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UK 'bulks': weighty opportunities in a slim sector

A breed of insurers under-researched by credit investors is taking on the liabilities of more UK pension funds, potentially yielding attractive returns.

After years of headlines about the demise of defined-benefit (DB) pensions you could be forgiven for thinking there are few savers left in these schemes.

That is, until you discover that there are still £2.16tn1 of DB liabilities in the UK – close to £300bn more than the nation’s entire 2017 economic output. Many of the schemes, which offer guaranteed post-retirement income no matter how long the beneficiary lives, are finding it challenging to fulfil this commitment.

Troubled waters for DB schemes

The 5% interest rates of yesteryear that enabled schemes to generate healthy income from investments have been replaced by the near-zero rates of today, causing the funds’ liabilities to outgrow their assets.

There were some 1,878 schemes in surplus at the end of last year while 3,710 were in deficit2. Schemes with uncontrollable deficits have limited choices.

Figure 1. UK pension funds’ liabilities are outstripping assets

Source: “The Purple Book 2018”, published by the Pension Protection Fund.

If the company operating the pension loses control of its debts, it might collapse. This was the fate of UK multinational Carillion in January – a failure that will cost the firm’s pension savers at least 10% of their income.

Schemes in deficit can try to make high-octane investments in an effort to get back in the black, but this would contradict de-risking strategies aiming to provide steady long-term income for savers in or approaching retirement.

Or, lacking the investment sophistication to get back on track, a scheme could ask a specialist insurer for help.

The incredible bulks

Insurers can provide annuities – where capital today is exchanged for a guaranteed life-long income stream tomorrow – en masse to troubled pension schemes. This is known as bulk annuitisation.

These can either be provided on a person-by-person basis to members of a pension scheme that closes, or as one large annuity to cover some of a scheme’s liabilities if it continues to run part of its portfolio.

Bulk annuitisation can be carried out by general life insurers, including some of the UK’s biggest names in the sector. But there are also specialist firms which focus on ‘bulks’ – and we have paid attention to these under-researched credit issuers.

As interest rates are likely to remain low for many years, these businesses have growing pipelines of companies eager to offload their pension liabilities to a specialist.

Early-mover advantage

The bulks tend to issue 10-year subordinated debt, making them an appropriate long-term investment, with bonds sized between £250m-£350m. The sector is niche and today only Fitch provides ratings on the issuers, which in our assessment are essentially investment-grade companies.

Today only £93bn3 of pension schemes’ liabilities are insured through bulk annuitisation. In our view, as early movers in what could well become a much larger industry, the bulks are well positioned to grow.

In essence, their strategy is to manage the assets associated with a pension scheme’s liabilities effectively enough to make a consistent margin on them over the very long term. We believe that two core skills are required for a UK bulk to be worthy of investment.

The first is its ability to offload some of their longevity risks in the reinsurance market, which is crucial to ensure the long-term sustainability of their businesses and must be done in a cost-effective way. The second is the ability to manage investment risk sufficiently to be able to deliver on ultra-long-term liabilities.

Within this sector, we favour pure-play bulk-annuities providers: businesses focused solely on providing these services, rather than diversified insurers. For us, two companies fit the bill and we are excited about their long-term prospects.

Rothesay and PIC

Established in 2007, Rothesay Life is now one of the largest specialist bulk-annuity providers in the UK market. It has more than £37bn in assets under management (AUM) and insures the annuities of more than 750,000 individuals.

One of its competitors, Pension Insurance Corporation (PIC), is also a pure-play bulk. Founded in 2006, the business underwrites the annuities of more than 162,000 individuals and has £27.9bn in AUM.

The need for de-risking is here to stay

Overall, the risks of longevity and poor market returns due to low interest rates seem likely to persist for some time, and therefore so is the need to de-risk pension funds while addressing deficits.

Insurers are the only businesses with enough expertise in managing and redistributing risks to handle the problem, and so the UK bulks are likely to grow in significance as solution providers.

They are also under-researched companies in a niche sector, and we are committed to capturing the opportunities available.

Bulk annuities: buy-ins v buy-outs

When a pension scheme decides it is time to offload its liabilities to a provider of bulk annuities, there are two ways to proceed: buy-out or buy-in.

Put simply, under a buy-out the pension scheme is scrapped and investors become customers of the insurance company. In a buy-in, the insurer provides an annuity to a scheme that continues to run.

Bought out

  • Under a buy-out, the insurer takes over the entire responsibility for fulfilling the scheme’s liabilities.
  • The pension fund is usually wound up and its trustees’ duties cease.
  • Policyholders of the pension fund become clients of the insurance company.

Buying in

  • Under a buy-in, a pension scheme continues to run and policyholders see no change in their customer relationships.
  • The insurer takes over responsibility for providing regular income to the pension fund to cover a pre-agreed amount of its responsibilities to policyholders.
  • A buy-in may be the first step towards a full buy-out.

A UK bulk annuity buy-out: before and after

Source: Hermes. For illustrative purposes only.

  1. 1 Source: “The Purple Book 2018”, published by the Pension Protection Fund in December 2018.
  2. 2 Source: Pension Protection Fund 2017/2018 Annual Report & Accounts, published 12 July 2018.
  3. 3 Source: “The Purple Book 2018”, published by the Pension Protection Fund in December 2018.

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