We are pleased to present the first edition of
"Pensions De-risking", our periodical update on
developments in the pensions de-risking marketplace. This first
edition includes topical content on illiquid investments in the
context of de-risking activity and links to other Travers Smith
content on the increasingly recurring theme of pension scheme
surpluses. We also highlight Travers Smith's recent work in
this area.
1 Illiquid investments
Many pension schemes engaging in endgame planning have illiquid assets in their investment portfolio and recent events may have increased the percentage allocation to illiquid assets. This can give rise to certain issues. Two of these issues (with some thoughts as to solutions) are set out below.
Issue 1: Timing mismatch
The timeframe over which illiquid assets mature or unwind may not align with the scheme's general endgame timeline. For example:
- Scenario A: the scheme may be fully funded on
a buyout basis, but only when the illiquid assets are taken into
consideration, and the full economic benefit of those illiquid
assets may not be fully realised for several years, creating an
apparent liquidity barrier to an insurance transaction.
- Scenario B: the scheme may have sufficient liquidity to secure benefits and wind-up but may seemingly be prevented from doing while its illiquid assets are still unwinding.
One obvious approach is to sell the illiquid assets on the open market. This will often mean taking a 'haircut'. This may be convenient in certain circumstances but may be viewed by some trustees (and sponsors) as handing expected return to a third party and presenting difficult decisions as to when to sell.
A variation on the above is a sale of the illiquid assets to the sponsor. Whether this is viable may depend on the sponsor having (i) sufficient available cash for the purchase and (ii) a willingness to accept the risks associated with holding the illiquid assets as they unwind (e.g. the investment may not perform as expected, there may be an obligation to make additional investments such as meeting capital calls attached to fund interests etc.).
Alternatively, schemes may choose to explore whether an insurer is willing to accept illiquid assets as part of a portfolio of assets used to meet an insurance premium. However, even if an insurer is willing to accept illiquid assets, whether this route is attractive to trustees (and sponsors) is likely to depend on the level of any haircut the insurer intends to apply and the impact on the insurer's pricing.
In Scenario A, certain sponsors may agree to lend to the trustee on a temporary basis and for the purpose of providing liquidity to the scheme, enabling a transaction which would otherwise be thwarted by the scheme's liquidity position.
In Scenario B, rather than wait for the illiquid assets to unwind as scheme assets, we are aware that consideration is being given in various cases to a potential return of surplus to the sponsor 'in specie'. A return of surplus to the sponsor will usually be subject to a 35% free-standing tax charge. This is relatively straightforward where surplus is to be returned as cash but how would this tax apply if the surplus is returned in specie? The valuation of illiquid assets is considered below.
Any potential transfer of ownership of the illiquid assets will obviously require careful consideration (including, for example, whether consent is required from a third party and/or whether any third party has pre-emption rights, allowing them to purchase the illiquid assets).
Issue 2: Valuation of assets
The timeframe over which illiquid assets mature or unwind may not align with the scheme's general endgame timeline. For example:
The approach to the valuation of illiquid asset will obviously depend on the nature of the asset. In the case of an investment fund, in many cases the trustee will receive regular (e.g. quarterly) updates of the fund's net asset value ("NAV"). NAV will often vary over time (which may mean that NAV upon which the trustee is relying could be quite stale). The market value of the asset (e.g. NAV less the 'haircut' that a buyer would apply when acquiring the fund interests) may also vary over time.
Where trustees intend to sell illiquid assets, the market value may arguably be more relevant than the NAV for the purposes of their endgame strategy and regular price monitoring and price discovery processes may be appropriate.
As noted above, in the event that the trustee and sponsor are considering a return of asset in specie, the value of the asset is also likely to be relevant for the purposes of the tax payable.
We expect the approach to illiquid assets to form a significant consideration for a growing number of schemes as they embark on the final leg of their de-risking journeys.
For example, we recently worked with a corporate client to
deliver a multi-phased strategy for DB pension de-risking. The
transactions involved several innovations, including flexibility
with the insurer around premium payments and residual risk cover
and a bespoke, employer-funded liquidity buffer arrangement to help
navigate short-term considerations in relation to the scheme's
illiquid positions. The latter helped lock in favourable insurance
pricing at a time when the trustees might otherwise have wanted a
larger liquidity buffer to transact.
2 Pension scheme surpluses
The resurgence of pension scheme surpluses
Pension scheme surpluses were very much a theoretical consideration for trustees and sponsors of defined benefit pension schemes in the early parts of this century. However, with many schemes finding themselves to be in a much stronger funding position as a result of improving gilt yields, surpluses are now firmly back on the agenda as sponsors look to avoid "trapped surplus" scenarios. Dan Naylor, Sheamal Samarasekera and former Pensions trainee Niall Fitzpatrick have published an article on the key considerations for both trustees and sponsors when dealing with surplus scenarios including the alternatives available to a return of surplus to the sponsor. Click here to read the full article.
Pension Scheme Surpluses: no deficit of choices
In this four-part "in conversation" series, EY-Parthenon partners Karina Brookes and Eimear Kelly and Travers Smith partners Dan Naylor and Joseph Wren discuss pension scheme surpluses, drawing out some important topics for consideration by trustees and sponsors.
Key themes from the discussion include the advantages of advance planning, the need for schemes and sponsors to respond to dynamic circumstances which can change scheme funding levels rapidly (such as the LDI crisis), and the ways in which good outcomes can be achieved both for members and for other stakeholders including the sponsor.
3 Our recent work highlights
OUR RECENT WORK HIGHLIGHTS
- Nortel Networks UK Pension Plan - We advised the trustee on a
buy-out with L&G covering around 15,500 pensioners and 7,225
deferreds. The buy-out allowed the Plan to exit its 10-year PPF
assessment period and provide members with benefits better than
those they would have received in the PPF. It was larger than any
previous PPF-plus buy-out. The Plan continued to receive recoveries
from the complex global Nortel insolvency processes and we advised
on the use of over £100 million of these funds to secure
additional member benefits in a further buy-out with L&G. This
sophisticated, member-focussed, phased PPF-plus buyout has required
careful innovation. We are now assisting the trustee in securing
remaining benefits, with a final insurance transaction.
- British American Tobacco - We advised British American Tobacco
on a further buy-in between the British American Tobacco UK Pension
Fund and Pension Insurance Corporation (PIC). This brings the total
value of transactions between the Fund and PIC to approximately
£4.1bn. This third transaction insured a further
c.£250m of liabilities, securing the benefits of a further
group of members and providing additional long-term certainty and
security.
- Westminster and City – Bulk Annuities Conference -
Increasing attention is being devoted to ensuring schemes'
asset portfolios are buyout ready. What impact has the LDI crisis
had on investment strategy and buyout preparedness? What challenges
do large allocations to illiquids present and how might these be
used as premium? Jonathan Gilmour was joined by James Fermont of
LCP at the "Preparing Scheme Assets for Buyout –
Illiquids and other Considerations" session on 26th
April.
- Confidential client - We acted for the trustee in connection
with a c.£700 million buy-in, covering more than 5,000
members across three sections of the scheme. The buy-in was
established as an "umbrella contract", enabling the
trustee to transact quickly in future buy-ins, and take advantage
of any favourable pricing opportunities available. This was the
scheme's first buy-in. It builds on an existing relationship
between the trustee and the insurer, following a previous longevity
swap. The transaction was completed against a backdrop of market
instability following the "mini budget". The
trustee's position was protected throughout because we had
secured a price-lock with the insurer that was not subject to
boundary conditions, negotiated whilst the trustee still benefited
from competitive tension.
- We acted for the Trustee of the British Steel Pension Scheme in
connection with a series of insurance transactions which have
resulted in all scheme liabilities being insured with Legal &
General, taking total buy-ins to £7.5bn and making it the
largest pension scheme to reach full insurance. As in relation to
the example of our work above, each insurance transaction was
implemented under an Umbrella contract structure and as part of a
broader commercial agreement which included appointing LGIM as
investment manager in respect of all of the Scheme's
non-insurance assets.
- Rothesay Life PLC - We acted for Rothesay Life PLC on the
£640 million buy-in of the TI Group Pension Scheme, insuring
the benefits of more than 8,750 members (deferreds and pensioners).
The Scheme is sponsored by Smiths Group plc. The buy-in was secured
in anticipation of a full buy-out and wind up over coming years and
includes residual risks cover. It was the final tranche in a phased
buy-in strategy, following several previous buy-ins. We are
currently acting for Rothesay in relation to two other live
transactions.
- Confidential client - Working with our specialist funds team, we advised a trustee on the process for the sale of two illiquid funds on the secondary market. The trustee had secured core benefits with a buy-in, and we had helped the Trustee to pre-negotiate the terms on which the insurer would allow the trustee to secure additional benefits with the proceeds of sale. The process enabled the trustee to lock down insurer terms to secure benefits for members utilising all scheme assets at buy-in, whilst assisting the trustee to efficiently realise the value of the illiquid holdings through a secondary sale to maximise member benefits.
Originally published 25 May 2023
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.