Lane Clark & Peacock LLP

Lane Clark & Peacock LLP Pension Buyouts 2009

This is the second edition of the Lane Clark & Peacock LLP Pension Buyouts report. It provides an in-depth analysis of pension buyout and longevity transactions in the UK. Lane Clark & Peacock LLP (LCP) is a leading actuarial consultancy at the forefront of advising companies and trustees on buyout and longevity hedging opportunities. LCP has developed the expertise and specialist skills needed to successfully negotiate and implement a pension plan buyout, buy-in or longevity hedge, combined with a wider understanding of how de-risking options fit into corporate and trustee strategy. UK Professional Pensions Awards Actuarial Consultancy of the Year 2005 2006 2007 Investment Consultancy of the Year 2007 FT Business Pensions & Investment Provider Awards Actuarial Consulting 2007 2008 Investment Consulting 2007 2008 Corporate Adviser Awards Best Member Communication Strategy 2008 Best use of Technology by a Corporate Adviser 2008 Best Strategy for Investment Advice on Pensions 2009 For further information about pension buyouts, longevity hedging and LCP s specialist de-risking services please contact Clive Wellsteed, Charlie Finch, Jill Ampleford, Jerome Melcer, Michael Berg or Ken Hardman in our London office or David Stewart in our Winchester office, or the partner who normally advises you. For further copies of the report, please download a copy from our website www.lcp.uk.com or contact Mark Roberts on +44 (0) 20 7439 2266 or email enquiries@lcp.uk.com. This report may be reproduced in whole or in part, without permission, provided prominent acknowledgement of the source is given. Although every effort is made to ensure that the information in this report is accurate, Lane Clark & Peacock LLP accepts no responsibility whatsoever for any errors, or the actions of third parties. The purpose of the report is to highlight the recent changes and developments within the buyout market. This report and the information it contains should not be relied upon as advice from LCP or a recommendation as to the appropriateness either of proceeding with a buyout, buy-in or longevity hedge or of any particular insurance company or provider. Specific professional advice should be sought to reflect an individual plan's circumstances. Lane Clark & Peacock LLP May 2009

Pension Buyouts 2009 Pension Buyouts 2009 The UK pension buyout market currently comprises: insurance companies competing to take investment and longevity risks from pension plans in return for a premium; and CONTENTS financial institutions competing to take on longevity risk from pension plans, with the trustees retaining control of the investment of the plan assets. Lane Clark & Peacock (LCP) has worked with the main players in the market to create the industry s most comprehensive database of: completed transactions since January 2008; and potential pipeline deals currently being considered by pension plans. We are grateful to the following institutions who have contributed to this report: AEGON, AIG Life, Aviva (formerly Norwich Union), Legal & General, Lucida, MetLife, Paternoster, Pension Insurance Corporation, Prudential and Rothesay Life (Goldman Sachs). Introduction Page 2 Market development Page 4 Market drivers Page 6 Preparing for a transaction Page 12 Market outlook Page 14 Business written Page 16 Security arrangements Page 19 Longevity hedging Page 22 Appendices 1 Protections 2 Insurance reserving 3 Longevity hedging 4 Transactions Page 27 Page 28 Page 30 Page 32 De-risking glossary Page 34 1

Pension Buyouts 2009 INTRODUCTION Key conclusions The September 2008 financial crisis marked the start of a new chapter in the UK pension buyout market, requiring pension plans and insurance companies to adapt to unprecedented global events. Insurance companies responded through stronger reserving and more cautious pricing. Paternoster has gone one step further and agreed with the FSA that it will not, for the time being, write any new business. Despite these challenges, over 900 million of buyout business was closed in the first quarter of 2009. Going into the second quarter, investment market conditions particularly in the swaps market are beginning to improve which will help pricing. The longevity market is now in a similar position to the pension buyout market two years ago prices have come down and the first deal has now been announced. However, we anticipate slower initial growth in the longevity market due to the more sophisticated nature and larger sizes of these deals. Buy-ins and longevity swaps are both effective forms of de-risking however their relative attractions will change over time as pension plans move towards their eventual end game. For longevity swaps it is important to consider the exit strategy for when the time eventually comes to buyout and wind-up in full. Access to capital and stronger reserving requirements are likely to be the main drivers for future consolidation in the pension buyout market. One established route is the transfer of business between insurance companies for example Prudential has acquired around 5 billion of individual annuities in insurer-to-insurer transfers since 2004. There will be a steady and growing demand for viable de-risking options as defined benefit pension plans continue to mature. We expect the emergence of insurance companies from the financial crisis to reinforce pension buyouts as sensible and effective means of securing pension promises to members. LCP is at the forefront of advising companies and trustees on buyout opportunities: We designed and implemented the first of the new-style pensioner buy-ins at the start of 2007 and since have completed 10 further buy-ins over 50 million. We advised on two out of the three significant buy-in deals which have included bespoke protections to provide additional security to pension plan trustees. In an article by Financial News in January 2009, we were recognised as one of the leading buyout advisers over 2008, having advised on more medium or large buyout deals than any other adviser. This followed LCP s market leading position in 2007, where we advised on 50% of all medium or large buyout deals. We are currently working with a range of major organisations and their pension plans to assess buyout and longevity swap opportunities. 2

Pension Buyouts 2009 INTRODUCTION Market statistics Total buyout business volumes for 2008 were 7.9 billion and several landmark deals were struck such as the first 1 billion deal between Cable & Wireless and Prudential. Business volumes in 2007 were 2.9 billion. Legal & General and Pension Insurance Corporation dominated the buyout market in 2008 and continued to do so in the first quarter of 2009. Conversely, Paternoster, who had a 50% market share in 2007, has not written any new deals since September 2008. Volumes of buyout business reduced to 900 million in the first quarter of 2009 the lowest quarterly volume since 2007. 2008 was characterised by insurance companies producing high volumes of quotations, many of which did not go on to complete. Data provided by insurance companies shows that less than 20% of quotations led to a completed deal in 2008. Data provided by insurance companies shows that buyout quotation volumes are down 60% in the past 12 months. However, a much higher proportion of quotations are at an advanced stage, including a number of pension plans in detailed negotiations. We expect 2009 to be characterised by a lower quantity, higher quality buyout pipeline. There is continued evidence that companies are recognising the cost of increased longevity. Over the last three years, FTSE 100 companies have added an extra year every year to pensioner life expectancy. This is likely to increase the demand for buyout and longevity hedging options. Business written in the insured buyout market 2,500 2,000 million 1,500 1,000 500 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 2007 2008 2009 3

MARKET DEVELOPMENT Pension Buyouts 2009 Market development 2006 and 2007 saw dramatic growth in the buyout market as an explosion of new and established providers developed buyout offerings. In contrast, the past 12 months has seen both new entrants and departures. Synesis Life exited the buyout market in 2008 after failing to secure any transactions. Pension Insurance Corporation subsequently acquired assets and some key members of Synesis Life s team. Swiss Re entered the market with a range of de-risking options but is now focusing on longevity-only transactions. A number of financial institutions continue to watch the buyout market closely with a view to getting more actively involved, although this is set against a backdrop of difficulties in raising new capital. Paternoster has agreed with the FSA that it will not, for the time being, write any new business. Insurer Correct as at May 2009 Date of entry 1986 1997 April 2006 May 2006 June 2006 October 2006 January 2007 July 2007 July 2007 November 2007 Offers longevity-only hedging? Longevity hedging for pension plans is presently available from a range of providers, primarily investment banks and insurance companies. The major players not listed above include: Institution Type of entity Investment bank Investment bank Investment bank Reinsurer 4

Pension Buyouts 2009 MARKET DEVELOPMENT Types of buyout This report covers buyouts by UK defined benefit pension plans with insurance companies that are authorised and regulated in the UK by the Financial Services Authority (FSA). It also covers longevity hedging options available from insurance companies and the capital markets. Full definitions of the different types of buyouts are set out in the Glossary. The key types are as follows: see page 34 for the Glossary of de-risking terms Buyout The process whereby a pension plan s liabilities are transferred to an insurance company and the obligation for the pension plan to provide those benefits is ceased. Usually this covers all of the liabilities of the pension plan as a full buyout and is followed by the wind-up of the pension plan. Examples: Rank, Thorn, M-Real Corporation Buy-in The purchase of an annuity contract with an insurance company as an investment to match some or all of a pension plan s liabilities, and therefore reduce risk. Crucially the liabilities remain in the pension plan and the trustees retain responsibility for them. Commonly this covers the pensioner liabilities as a pensioner buy-in but there have been several buy-ins of non-pensioner liabilities or a sub-set of pensioner liabilities. Examples: Cable & Wireless, TI Group, Friends Provident Longevity hedge The purchase of an investment to remove or reduce the risk of pension plan members living longer than expected. Examples: Babcock International* This report does not cover non-insured buyouts. In 2007 there were four such deals (telent, Thorn, Thomson Regional Newspapers and Thresher) whereby liabilities were transferred to institutions that were not FSA authorised insurance companies. Since then we have not seen any further deals. However, in May 2009, Bridge Pointe a Bermudan based captive insurance company has announced its entry to the market, offering a non-uk insurance-based stepping stone to full buyout. This report also excludes insurer-to-insurer transactions such as the 300 million deal between Rothesay Life and Prudential to reinsure the pensioners of the Rank pension plan. * Babcock International announced on 12th May 2009 that it had agreed in principle with two of its pension plans to enter into longevity hedges with an unnamed counterparty. 5

Pension Buyouts 2009 MARKET DRIVERS Market drivers The fifteen month period covered by this report can be divided into the periods before and after the collapse of Lehman Brothers in September 2008. January to September 2008 In the first part of 2008, buy-in prices for pensioners were frequently lower than the funding reserves being agreed between trustees and companies in their actuarial funding valuations the lowest point was reached in March 2008. This provided an opportunity for pension plans to transfer investment and longevity risk to an insurance company without increasing their funding deficits or requiring accelerated cash contributions to be paid into the pension plan. This can clearly be seen from the chart on page 9. Many of the deals were pensioner buy-ins, reflecting the fact that most pension plans had funding deficits and could not afford a full buyout. In addition, trustees and companies had a greater awareness of new options available in the market such as pensioner buy-ins. see page 19 for further information on additional security arrangements The deals over this period covered a wide spectrum of companies: from FTSE 100 companies (such as Cable & Wireless) to engineering companies (such as BBA and Powell Duffryn) to non-governmental public organisations (such as Ofcom) and, in the case of Friends Provident, a life insurance company choosing to transfer pension risk to another life insurance company. Major deals in January to September 2008 include: Friends Provident A 360 million pensioner buy-in with Aviva (formerly Norwich Union). This was the first deal to include a security arrangement where a portion of the premium is held in a segregated premium account. TI Group TI Group s pension plan undertook two 250 million buy-ins, the first with Legal & General in March and the second with Paternoster in September, covering different segments of their pensioner population. Delta A 450 million pensioner buyout with Pension Insurance Corporation. This was the only significant pension buyout in 2008 (all other significant pensioner deals were buy-ins). Delta plc paid 50 million to achieve a complete transfer of the liabilities through a buyout. Cable & Wireless The largest buy-in ever at 1,050 million with Prudential. The deal included an additional security arrangement. A 10 million cash payment was made by the sponsor to facilitate the transaction. 6

Pension Buyouts 2009 Major buyout and buy-in transactions Financial crisis 7

Pension Buyouts 2009 MARKET DRIVERS Post September 2008 see page 29 for commentary on insurance companies allowances for defaults on their corporate bond portfolios The collapse of Lehman Brothers signalled some dramatic changes to the market both to the practicalities of completing a buyout and in the attitudes of trustees and companies towards them. The key changes included: insurance companies adopted more cautious pricing and reserving assumptions in particular many insurance companies increased their assumed default rates on corporate bonds backing their annuity portfolios to reflect a gloomier economic outlook; many key investment markets became significantly less liquid this impeded asset transfers from pension plans to insurance companies as market prices for certain assets were distorted, thereby making accurate valuation difficult; and confidence in financial institutions was eroded as evidenced by investors heavily marking down insurance company share prices. Trustees of larger pension plans increasingly sought additional protections as part of buy-in contracts. Each of these factors is explored in the sections below. We then look at the outlook for the buyout market in 2009 and beyond. Major deals since September 2008 include: Thorn The largest buyout ever at 1,100m. This was previously a non-insured buyout in 2007. As part of the buyout a 5% uplift was provided to members pensions from surplus funds. Pricing and reserving Following the collapse of Lehman Brothers in September 2008, there was a sharp increase in buyout prices, both in absolute terms and relative to funding and accounting valuations. see page 29 for further details on the challenges facing insurance companies Lehman s collapse also represented a step-change in attitude towards the likelihood of financial institutions defaulting. This is significant as the financial sector is a major issuer of the corporate bonds held by many insurance companies to back their annuity portfolios. The level of increase in buyout prices since September 2008 has varied widely, reflecting differing outlooks for defaults on corporate bonds. Many insurance companies also moved away from investing in debt issued by the financial sector. Insurance companies underlying investment strategies are also relevant. For example, many insurance companies link their pricing to the market prices of the swaps and other derivatives they plan to invest in after taking on new business. Thin trading volumes in the inflation swaps market have led to distorted pricing since September 2008 and this has fed directly into higher prices. 8

Pension Buyouts 2009 MARKET DRIVERS The divergence in pricing between different insurance companies is clearly shown in the chart below: Divergence in buy-in pricing Financial crisis Lehman Brothers insolvency Investment conditions began to improve in April 2009 particularly in the swaps market and we expect this to have a beneficial impact on pricing Buy-in premium equals 100 at 31st December 2007 The divergence in pricing has two key implications for pension plans: it is more difficult to gauge what prices will be in advance of obtaining detailed buyout or buy-in quotations; and it is even more important to understand how insurance companies are pricing and to carefully consider the asset implications both on how to invest to match the insurance companies pricing and the strategy for transitioning assets. Most pension plans are likely to conclude that there is a modest immediate increase to the valuation deficit if they proceed with a pensioner buy-in. The challenge for pension plans is to consider what level of increase is acceptable in return for the risk reduction achieved by the transaction. 9

Pension Buyouts 2009 MARKET DRIVERS Confidence in financial institutions see page 27 for policyholder protections The wider deterioration in the UK and global economy over late 2008 and early 2009 has impacted on attitudes towards insurance companies both from investors and pension plan trustees. This led many pension plans to adopt a wait-and-see approach to buyout with completed deal volumes falling as a result. The reduction in investor confidence can clearly be seen from the chart of insurance company share prices below. In line with most financial stocks, the share prices of insurance companies were marked down heavily in early 2009. This reflected market concerns that further shareholder capital would be needed to strengthen policyholder reserves. Since then, there has been a rebound in sentiment as confidence grows that insurance company reserves are adequate to meet the challenges of the next few years. However, share prices are likely to remain volatile until greater certainty emerges on the economic outlook. 10

VIEWPOINT Despite negative factors, we continue to view favourably the strength of [life insurance] regulation in the U.K., improvements in risk management across the [life insurance] sector, the long-term fundamental strengths of the U.K. economy, and the size and diversity of the U.K. life market. Standard & Poor s 25th February 2009

PREPARING FOR A TRANSACTION Pension Buyouts 2009 Practical steps to prepare for a pension buyout or buy-in The implementation of a pension buyout or buy-in is a significant exercise and there are a number of steps that companies and trustees can take now to ensure they can act quickly to take advantage of attractive pricing when market conditions are right. Set up a trigger-based approach A buy-in is essentially an investment decision. Therefore it is helpful to set up a framework for assessing whether a buy-in price represents an attractive investment. By monitoring pricing closely, pension plans can identify when the price is within their target zone and work quickly to execute and achieve the desired risk reduction before the opportunity goes away. Possible action: Agree a trigger for assessing whether buy-in is attractive (eg relative to technical provisions) so that when price triggers are met the transaction can be executed rapidly. Review your data Whether trustees are aware of them or not, most pension plans have a range of issues with their data (from untraced members to key data not being held electronically). This can significantly delay transactions. If insurance companies are concerned about data quality they may add margins to their prices, or even refuse to quote at all. Possible action: A data audit in advance of a buyout process can speed up negotiation and implementation, as well as providing keener and more certain pricing. It can also improve the ongoing governance of a pension plan. Review your investments Transitioning significant amounts of assets can be challenging in volatile financial markets and this has been a significant hurdle in recent transactions. By reviewing the marketability and liquidity of the pension plan s investments in advance of any deal, work can be undertaken to prepare asset portfolios to allow a buyout transaction to be executed more rapidly. Some pension plans may also wish to adjust their investment strategies to better match their position against buyout or buy-in pricing. Possible action: Consider transitioning your assets into a form acceptable to insurance companies whilst ensuring they remain marketable and liquid to retain flexibility. Review the insurance companies One of the most difficult decisions for trustees is the ultimate selection of the insurance company to place the business with. This decision can be made easier by spending time now understanding who the insurance companies are and what they can offer. Assessing the insurance companies strengths and weaknesses, understanding the UK insurance regime and considering potential selection criteria will allow the final decision on selection to be made much more quickly when the time comes. Possible action: Meet the insurance companies to understand who they are and what they can offer. 12

LCP INSIGHT In our experience, careful preparation pays dividends for companies and trustees when executing a buyout better insurance company engagement, keener pricing and being able to move quickly when the time comes these are the key ingredients to achieving a successful deal. Clive Wellsteed, Partner, LCP

Pension Buyouts 2009 MARKET OUTLOOK Insurance company pipelines quality rather than quantity? The dynamics within the buyout market have changed markedly and this can clearly be seen by examining the insurance companies pipelines: The demand for pension buyouts has reduced in the past year. For example, one of the leading insurance companies has seen the number of pension plans seeking quotations fall by nearly 60%. On the other hand, the quality of the pipeline has improved. One leading insurance company states that over 50% of current deals in their pipeline are beyond the initial quotation stage which compares to around 20% a year ago. The completion rate in 2008 was low. One insurance company states that less than one in five quotations that they issued went on to complete, either with them or another insurance company. We expect the buyout market in 2009 and 2010 to be characterised by quality rather than quantity This paints a picture of a maturing and more orderly market than the initial rush in the summer and autumn of 2008. We are also seeing a greater level of sophistication in the deals that go through as trustees develop their requirements and insurance companies develop the features they are able to offer. Demand for buyout from pension plans in 2009 onwards Whilst attractive pricing has been available from a small number of insurance companies in early 2009, most insurance companies have now strengthened their pricing bases. Some pension plans, particularly those who value the risk reduction achieved from a buyout, are proceeding nonetheless and the insurance companies retain a core quality pipeline. However, many pension plans have taken a wait-and-see approach given the current financial turmoil. We expect that buyout quotation activity will pick up over the next few months as confidence begins to return to financial markets. After all, the demand for de-risking remains high the financial turmoil has been an effective demonstration of the level of risk that is being run by UK defined benefit pension plans and their sponsoring companies. In the short-term, depressed pension plan funding levels mean there is limited affordability for full buyouts and so a continued stream of pensioner-only deals is the most likely prospect. Over the medium term there is significant demand for risk reduction, and the recent trend for companies to cut back pension provision and even close pension plans to future benefit accrual will only serve to accelerate this. The pace at which pension plans move towards ultimate buyout depend on investment markets and available cash within sponsoring companies. 14

Pension Buyouts 2009 MARKET OUTLOOK How will the buyout market develop? The table below sets out three possible scenarios for investment markets over the next couple of years and the implications for the buyout market. Economic scenario Impact Estimated volumes 2009 2010 Optimistic Fiscal stimuli and quantitative easing prove successful Markets rebound over 2009 and 2010 Inflationary pressures potentially grow Pension funding levels recover from lows in early 2009 Buyout market volumes increase as pension plans decide conditions support further de-risking and locking-in of gains through buy-ins and buyouts 7 billion 12 billion Middle of the road Economies struggle throughout 2009 Deflationary pressure through 2009 Unprecedented government bond issuance potentially leading to: fiscal tightening inflationary pressures currency devaluations Steady stream of buyout transactions Initially pensioner-only transactions as they are most affordable Increasing number of full buyouts over the medium term 4 billion 8 billion Gloomy Serious further deterioration in markets Bank of England initiatives prove unsuccessful with resulting debt and fiscal burden Solvency positions of insurance companies become stretched Pension funding levels remain very low Limited buyouts due to concerns over insurance company solvency Most buyouts arise from the wind-up of pension plans where the sponsoring company is insolvent but the plan is funded above the level for entry to the Pension Protection Fund 2 billion 4 billion Insolvent companies a source of new deals? The insolvency of companies with defined benefit pension plans (such as Lehman Brothers and Woolworths) is another source of potential activity for the buyout market. Under UK legislation these pension plans will aim to secure pensions with an insurance company, subject to a minimum level of compensation being provided by the Pension Protection Fund for less well-funded plans. These transactions are generally quite difficult due to the complex legislative requirements and so it may be 2010 before some of these deals start to come through. We may also see some compromise deals where pension plans are bought out as part of a company restructuring or rescue deal. Such deals will involve many different parties, generally including the Pensions Regulator. 15

Pension Buyouts 2009 BUSINESS WRITTEN 2008 calendar year 2008 saw buyout volumes hit 7.9 billion, a rise of over 150% on 2007 volumes. The following chart shows the market share of each insurance company over 2008 by value of transactions written. All significant transactions in 2008 and the first quarter of 2009 are listed on page 32 Insurance company market share over 2008 by transaction value For all insurance companies, there is a delicate trade-off between achieving market share and return on capital Whilst 2007 was split between Legal & General and Paternoster with over 90% of business between them, in 2008 the business was much more evenly split demonstrating the greater maturity of the market. Six insurance companies now make up over 90% of the market. Legal & General s and Paternoster s shares have reduced since 2007, but they are shares of a much larger market. Legal & General had the highest volumes at 1.9 billion up from 1.4 billion in 2007 and replacing Paternoster in first place. Conversely, Paternoster pulled back from the market in the fourth quarter. This allowed Prudential to push them into fourth place with their 60 million deal with the Thomson Regional Newspapers pension plan in December. Pension Insurance Corporation was perhaps the surprise entrant in 2008. Having written no insured buyouts in 2007 or in the first four months of 2008 they wrote five deals before the end of 2008 totalling 1.7 billion. This put them in second place with a market share of 21%, only marginally behind Legal & General. Lucida and Prudential also separately struck deals with Bank of Ireland Life and Rothesay Life. As these deals were not with UK defined benefit pension plans they are excluded from the figures in this report. 16

Pension Buyouts 2009 BUSINESS WRITTEN 2009 quarter one The first quarter of 2009 saw over 900 million of business written. The following chart shows the market share of each insurance company over the first quarter of 2009 by value of transactions written. The volume of business written by each insurance company is set out on page 33 Insurance company market share over Q1 2009 by transaction value Legal & General carried on their success into the first quarter of 2009, writing just over 500 million and giving them the leading market share. Pension Insurance Corporation also continued to be successful writing 226 million of business. Paternoster remained out of the market in 2009 citing that the current regulatory and financial uncertainties are making pricing difficult and that their primary obligation is the security of policyholders. At the current time they are not accepting further liabilities. AIG Life wrote its largest buyout yet of 29 million at the end of March 2009 showing that whilst its parent company in the US has had highly public difficulties there is still confidence in the UK insurance business as a continuing entity. 17

LCP INSIGHT A well structured security arrangement, available at a proportionate price and with a clear understanding of the limitations, can provide additional protection and comfort to members, trustees and sponsoring companies. Charlie Finch, Partner, LCP