Imagine you are a banker and a customer approaches you for a loan of £850,000 to buy a £1m house. Would you be willing to lend the money on an unsecured basis, or would you first insist on taking a charge over the property?
It seems a silly question. Of course you’d do the latter. But let’s park that for a moment and imagine our customer has even more extravagant demands. Not only do they refuse to put up any collateral, they want the loan to be “non-accelerable”. So even if they miss an interest payment, the lender can’t demand immediate repayment of the loan in full.
Sounds like an interesting proposition? I think most lending institutions would tell that customer to take a hike.
Now let’s look at what happens when defined benefit pension schemes insure their liabilities to pay future retirement incomes. It’s increasingly common. In the last 12 years, schemes with liabilities worth £175bn have sought insurance protection through so-called buyouts, according to consultants Lane Clark Peacock. That’s almost a tenth of the £2tn-plus of scheme liabilities outstanding in the UK.
Under the traditional pension arrangement, an average scheme funds roughly 90 per cent of its liabilities with assets and relies on its sponsoring company to make good the shortfall.
With buyout deals, that same scheme transfers all of those assets plus a premium to an insurance company. In the process it surrenders title to the assets and control over how they might subsequently be invested. What it receives in return is a piece of paper promising to pay the insured pension payments as they fall due.
One way to think about this is that the scheme has lent money to the insurer which it has used to buy the scheme’s assets. In the process, the trustees have contrived to forfeit any security and the right to foreclosure. Even if the insurer defaults on a payment, they cannot recover their investment.
It is easy to see the appeal to the insurer. Just as our demanding bank borrower wanted, it gets no-strings, long-term money. Even better, it only has to pay a few basis points over government bond rates.
No wonder so many clever financiers have homed in on pension buyouts — insurers such as PIC and Rothesay. After all, they get to reinvest some of the assets they inherit from insured schemes in higher yielding instruments, keeping much of the surplus earned over the rock-bottom funding cost.
Meanwhile, many of these insurers put up very little tangible capital. As they switch some of the transferred funds out of boring gilts into higher-return instruments, the regulator permits them to discount scheme liabilities at that higher rate. This essentially manufactures equity (a practice known as “Matching Adjustment”) by recognising up front future profits deemed to be risk free.
For many of the specialist players this is pretty much all their equity. Take the three most focused operators, PIC, Rothesay and Just Group. Collectively they had £13.7bn of regulatory net assets, according to their 2019 Solvency and Financial Condition Reports. But, strip out the Matching Adjustment, and that fell to just £172m.
Anyway, goes the salesman’s patter, insurers are as safe as houses. The regulator applies tough rules that prevent insurers from acting recklessly. And should one get through the net, the Financial Services Compensation Scheme offers 100 per cent protection for retirement incomes.
Yet how much credence these assurances deserve is debatable. While the UK’s insurance regime is sound on paper, recent financial history suggests that regulators are never infallible. Meanwhile the FSCS is essentially an unfunded scheme. In the event of large losses, much would depend on a future government being willing to use taxpayers’ funds to bail out some of the UK’s wealthier citizens.
It is hard to avoid the conclusion that pension schemes are being unusually trusting with their members’ hard-earned savings. Neither a bank nor a fund manager would lend on anything like these lax terms. Nor is there any compelling reason why pension trustees should do so to insure future liabilities. Scheme members might usefully ask them why they are so compliantly playing along.