There is no doubt that the rising interest rate environment has shortened the time to DB endgames significantly, leaving asset managers pondering the relevance of their solutions as many schemes rapidly approach some form of risk transfer. But why exactly are buy-outs so appealing? Improved funding levels are only half the story. 

 

 

The mallowstreet Trustee Report 2022, in partnership with Janus Henderson Investors, shows that 82% of trustees now struggle with the growing regulatory complexity of their jobs – a proportion which has been increasing steadily since 2019. 

 

All of the challenges confronting UK pension schemes have to do with regulation: DB schemes are focused on agreeing endgame plans with their sponsors, equalising GMP benefits, and getting member data in check especially if they are looking to conduct a buy-in or a buy-out. But the list does not stop there: trustees are also grappling with ESG reporting, new ESG requirements under the single code of practice, the new DB funding code, pension scams and much more. 

 

 

Covenant risk remains one of the lesser considered risks on the pensions agenda – and this may be because the current covenant grading from ‘strong’ to ‘weak’ is masking some of the volatility in employer business outlooks. Indeed, covenant risk is a top concern for 4% of schemes with strong sponsors, and 13% of those whose sponsor covenant is tending to strong – but this proportion skyrockets to 43% when the covenant weakens further. 

 

 

A huge part of the problem is the dominant way to analyse covenant risk – 78% of all schemes take a qualitative approach, which mainly relies on case-by-case analysis, while only a third make use of scenario analysis. Stochastic and probability-based approaches are largely unpopular. 

 

 

To make matters worse, over half of schemes with 10 or more years till their endgame only have visibility over their covenant strength up to the next three years. While it is hard to predict the future this far out, this mismatch in horizon should be prompting a more robust and proactive approach to covenant risk mitigation. 

 

 

However, 70% of UK schemes primarily rely on information sharing protocols to mitigate covenant risk. Only a third of schemes have secured guarantees and security over assets (or plan to do so). The use of dividend-sharing mechanisms and other contingency assets is very rare on average, despite their importance when the covenant and/or the funding level of a scheme deteriorates. 

 

 

Indeed, TPR states that less than a fifth of all schemes in the UK have contingent funding – which is arguably the only way to address covenant risk if there is no buy-out. This leaves troubled schemes more vulnerable, and merely sharing information about negative developments is hardly a proactive approach.

 

 

About half of schemes with a weaker covenant are only funded to a level below 90%, leaving  them faced with significant funding gaps despite improvements from rising interest rates. 

 

 

When confronted with a deteriorating funding level, schemes are left with only one move: delay their endgame. This is evident in the fact that a majority of schemes with a funding level below 80% will only achieve their endgame in 10-15 years from now. 

 

 

 

Against this backdrop, it is not surprising to see buy-outs overtake run-off with low dependency on the sponsor as the preferred endgame across the UK pensions industry. A buy-out is effectively the only solution ending the sponsoring employer’s responsibility to the scheme, as well as the need for a trustee board to keep up with ever-changing regulations. 

 

 

Buy-outs have become especially popular among schemes with weaker sponsors: while a stable one-third of strong schemes are headed towards risk transfer, that proportion is 57% among schemes with a weak or weakening covenant and has doubled since last year. 

 

 

And while many schemes still have a few years to go until they buy out all the liabilities and wind up properly, 40% also name buy-ins as the most popular way to respond to the growing regulatory complexity of UK pensions.