to quadruple to over £10m in 2008, attention is turning towards Europe’s other large pensions markets, most notably Germany and the Netherlands, where the model seems fitting.

But some experts question whether a perfect storm is driving UK demand beyond what other countries would likely achieve.

The rapid growth experienced by Paternoster, one of the largest players in the UK buyout market based on 2007 volumes, is evidence of the boom in Britain: during the first 27 weeks of 2008 alone, the firm transacted £5.5bn of business, the value of the whole buyout market last year.

Legal & General, again one of the largest, is also enjoying considerable success with 350 per cent growth in its buyout business in the six months to 30 June compared to the same period last year.

Estimates show that there is still plenty of room for further growth: £10bn is only one per cent of the potential market for private sector DB pension schemes in the UK.

According to Graham Withers, director of independent trustee firm, HR Trustees, this is a phenomenon that is very real but won’t last forever: “The buyout market is going through a purple patch at the moment and it is a once in a generation opportunity. We are unlikely to see another period with a similar level of competition and such wide credit spreads.”

Hugo James, sales development director for Legal & General’s bulk annuity business, believes the compound effects of international accounting standards and longevity have been the biggest triggers.

“In the past, buyouts happened where a sponsor went bust,” he says. “Over the last two years, the market has really taken off and large, solvent sponsors have taken action driven by increasing awareness of liabilities’ volatile nature and nervousness about longevity.”

Historically, he believes the impact of increasing longevity has been underestimated and, because of the funding implications for corporates, schemes have not been as conservative in their assumptions as insurance companies.

“Now that funding levels are reported directly in balance sheets, sponsors have to take a more sensible approach,” he says, “but raising longevity assumptions can wipe out all the benefits of the last ten years’ strong economic growth.”

Longevity risk and market volatility are not unique to Britain, however. Germany, in particular, is teetering on the edge of recession with new accounting standards coming into effect next year, bringing them in line with IFRS17.

“Germany represents the biggest potential opportunity in continental Europe,” says Robert Gardner, investment consultant and co-founder of Redington Partners. “Pension fund obligations are unfunded and liabilities are
not properly accounted for, but this will change with the new accounting rules.”

Gardner argues that, for many schemes, it will be more efficient to take pension fund liabilities off balance sheet or explore externalising options, such as buyout.

This view is shared by Royal Bank of Scotland and German insurer Ergo, which have already joined forces to offer a pension liability service to German corporates in view of the new rules.

Mark Wood, founder and CEO of Paternoster, is not so convinced: “The question is the extent to which German corporates are in a position to fund schemes to buyout levels.”

In the UK, he explains, companies have aspired to reach fully funded status, which is close to buyout level. “In a pay-as-you-go culture, such as Germany’s, corporates would need to immediately capitalise future benefits, which is quite a big demand to place on their financial capital.”

Richard Farr, SwissRe’s head of pensions, agrees adding: “It is hard to envisage considerable take-up of buyouts in Germany as traditionally strong employer covenants make it culturally less acceptable.”

To some extent these arguments have already been proven.

External pension vehicles, known as Pensionfonds in Germany, are not structurally dissimilar to buyout as they require that liabilities are calculated on a very conservative basis, similar to that used by insurance companies for pricing annuity business.

The market has been slow to take up these structures, however, as the amount needed to transfer the liabilities is far more than companies would typically hold on their accounting books, according to Mercer.

Far more popular is the Contractual Trust Agreement (CTA) that ring-fences certain assets for the benefit of the pension fund, which cannot then be used by the corporate for other purposes such as capital expenditure or acquisitions.

Something comparable, however, could also emerge in the Netherlands, where Gardner believes the model of large self-managed schemes could lead to internal buyouts. “This would involve getting the investment mix right combined with longevity hedging in back to hedge the liabilities, which is effectively what many buyout providers are doing,” he says.

Pension fund wind-ups are already a theme in the Dutch market, which Henk Van Embden, partner of Lane Clark & Peacock in the Netherlands, says is a result of the 1 January 2008 deadline for schemes to comply with the Pension Act. “The regulations have had quite an impact on pensions in terms of additional governance burden and stricter funding requirements,” he says. A number of smaller schemes have already decided to terminate by selling to insurance companies.

Van Embden believes inflation concerns could accelerate the market going forward: “The impact of new premiums will not be enough to compensate for inflation, which will push more schemes towards buyout.” But, he says, the business is unlikely to grow to a similar scale as the UK.

Wood also questions whether the motivation for buyout would ever be as strong in Holland: “Pensions in the Netherlands have considerably more flexibility in setting payment levels than their UK counterparts. If markets move and capital is short, benefits can be shifted accordingly.”

As a result, the cost of crystallising future benefits through a buyout is unattractive as they would likely be set at a higher level than would otherwise really be paid, he adds.

And, while Germany and the Netherlands could in theory move in the same direction, there are some unique factors driving the success of the UK market.

“The increase in life-expectancy has been much more significant in the UK than anywhere else in the world,” argues Wood. “Although longevity has been increasing everywhere, the proportion of GDP that the UK has historically spent on healthcare has been significantly below other European Community countries. This is changing as the
UK harmonises with Europe to a level that is consistent with its economic standards.

“As a result,” he says, “life-expectancy in the UK is increasing at a rate of five hours a day.”

UK schemes, therefore, have to more rapidly reappraise their longevity assumptions, significantly impacting balance sheets and affecting directors’ ability to run sponsor companies.

This is compounded by a number of other factors: pressure from the International Accounting Standards Board (IASB), who have suggested a risk-free rate to discount pension liabilities; the prospect of rising levies from the Pension Protection Fund due to more volatile scheme risk over the last year and an uncertain long-term outlook; and the existence of a regulator, who is prepared to intervene in how schemes are run and funded.

Trustees also have to consider the merits of fully capitalised and secured payments from an insurer, versus a trust based system that is dependent on a corporate sponsor for its funding.

“If a sponsor is willing to fund a scheme to buyout level and secure future benefits, that is bound to be attractive,” Wood says.

“It is the crushing weight of all these factors together that is driving the take-off of the UK buyout market,” he says. “There is no recognition of a similar combination elsewhere.”

For now, at least, Britain looks set to rule the buyout wave.

Written by Emma Oakman, a freelance journalist