Triggers for buy-in – playing the 'waiting game'

In a blog earlier this year, we discussed the idea of ‘catching’ buyout when reaching full funding on a buyout basis.

However, pensioner buy-ins before reaching full funding can also be a good idea[1]. If they are funded out of cash and liability-driven investment (LDI) and provided collateral isn’t too much of an issue, buy-ins prior to reaching full funding can allow schemes to both boost returns and reduce risk.

In some cases, pensioner buy-ins may compromise the ability to hedge or generate excess returns efficiently. For the purposes of this blog, I’ve excluded such schemes[2]. The question I then investigate is what should pensioner buy-in triggers look like? There are two types of trigger that may make sense:

• Market-based triggers. The idea here is that if the buy-in looks cheap then perhaps schemes shouldn’t wait around. Conversely, the more expensive the buy-in appears, the more likely it is worth waiting for prices to improve. Buy-in spreads (a way of expressing pricing relative to gilts) tend to mean revert, so it isn’t crazy to take a view on cheapness.
• Triggers based on appetite for risk. There are many reasons why a scheme’s appetite for risk may change. Two examples relating to funding levels are:
  • It is not possible to ‘catch’ buyout instantaneously in practice. As funding levels improve, this may encourage some degree of de-risking (into buyout-aware strategies), notwithstanding that there can be some merit to embracing volatility
  • From a behavioural perspective, as funding levels improve, trustees may seek to de-risk their strategy to avoid potential feelings of regret should growth assets subsequently tank

Helpful heatmaps

Capturing these trade-offs in a stochastic model we built, the heatmap below shows the results for a scheme under some plausible assumptions, listed at the end of the blog. The findings show how the ‘ideal’ proportion of pensioners to buy-in varies with the overall return target of the scheme and with how cheap buy-ins currently appear. A few things to note before looking:

• The calculations are based on minimising funding level risk for a given return target
• Buy-ins may be accompanied by a change in the allocation to return-seeking assets so that the overall scheme return target is met
• For illustration we’ve assumed that pensioner buy-in liabilities are 50% of scheme assets.

The basic idea is that the heatmap could be used to inform a set of triggers. We can see that:

• Moving down the columns we buy-in fewer pensioners as the return target and appetite for risk increase.
• As the current buy-in spread increases (moving left to right), buy-ins become more attractive, so they’re used more.

So far, so good! What may be more surprising is that the map isn’t a sea of green 100%’s whenever the buy-in price is gilts or better! This is true even if spreads are at or above their average level (here assumed to be 0.1%). For example, with buy-in spreads at 0.2% and a scheme return target of gilts + 0.7%, the heatmap says you should only buy-in around 45% of pensioners. How does that make sense?

The key is that there is a potential benefit to ‘playing the waiting game’ – waiting for the chance –not the guarantee – that spreads widen to more attractive levels. By remaining in cash and LDI schemes sacrifice expected returns and incur longevity risk, at least in the short term. But the reward is optionality – they effectively keep the chance of being able to lock in a great price in the future, that could eventually make it a worthwhile strategy[3].

An important point here is that buy-ins are irreversible – if you buy-in at gilts + 0.2% but then buy-in spreads widen out to 0.5%, there is no price drop refund!

We believe schemes should be less willing to play this game if their liabilities are shorter duration (in our analysis we assumed pensioners have duration 14 years) or if spreads are higher. Beyond a certain point – if spreads exceed about 0.7% – the game isn’t worth playing no matter what their risk appetite is (for this setup). The game would also be more worthwhile to play if spreads are more volatile.

The benefits of phasing

Other reasons to adopt a phased approach to buy-ins include the pensioner pool growing as the scheme matures. The heatmap promotes phased buy-ins as pricing improves, which may help with transaction timing. Another related benefit of using a series of smaller transactions is that the ‘asset sourcing/transition risk’ is lower. This could otherwise be a concern for large schemes, although it might also be dealt with by a well-prepared large transaction.

Worth the wait?

To summarise:

• The rationale for buy-in triggers is fundamentally different to that of full buyout or buy-in. For a full buyout or buy-in, the aim is to avoid taking unnecessary risk once the scheme is fully funded. For a pensioner buy-in, in contrast, it comes down to market conditions and appetite for risk. Appetite for risk can, in turn, be influenced by myriad factors (including the funding position)
• A buy-in can be priced better than gilts but it can still be logical to not act immediately, or to scale down the purchase. This is because there can be some benefit to playing the ‘waiting game’, particularly (but not only) if buy-in spreads are below their long-term average
• Models may help set a framework for suitable triggers

Watch this space for how this and other research can translate into practical triggers!

Key model assumptions:

[1] ‘Catching’ pensioner buy-ins makes little sense – only catching full scheme buyout makes sense.

[2] Although we have actually checked that the solutions we present can support full hedging assuming return-seeking assets have an expected rate of return of gilts + 3.6%.

[3] I must admit I didn’t appreciate the importance of the potential value of waiting until recently! Previous buy-in analysis explored other trade-offs but did not capture the benefits of playing the waiting game.