In fact, our analysis suggests there are around 1,000 schemes who are currently in surplus and an even larger number within cheque-writing distance.

However, their readiness to approach the insurance market is still lagging because of issues with data or benefits.

In addition, a common issue for some schemes is the fact they are holding illiquid assets within their investment portfolio. Illiquid assets come in many flavours, with differing degrees of liquidity, and have been a widely used strategy for driving growth in assets as well as a tool for diversification. However, the faster than expected improvement in funding levels means schemes are now having to consider how they can deal with such assets as part of securing a buy-out.

From our perspective as a risk transfer adviser, a key driver (although not the only one) in any bulk annuity transaction is value for money. This often entails running a broking process that makes the formula Assets (A) – Liabilities (L) the smallest negative number (deficit) or the largest positive number (surplus) possible.

In advising a scheme with entirely liquid assets, much of our effort is taken up in minimising L, i.e. getting the lowest possible quote from insurers but there is limit to what I can do to influence A. That’s not to underplay the work still required, for example, in making sure schemes avoid out-of-market risk, don’t incur unnecessary trading costs and generate value by, say, trading at mid-pricing rather than bid-pricing, if possible.

When brokering a transaction where there are material levels of illiquid assets, the dynamic is very different. By definition, part of A doesn’t necessarily have a market value and might not even be tradeable, so now the solutions to consider could materially impact A as well as L. The solution that minimises L might not maximise A, and so might not be the optimal solution.

Solutions for schemes with illiquid assets fall into two broad camps:

Liquidating an illiquid asset might involve selling the asset into a secondary market. Often this will be at a discount to its net asset value (NAV), but this solution does give certainty over the amount received and enable the bulk annuity transaction to be simpler. Within this bracket, we include transfer of the illiquid asset directly to the insurer. This is not a well-trodden path and is often difficult to achieve, but it’s certainly not impossible. Alternatively, the scheme sponsor might be willing to take the asset from the scheme. If this is possible, it avoids needing to realise a below NAV price for the asset. In that situation, the sponsor clearly needs its own liquidity to buy the asset and the risk appetite to take it on.

Such options, which enable the insurance transaction to be kept simple, have advantages. Simpler transactions generally attract more insurers and, hence, more scope to get a better price (lower L). They also enable the scheme to move from buy-in to buy-out more quickly and, hence, remove the scheme from the sponsor’s balance sheet, which is often a key driver for employers.

The alternative approach is to structure the bulk annuity transaction to buy more time to deal with the illiquid asset. One of the most common ways of achieving this is by deferring part of the buy-in premium. This still enables the scheme to fully de-risk upfront. For example, we have seen transactions where anything from a few percent to up to 30% of the premium is deferred for anywhere between a few months to several years. There are other options, especially where the illiquid asset is generating cash flows, where schemes may agree to continue to fund the first few years of pension payroll to lower the insurance cost, covering the payroll with the run-off of the illiquid asset.

The advantage of these structural options is that you don’t need to trade the illiquid asset at a discount to NAV, although you are then exposed to the market risk of those assets. So this solution might lead to a higher value for A but it is now a more complex bulk annuity transaction which might reduce competition and, for example, lead to interest charges on the deferral of premium, meaning L will very likely be higher.

In these complex transactions, it is our job to understand the market and work closely with a scheme’s investment adviser to enable all options to be considered and then assess them against the trustees’ and sponsor’s objectives, in order to drive the right risk transfer outcome.

Adam Davis, Managing Director at K3 Advisory