Right now, I believe we might be on the verge of a lack of insurer capacity becoming an issue, but this isn’t due to a lack of capital or appetite, it is a matter of limited human resources. A flood of schemes, mostly small (sub-£100m), ought to be looking at bulk annuities. If they all do, then the way the market currently operates means many schemes won’t be able to secure deals and, unfortunately, it will be the smaller schemes that tend to miss out.
Favourable market conditions
Since the start of 2021 and over the past few months in particular, we have seen material movements in the key economic measures, most notably interest rates, that affect schemes’ funding levels.
Nominal interest rates at key durations for pension schemes have risen by over 100 basis points since the start of 2021 and by around 70 basis points since the start of this year. In isolation, this movement since the start of the year will have knocked off between 7% and 15% of the value of a scheme’s liabilities, depending on the maturity of the scheme.
Countering this is the inflationary pressure we are all feeling at the moment.
However, as the chart above illustrates, for pension schemes with long duration liabilities, the impact of inflation changes has been modest and the large short-term increases in inflation expectations have less of an impact than you might expect, given most schemes’ pension increases are limited by annual caps (e.g. 5%).
Many schemes also have a significant proportion of liabilities which are not inflation-linked or have lower annual caps on inflation-linked increases (such as 3%). Based on this, our analysis suggests that inflation changes since the start of the year have added 2% to 3% to pension scheme liabilities on average.
In combination, therefore, liabilities are significantly lower than a few months ago for many schemes.
That alone doesn’t mean buyout funding levels are improved, as that will also depend on the asset side of the equation for a scheme.
Many schemes now try to protect themselves to some extent against the effect of interest rate movements, but many still have material exposure to interest rates, especially smaller schemes.
Those with greater interest rate exposure also tend to have greater exposure to the performance of growth assets. As a broad indicator, the FTSE 100 Total Return Index has risen by around 10% over the past year, although more modestly since the start of 2022 (source: Financial Times).
Our analysis suggests that since the start of the year, buyout funding for many small schemes may therefore have improved by around 8%.
Impact on market capacity
In 2021, K3 advised on around 15% of all sub-£100m bulk annuity transactions and we saw an increasing trend of schemes finding themselves in surplus to buyout. Of the thirteen full buyout transactions we advised on, seven of them ended up in surplus. That trend has continued so far in 2022, with half of the transactions we have led also being in surplus.
Given the market conditions changes described above, I can’t see this trend changing in the near future and I wonder just how many schemes, again particularly smaller schemes, are blissfully unaware of just how good a position they are in. This ought to be a major concern for the pensions industry and could be quite the scandal if a large number of schemes miss the opportunity to insure because they weren’t made aware of it.
Should favourable market conditions persist, there should be a material increase in demand for insurers to quote. Typically, the buyout market quotes on 100 to 200 schemes each year. If an extra 1% of all defined benefit schemes approach the market each year, that would be an additional 50 schemes or so, i.e. a 25% to 50% increase in demand. Our analysis of funding improvements suggests there ought to be significantly more than an increase of 1% of schemes ought to be looking to approach the insurance market.
How can this capacity crunch be resolved?
Firstly, insurers know the likely increase in demand is coming and many are beefing up their front- and back-office staffing to be able to increase capacity. We are also aware of several potential new entrants to the market, and we have the developing “superfund” market that might provide a different but potentially desirable home for some schemes. However, scheme and employer advisers have a critical role to play, by making quoting easier for insurers.
Transaction simplicity and certainty, two founding principles of how K3 undertakes projects for our clients, are now of critical importance across the industry. Schemes need to be well prepared, but the processes run to implement bulk annuity transactions also must be kept simple, so insurers are willing to take part in them, and to minimise the resource needs so more schemes can receive quotations. A failure to do this will restrict the number of schemes that can get access to this market to the detriment of scheme members and employer.
Adam Davis, Managing Director, K3 Advisory
