Insurance, run-on, run-off – how do you decide?

Endgame strategy is generating a lot of discussion in the industry right now. For many years, schemes were running with (often substantial) solvency deficits. The decision as to whether to insure and buy-out, or run-on, seemed a distant, perhaps even fanciful prospect.

But we are now in a world where many schemes are exploring their endgame decision from a position of strong funding, strong covenant support, and with real choice as to how to proceed.

The debate isn’t necessarily emerging as one might suspect. For example, some of the UK’s largest schemes are using full insurance as part of their endgame toolkit (whereas you may have once expected all large schemes to run-on), with risk transfer transactions for the likes of RSA and Boots showcasing insurers’ abilities to write bulk annuity transactions at scale. And, at the other end of the spectrum, we’re finding an increasing number of small to medium sized schemes more actively exploring run-on.

This optionality is, of course, a good thing. But with more choice comes greater scrutiny of decision-making, potential tensions between different stakeholder views, and, of course, greater prospect of regret risk.

So, should you buy-out or run-on?

Sponsors and trustees are put in a difficult position where it can be hard to know what the right decision is. The industry is awash with assertions from those in “buy-out” or “run-on” camps as to why their preferred strategy should be the favoured one – focussing on the benefits their approach can bring and the risks associated with alternative courses of actions. The issue is emotive and the potential for conflicts of interest is rife.

Framed as a choice between buy-out or run-on, the decision appears somewhat stark and binary. But buy-out immediately or run-off forever are simply bookends to what is an endgame continuum. Just as in politics, there is a significant centre ground – applied to the world of pensions this is schemes who intend to run-on for a period before ultimately insuring.

Perhaps endgame strategy should more simply be distilled down to the question “what is the period, if any, we should run-on beyond the point of buy-out affordability?”

A cohesive single framework for all

Focussing in on the variable of time (T) enables us to create a much more inclusive, single framework for considering endgame strategy, bookended by T = 0 (insure asap/when affordable) and T = 50+ years (akin to run-off).

We look at some of these different groups of schemes below.

Insure asap or when affordable (T=0)

For many schemes, recent rhetoric on the benefits of run-on won’t have changed anything. A trustee’s fiduciary duty is to deliver members’ promised benefits in full, and many will reasonably take the view that this is best satisfied by fully insuring as soon as they can. Insurance offers a secure and well-capitalised long-term home for pension liabilities, giving trustees the option to hang up their boots knowing they have done the job envisaged in their governing documentation.

Whilst the prospect of generating surpluses can be a big draw for some sponsors, there will be many for whom the memory of risks and deficit contributions will be too strong. Indeed, we are still seeing some sponsors willing to write a cheque to accelerate insurance buy-out (to simplify pension arrangements, increase flexibility, or preserve corporate leverage).

The schemes in the T = 0 group form the backbone of the UK buy-in market that has settled at c£40-50bn pa with ten insurers actively competing for business.

The run-in to insurance (T= ?)

This is another big group of schemes, and the group that has arguably been growing over the last two years. It is driven by schemes wondering if there is a period over which they might run-on beyond buy-out affordability – in some cases driven by some interest in sharing of surpluses, but perhaps more so by continuing the trustees’ current stewardship and oversight of member experience. There may also be practical considerations that drive this approach, enabling the scheme to complete data cleansing, manage closure projects, and preserve value in illiquid assets that might otherwise need to be sold for a haircut.

Where schemes are better-funded and covenant support is strong, we are also rightly seeing trustee boards set a higher bar for the terms and value any insurance solution needs to deliver – this can take time to work through and can act as a helpful catalyst for driving further innovation in the insurance industry.

Many of these schemes won’t imagine being here in 20 years’ time (or maybe even 5 or 10) but do envisage an orderly and controlled glide into insurance over a more extended period, whilst benefitting from the factors above and keeping their options open to any future industry developments.

There are a variety of ways the expected run-on period could be framed, for example:

• the foreseeable future of the sponsor covenant;
• the time until the majority of the scheme’s membership has retired (enabling the scheme to retain oversight of pre-retirement communications and bespoke options); and/or
• reaching a required funding level to secure a target level of benefits.

Key for schemes in this group is weighing up the potential benefits of this approach, working out the investment risk appetite over the run-on period, considering the regret risk if a downside funding shock occurs and the scheme could have insured sooner, and agreeing with the sponsor what support is available to appropriately mitigate this risk. The longer the time period to insurance, and the more risk in the investment strategy, the more important these discussions.

Longer-term run-on (T = 30, 40, 50 + years)

There will be some schemes (albeit we expect a minority) who will sit somewhere closer to the true run-off category – this group might for example include the largest of the UK’s open DB schemes and perhaps future consolidators.

This is the group for which the Government’s Mansion House thinking, including investing in productive UK assets and generating / sharing surpluses, is likely to best match the time horizon of the pension scheme.

However, even for these schemes, the single framework has relevance. As part of the contingency planning, schemes targeting long-term run-on should be proactively thinking about the factors that might cause them to pivot strategy in future – what if the sponsor covenant deteriorates materially? What if expenses become disproportionately large? What if the scheme can’t get the governance and advisory support it requires to be managed effectively? In other words, what circumstances would cause them to reduce T, and are there steps they could take now to be prepared for that?

Conclusion

There is one variable – time – that threads all of the above together. Our single framework is about creating a rationale strategy whereby the scheme runs on for a period until potential insurance at some future time – be that 1 year, 5 years, 10 years, or many decades into the future.

Endgame strategy is not a one-time binary choice. In our view, it can be focused on working out what the period to full insurance looks like, what the trustee’s and sponsor’s duties and attitudes to risk are over this period, and what the triggers should be to complete full insurance in an orderly way at the right time.

This article was originally published in Professional Pensions on 14 October 2024.