Should DB schemes buy in to the case for buy-ins?

As defined benefit (DB) pension schemes mature and become better funded, they are increasingly looking to insurance solutions to help them de-risk.

One common solution – alongside buyouts (paying a premium to an insurer to take ownership of some of the scheme’s assets and liabilities) and longevity swaps (transferring the risk of pensioners living longer than expected to a counterparty) – is the buy-in.

Buy-ins are similar to buyouts, but with a buy-in, the insurer makes payments to the scheme, rather than to the members directly. The trustees can essentially treat their buy-in insurance policy as another asset.

The key benefit of buy-ins is that they remove all the risks relating to those members covered by the policy. These include investment risk, reinvestment risk, rates and inflation risk, and longevity risk.

Buy-in bulk

In our new paper, we argue that several factors can make a buy-in appealing:

• Attractive pricing of the buy-in 
• A low return target for the scheme 
• An inefficient current investment strategy for pensioners 
• Pensioner risk dominating the scheme 
• Substantial hedging challenges (perhaps relating to the benefit structure) which are better transferred to an insurer to handle 
• Limited governance bandwidth

Our paper discusses each of these points in greater detail, and then brings them all together in a model we have developed to indicate the ‘optimal’ proportion of overall assets to spend on buying-in a proportion of the scheme.

This proportion will of course vary according to both the fraction of the scheme that is made up of pensioners, which is strongly related to scheme maturity, and the target return of the scheme over gilts, including the implicit return from insured pensioners.

As an example, the model suggests that a scheme with 90% pensioners and whose overall assets (including insurance policies bought) are targeting gilts plus 0.75% should spend about 28% of its assets on buy-ins for pensioners.

Bespoke tailoring

A crucial aspect of this research is that the results from our analysis are sensitive to the exact assumptions made, which will vary with the scheme’s circumstances.

These sensitivities underline why bespoke analysis is so important. A decision to buy-in would clearly not be taken lightly by trustees, who must work with actuarial and investment advisers to ensure the funding strain is manageable.

We believe our framework offers a valuable, additional layer of insight, combining key factors into a quantitative tool for use in reaching a decision.

This approach can be combined with our models that simulate long-term outcomes for use in judging success for schemes – in particular, when helping to set an appropriate target return.

Trustees and sponsors have more choices than ever before to secure members’ benefits. Whether a trustee board decides to keep responsibility for this itself, or transfer some or all of that responsibility to an insurance company, the decisions to be made will be different from those made previously.

Each scheme’s endgame is nuanced, and buy-ins can be a useful tool for schemes as they de-risk. As we show in our paper, there are a number of interesting factors at play which, when viewed together, provide a critical insight that should help inform a decision on whether a buy-in is the right course of action.