As the sun rose on a crisp autumn morning in 2022, pension fund managers worldwide awoke to a startling new reality. The gilts crisis that had rocked UK financial markets had not only sent shockwaves through the economy but also dramatically reshaped the landscape of defined benefit pension schemes. For many, the path to buyout—once a distant horizon—had suddenly become a stone’s throw away. Yet, as these managers peered into their portfolios, they grappled with an unexpected dilemma: what to do with their illiquid assets?
It is a tale as old as investing—the siren song of higher returns luring pension schemes into the embrace of private equity, real estate, and infrastructure investments. But what exactly are these illiquid assets causing such consternation? Simply put, they are investments that cannot be easily or quickly converted to cash without potentially incurring significant losses.
Think of sprawling real estate developments, stakes in private companies, or complex infrastructure projects. These aren’t assets you can sell at the click of a button like stocks or bonds. They are valuable, certainly, but finding a buyer willing to pay full price and close the deal quickly? That’s where the real challenge begins.
“We’ve spent years cultivating these investments,” one might imagine the trustee muttering, “and now we’re supposed to just… what? Sell them off at a discount? Hold onto them and delay our buyout? Or perhaps we should simply present them to insurers with a hopeful smile and a shrug?”
The question of how to manage illiquid assets in pension risk transfers has become the elephant in the room. It is a problem that’s equal parts financial conundrum and existential crisis, forcing us to reckon with the very nature of long-term investing in a world that suddenly demands immediacy.
The Impact of Illiquid Assets on Pension Risk Transfer (PRT) Transactions
To quantify the scale of this issue, consider that a Standard Life survey revealed 40% of pension schemes approaching the market for de-risking solutions reported having illiquid assets to manage. According to an OECD survey, the average allocation to illiquid assets across pension schemes in 34 countries is around 15%, with some holding up to 50% of their portfolio in illiquid assets.
Several employee benefit consultants reported that issues with illiquid assets had directly led to delays in completing transactions. In the fast-moving world of bulk annuity pricing, delays can translate into missed opportunities and potentially less favorable terms for pension schemes.
At the heart of the matter lies a fundamental mismatch between the nature of illiquid assets and the requirements of insurers participating in bulk annuity transactions. Pension schemes, with their long-term investment horizons, have historically benefited from the potential higher returns and diversification offered by illiquid assets. Insurers, on the other hand, operate under stricter regulatory regimes that prioritize assets that can be readily valued and liquidated.
Moreover, the issue has broader market implications. The need to manage illiquid assets is influencing transaction structures, pricing dynamics, and even the competitive landscape among insurers. Some providers are rolling up their sleeves to find innovative solutions, while others are hesitating at the starting line.
Reasons for the Increased Prominence of Illiquid Assets
So, how did we get here? What’s led to the swell of illiquid assets in pension portfolios, turning them from prized possessions into cumbersome baggage?
First, consider the most recent catalyst: the unexpected acceleration of funding level improvements. This rapid improvement, while positive, has had the unintended consequence of bringing forward de-risking plans for many schemes. Data from the Pension Protection Fund’s Purple Book shows that the aggregate funding ratio of UK defined benefit schemes on a Section 179 basis improved from around 102.8% at the start of 2022 to 134% by March 2023.
But why were these illiquid assets so prevalent in the first place? After the 2008 financial crisis, in an era of low interest rates and lackluster returns from traditional asset classes, pension schemes turned increasingly to alternative investments in search of higher yields.
Secondly, illiquid assets offer diversification benefits. In a world where correlations between traditional asset classes seemed to be increasing, the relatively low correlation of private markets to public equities and bonds was particularly attractive. During the market turbulence of 2020, many illiquid assets demonstrated resilience, further cementing their place in pension scheme portfolios.
Thirdly, certain types of illiquid assets, particularly those with stable, long-term cash flows, offered attractive liability-hedging characteristics. Infrastructure investments, for instance, often provide inflation-linked returns that align well with pension scheme liabilities.
The trend towards illiquid assets was further accelerated by regulatory changes. In the UK, the introduction of the Pension Schemes Act 2021 placed greater emphasis on long-term funding strategies, indirectly encouraging investment in assets that could match the long duration of pension liabilities.
Moreover, the post-COVID economic landscape saw many asset managers extend the time horizons of their private debt investments. This was partly in response to the uncertain economic outlook but also aligned with the long-term nature of pension scheme liabilities.
The Willis Towers Watson Global Pension Assets Study shows that the average illiquid asset allocation across the seven largest pension markets (Australia, Canada, Japan, the Netherlands, Switzerland, the UK, and the USA) increased from 4% in 1997 to 25% in 2017.
Challenges for Insurers in Accepting Illiquid Assets
Now, let’s flip the coin and see things from the insurers’ perspective.
Pension schemes and insurers, despite both being in the business of long-term financial management, operate under markedly different regulatory frameworks. This divergence creates a situation akin to trying to fit a square peg into a round hole—possible, perhaps, but not without considerable effort and potential compromise.
For insurers in the UK, the Solvency II regime (soon to be Solvency UK) imposes strict requirements on the assets they can hold to back annuity liabilities. These requirements are designed to ensure that insurers can meet their obligations to policyholders with a high degree of certainty.
The Matching Adjustment (MA) is a key mechanism within the Solvency II framework that allows insurers to benefit from holding certain long-term assets. However, to qualify for the MA, assets must meet specific criteria, including having fixed cash flows. Many illiquid assets held by pension schemes do not fit this mold. Accepting these assets could potentially increase an insurer’s capital requirements, making the transaction less economically viable.
This leads to another significant challenge: valuation. Illiquid assets are difficult to value with precision. Unlike publicly traded securities, there is no readily available market price. This opacity can create significant discrepancies between the value ascribed to these assets by pension schemes and the value insurers are willing to recognize. In some cases, these valuation gaps can derail a transaction entirely.
For insurers, it is not just a matter of deciding they like an asset. They need to ensure they can model it accurately, understand its risk profile, and integrate it into their overall asset-liability management strategy. This often involves seeking approval from the Prudential Regulation Authority (PRA) to include new asset types within an insurer’s Matching Adjustment application, a time-consuming and resource-intensive process.
Even after an asset is onboarded, the challenges persist. Ongoing management, regular valuations, credit assessments, and regulatory compliance become part of the daily grind.
Options for Managing Illiquid Assets in PRT Transactions
So, what is a pension scheme to do? Fortunately, there are several strategies to navigate this tricky terrain.
- Using Illiquid Assets as Premium Payment: This strategy involves transferring the illiquid assets directly to the insurer as part of the transaction. While this might seem like an elegant solution, it is not without complications. Insurers, bound by regulatory constraints, often apply significant discounts or “haircuts” to the value of these assets—sometimes reaching 20-30% of their perceived value—potentially making the transaction less economically attractive for the pension scheme.
Assets that align closely with insurers’ liability profiles, such as certain infrastructure investments or long-lease property, may be more readily accepted. Others, like private equity holdings or hedge fund investments, are likely to face greater scrutiny and potentially larger discounts.
- Deferred Premium Approach: Under this arrangement, a portion of the premium is paid upfront, typically using liquid assets, while the remainder is deferred until the illiquid assets can be sold or reach maturity. This approach can be particularly attractive for schemes with illiquid assets expected to generate returns or distributions in the near to medium term. It allows schemes to lock in pricing and terms while providing time for an orderly disposal of illiquid assets.
- Secondary Market Sales: Secondary markets allow schemes to sell their stakes in private equity funds, real estate investments, and other illiquid assets to specialized buyers. The appeal of this approach lies in its potential to provide a quicker exit from illiquid investments. According to recent data, the secondary market for private equity alone has grown to over $112 billion globally. However, secondary market sales often come at a price. Discounts to net asset value are common, particularly for less desirable assets or during periods of market stress.
- Cash Flow Matching Strategies: Think of this as choreographing a dance between your assets and liabilities, ensuring they move in perfect harmony. By selecting assets whose cash flows align with the timing of your pension payments, you can reduce the pressure to liquidate illiquid investments hastily. It doesn’t make the illiquid assets liquid, but it does create a smoother path, allowing you to meet obligations without scrambling for cash.
- Engaging with Insurers Earlier: This approach allows schemes to understand insurers’ preferences and constraints well in advance of a transaction, potentially influencing investment decisions or allowing time for more gradual portfolio adjustments. A survey by Standard Life found that 11 out of 12 employee benefit consultants believe engaging with insurers earlier regarding illiquid assets could help with challenges if buyout is a scheme’s end goal.
- Portfolio Run-Off: Some schemes opt for a more patient approach, choosing to allow their illiquid assets to run off naturally before approaching the insurance market. This strategy can be effective for assets with a clear maturity date or those expected to generate significant distributions in the near term. However, waiting for illiquid assets to run off might risk missing out on favorable pricing in the meantime.
- Sponsor Solutions: In some cases, scheme sponsors may step in to provide solutions. This could involve the sponsor taking on the illiquid assets, providing a loan to bridge any funding gap, or offering guarantees to support a deferred premium arrangement. Sponsor solutions can be a game-changer, but the economics and risks need to make sense for all parties.
- Innovative Structuring Solutions: These might involve creating special purpose vehicles to hold illiquid assets, developing new fund structures more palatable to insurers, or using derivative overlays to manage the risk characteristics of illiquid assets.
Market Developments and Solutions to Combat Illiquidity
The industry is not standing still. Innovations are sprouting up to tackle the illiquidity challenge head-on.
- Innovative Platforms and Tools: The industry has seen the emergence of new platforms and tools designed to facilitate the management and transfer of illiquid assets. For instance, XPS Group’s Xchange platform aims to create a marketplace for pension schemes to trade illiquid assets. Similarly, Isio’s Fund Liquidity Options (i-FLO) tool helps schemes assess the liquidity profile of their portfolios and model different scenarios for managing illiquid assets.
- Evolution in Insurer Capabilities: Some insurers are exploring the use of advanced data analytics and machine learning algorithms to improve their ability to value complex illiquid assets. Others are building dedicated teams with expertise in specific types of alternative investments.
- ESG Considerations: Many illiquid investments, particularly in areas like infrastructure and real estate, have significant ESG implications. This trend is leading to the development of new ESG-focused illiquid investment products, as well as enhanced due diligence processes for existing investments.
- Collaboration and Knowledge Sharing: Increased collaboration across the industry is leading to shared best practices and standardized approaches to managing illiquid assets in PRT transactions. For instance, the Institute and Faculty of Actuaries has established a working party to explore the challenges and opportunities presented by illiquid assets in bulk annuities. There’s recognition that this is an industry-wide challenge, and by working together, more robust, and efficient solutions can be developed.
Recommendations for Pension Schemes to Manage Illiquid Assets
Navigating these waters is not easy, but with the right approach, schemes can chart a successful course.
- Take Early Action: The importance of early preparation cannot be overstated. The time to start thinking about your illiquid assets is not when you’re on the doorstep of a buyout. This preparation should include a thorough review of the scheme’s illiquid asset holdings, understanding their characteristics, valuation methods, and potential exit strategies.
- Elevate Investment Strategy in Insurer Negotiations: Traditionally, discussions with insurers have focused primarily on scheme data and benefit structures. However, investment strategy—particularly as it relates to illiquid assets—should be a key part of these conversations. Do not treat your illiquid assets as an afterthought; they should be front and center in insurer negotiations.
- Develop a Clear, Realistic Plan: Before approaching the market, schemes should have a clear and realistic plan for managing their illiquid assets. This plan should consider various scenarios and options, from asset retention to secondary market sales.
- Consider a Combination of Approaches: Given the complexity of illiquid assets, a one-size-fits-all approach is rarely optimal. Schemes should consider a combination of strategies tailored to their specific circumstances and asset holdings. For instance, a scheme might choose to sell some assets on the secondary market, retain others for natural run-off, and work with the insurer to transfer a select few as part of the premium payment.
- Invest in Expertise: Managing illiquid assets in the context of a PRT transaction requires specialized knowledge. Schemes should consider investing in internal expertise or engaging external advisors with deep experience in this area.
- Prioritize Data Quality and Transparency: Insurers place a high premium on data quality and transparency, particularly regarding illiquid assets. Schemes should ensure they have comprehensive, accurate data on their illiquid holdings, including valuation methodologies, cash flow projections, and risk characteristics.
- Stay Informed of Market Developments: Given the rapid pace of change in this area, it is crucial for schemes to stay informed of market developments. Participation in industry forums, regular engagement with advisors, and ongoing dialogue with potential insurers can all help schemes stay ahead of the curve.
- Maintain Flexibility: Finally, while having a clear plan is important, schemes should also maintain flexibility. The PRT market can move quickly, and opportunities can arise unexpectedly. An insurer’s job is to anticipate it, adapt to it, and hopefully, stay one step ahead.
Conclusion
We are seeing a growing willingness to learn from experiences in other markets. A solution developed in the UK might be adapted for use in the Netherlands or Canada, and vice versa.
In the world of pension risk transfers, the only constant is change. The road ahead may be complex, but with careful planning and strategic action, schemes can navigate the challenges of illiquid assets and achieve their de-risking objectives.