What is an illiquid asset?
An illiquid asset is one where it is not possible to sell or redeem it in the short term, without potentially losing a significant proportion of its value.
For many schemes, investing in such an asset class was considered appropriate at the time, when their ‘end game’ seemed a long way off into the future. However, the rise in interest rates in the autumn of 2022 (along with other factors, such as positive returns on other growth assets) has seen many schemes come within touching distance of their end game sooner than they had expected.
Over the past two years, around 15% of the schemes advised by K3 that have completed a bulk annuity transaction have had an illiquid asset of some description. However, the proportion of schemes in the UK DB scheme universe with illiquid assets may be significantly higher than this. For example, according to a report from Standard Life in 2023
[1], around 40% of schemes approaching the market in the previous year had illiquid assets to manage.
Whilst the proportion of schemes that hold some illiquid assets is not immaterial it is worth noting that typically such asset classes only make up a modest proportion of any scheme’s overall asset portfolio.
Typically, in moving to a bulk annuity transaction, particularly so for smaller schemes, the premium is required to be paid to the insurer in cash, so solutions are needed to allow this important de-risking step to proceed.
How can a bulk annuity transaction proceed where a scheme has an illiquid asset?
There are several options that may be utilised in order to not delay a bulk annuity transaction:
1. Deferred premium: Probably the most common solution used is to delay paying the part of the premium that is expected to be covered by the illiquid asset redemption in the future. The deferred premium will typically have an associated interest charge, which in the current interest rate environment may not be immaterial, and not all insurers are willing to offer such a solution, so it does reduce the market available. For these reasons we do not see this as the default solution of choice.
2. Deferred cover: An alternative to deferring premium is to delay the start of the insurance cover by a short period of time, e.g. so that the insurer does not cover the first X months/years of current pensioner cash flows for the scheme. The scheme will instead have to continue to meet those payments, so this reduces the premium by the present value of the cash flows foregone by the insurer. This involves no interest charge, unlike the deferred premium solution, making it potentially more financially efficient in a higher interest rate environment. In our experience this also avoids eliminating insurers, although such a solution clearly adds a little complexity which could impact on insurer appetite.
3. Sell asset: It may be possible, and economically viable, to sell the asset in the short term, if the discount to the asset value is not sufficiently big that it makes the transaction unaffordable, or if the illiquid asset makes up only a small proportion of the scheme’s total portfolio. There are three main ways this can be achieved:
a. Transfer asset to insurer in specie: In limited circumstances, it may be possible to transfer the asset to the insurer in specie. Again, this may mean having to accept a discount to the ‘true’ asset value.
b. Secondary market sale: effectively sell your illiquid asset to a different investor, again most likely at a discount to the net asset value. With so many bulk annuity transactions now involving dealing with some illiquid assets we’ve recently seen a number of new businesses or new offerings from traditional consultancies, all of which effectively try to improve and provide a rigorous process for a secondary market sale.
c. Transfer the asset to the sponsoring employer: This route requires detailed legal and tax advice to ensure it will work but can be a neat solution to avoid accepting a lower net asset value for the asset and achieving liquidity for a bulk annuity.
4. Loan: An alternative may be for the scheme take out a loan in order to pay the full insurance premium immediately, and then pay back the loan when the illiquid asset is redeemed. Most commonly we’ve seen scheme sponsors providing the scheme with a loan for short term liquidity support until the illiquid asset redeems.
What lessons can be learnt from experience to date?
· Think ahead. Even if your scheme is some distance from being able to afford a bulk annuity, it is worth reviewing what illiquid assets you have in order to get clarity on what position they will be in at the expected point of reaching buyout funding.
· A bulk annuity transaction may well be possible even if you do have an illiquid asset as part of your scheme’s asset portfolio. The above options demonstrate that this doesn’t necessarily mean that you’ll need to delay.
· Engage with a risk transfer specialist early. It’s better to flag this early to your bulk annuity broker and to any potential insurers so that all stakeholders can work together to achieve the best outcome.
· Understand the options. Your bulk annuity broker and investment advisor can help you understand what your options are and how they fit in with your objectives.
Andrea Mendham, Partner K3 Advisory
