Articles - Is there still a place for liability management

Historically, liability management has been an effective way of helping schemes improve their funding position on longer-term funding measures, and ultimately accelerate their journey towards end-game. A well-run transfer exercise, for example, could result in a material saving in a scheme’s buy-out deficit, given that the transfer value paid out (even with a generous enhancement) would still be a lot lower than the prudent reserve needed to secure an insurance premium.

 By Ben White, Senior Consulting Actuary, Buck

 Within the last year, though, the market has shifted and some of the potential benefits of running a liability management exercise have arguably been diminished. In this new environment, some trustees and sponsors may quite rightly be questioning, is there still a place for liability management within their strategic plans?

 Stronger funding levels
 The funding levels of most schemes improved considerably over the course of 2022, through a combination of a significant rise in gilt yields, which drove down liabilities, and investment out-performance from return seeking assets. Recent analysis from The Pensions Regulator shows that around a quarter of schemes may now have sufficient assets to buy-out their liabilities with an insurer, notwithstanding current capacity constraints in the insurance market, of course.

 This means that many schemes have found themselves in a position where they have already reached their end-game targets, and they may no longer need to consider possible liability management exercises in order to accelerate that process. That does, however, leave around 75% of schemes where buy-out is not yet affordable, and where undertaking a liability management exercise could help to bridge the gap.

 Potential downsides
 For these schemes, though, the potential buy-out funding gains from undertaking liability management are not always cut and dry. Trustees and sponsors need to appreciate that there can be second order effects which can actually have a detrimental impact on buy-out pricing. In particular, insurers and reinsurers may reflect the selection risk resulting from a liability management exercise and load up the premium accordingly. This effect could eat into the potential savings and possibly offset them completely, depending on the take-up rates achieved.

 It is also worth noting that the potential savings may have narrowed recently anyway. To take a transfer exercise as an example, many schemes will have taken the opportunity to de-risk their investments as a result of recent funding improvements, which means their best estimate transfer value bases will have strengthened. This could narrow the gap between a transfer value payment and a buy-out funding reserve.

 One of the key barriers to buy-out which the industry is currently grappling with is the level of illiquid assets being held by schemes wishing to transact. The liabilities settled as part of a liability management exercise would come from the liquid part of the asset portfolio, thereby increasing the residual proportion of illiquids and potentially exacerbating this problem.

 Market factors
 Additionally, increases in yields mean that it might also be a lot harder to achieve good take-up rates on liability management options in the current climate. For example, a typical transfer value might have reduced by as much as 50% over the past year, meaning a much higher enhancement would potentially be needed in order to achieve a positive recommendation from an IFA.

 The current cost of living crisis might also dissuade members from making long-term decisions about their finances. Whilst a pension increase exchange might appear attractive to someone who needs more cash now in order to meet rising bills, members may also view this as a bad time to be giving up future inflation protection.

 Recent market volatility has also made it much harder to assess the financial viability of a liability management exercise, and reduced the certainty of the potential benefits. For example, the accounting implications could have changed significantly from the point of initial feasibility to the point of actually recognising the impact in the sponsor’s accounts.

 Finding an appropriate IFA to support a liability management exercise has also become more difficult over time. A number of participants have exited the market thanks to a combination of market volatility impacting the level and predictability of future business, pressure on fees reducing the profitability of this work, and the risks associated with DB advice leading to rising insurance costs.

 The future of liability management
 So, does this spell the end the end for liability management? Absolutely not. These factors simply reinforce the need for trustees and sponsors to go into such projects with their eyes wide open so they fully understand all of the potential implications and the sensitivity around the relevant financials.

 When assessing the viability of a liability management exercise, they should also take the time to ensure they really understand the characteristics of the membership, given that softer demographic factors can have a huge influence on whether an IFA recommends a particular member option as an appropriate course of action.
 Most importantly, it is key to remember that liability management has never been just about manging liabilities and the issue is even more pertinent as we approach the Consumer Duty deadline. One of the main drivers for many trustees and sponsors is the desire to increase their members’ awareness of their benefit options and improve their access to high quality advice, so they can make better informed choices, which ultimately lead to better outcomes. That is something that is unlikely to ever change.

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