Beyond Buy-out: Rethinking the Endgame for UK Pension Schemes

The UK’s defined-benefit pension schemes are at a crossroads. With funding levels at an all-time high,¹ many trustees are taking the opportunity to have a strategic rethink about the endgame planned for their schemes. Should they prepare to transfer their obligations to an insurer in a buy-out transaction? Or is the scheme better placed to run on, managing its own obligations?

The surge in funding levels that brought pension schemes to this decision is the result of the high interest-rate environment in recent years. Rising rates drove down the value of pension funds’ long-term liabilities and boosted their funding levels. As a result, the aggregate funding ratio on the Pension Protection Fund’s s179 basis across more than 5,000 UK defined-benefit pension schemes stood at 148.5% at the end of July 2024, down slightly from 149.4% a month earlier. There were 4,589 schemes in surplus and 461 in deficit.² These figures flatter the overall position because the s179 calculation does not cover all pension scheme liabilities or fully reflect the cost of an insurance transaction, but they do provide a good first-order approximation.

With so many schemes in a strong financial position, the long-term trend toward de-risking strategies accelerated last year to a record total of 226 buy-in and buy-out transactions.³ These are not the only options available to trustees, however. Thanks to sustained higher yields, we believe fixed income is once more fulfilling its traditional role as a source of predictable income in a diversified investment portfolio, facilitating liability matching and reducing the risk of pursuing a run-on strategy.

There has been a lot of discussion in the press recently about which of these options – buy-out or run-on – is best under current market conditions. We believe a case can be made for both, and the decision depends on the specific situation of individual schemes. In this article, we will examine the potential benefits and risks associated with both strategies as well as the role that fiduciary managers can play in helping pension fund trustees choose and implement a strategy that fits their needs.

Option 1: Buy-out

We believe the chief benefit of a buy-out is that it provides a complete transfer of a pension scheme’s assets and liabilities to an insurer, bringing the obligations of the trustees and sponsor to an end and allowing for the closure of the scheme. This endgame option remains popular with trustees: about 75% of UK pension schemes say they are targeting buy-out in the long term.⁴ As more schemes pursue buy-outs, the capacity of insurers to conduct these transactions could potentially limit expansion of this market, though the entrance of new participants may allay this constraint.⁵

While the finality of buy-out may make it an attractive endgame option for many schemes, trustees should consider several issues before proceeding down this road. The first of these is cost. This can vary based on the specifics of a transaction, but we estimate that the assets transferred in a buy-out are 10% to 30% above what is required to prudently meet a scheme’s obligations. Insurers require this premium to cover their own costs, including capital requirements, and to enhance the profitability of the transaction.

Given the continued strong demand for buy-outs, pension schemes planning to pursue this option need to make all aspects of their operation transaction-ready. This process can be costly and time-consuming. It encompasses everything from governance and funding to data cleansing. Trustees also need to consider the scheme’s relationship with its sponsor. Where the sponsor’s covenant is seen as volatile, as in cases of potential insolvency, trustees may prefer to move toward buy-out to bolster the security of members’ benefits.

Option 2: Run-on

Trustees and sponsors may choose to run on their pension schemes for a variety of reasons. Where a scheme is in surplus, for example, trustees may choose to retain control in order to share this surplus with their members by improving benefits, and in some cases with their sponsors. In February 2024, the previous UK government proposed measures to make the extraction of surplus easier for trustees,⁶ but it remains to be seen if the new government will pursue this proposal as part of pension-industry reforms announced in July.⁷

Trustees may also decide to retain control of the pension scheme with the goal of improving returns and ensuring that its assets are invested in line with the values of the membership and sponsor. An example could be a shared commitment to supporting global efforts to address climate change and advance the transition to a low-carbon economy.

Avoiding the costs associated with buy-out is another consideration, though run-on means that the sponsor continues to cover costs including administering the scheme, running the board of trustees and paying advisors.

Finally, a sponsor may prefer to keep its pension scheme running out of a sense of responsibility to its current and former employees. Rather than hand over the obligation to make pension payments to an insurer, sponsors may choose to remain involved, retaining the attendant risks and responsibilities, including injecting fresh capital if required.

Aligning Investment With Endgame

Having considered their endgame options, trustees need to implement an investment strategy that aligns with their chosen goal. In both cases – buy-out or run-on – schemes with strong funding levels may want to increase their hedge ratios to bring the interest rate and inflation sensitivities of their assets and liabilities into closer alignment.

The current higher yields in high-quality fixed income, including government, agency and corporate bonds, presents a potentially attractive opportunity to use cashflow-driven strategies to match the timing and magnitude of portfolio and liability payments. This could also reduce future market sensitivity for a portion of liabilities. The appeal of investment-grade bonds in this high-yield environment was clearly expressed in Goldman Sachs Asset Management’s survey of pension funds in Europe, including the UK. Nine of 10 respondents in the survey said they planned to increase or maintain their allocation to investment-grade debt in the year ahead.⁸

Given the long duration of their obligations, this could also be a good time for trustees to prepare their portfolios for the risks and opportunities associated with the transition to a low-carbon economy. We believe their long-term perspective puts pension schemes in a good position to assess and mitigate these risks and to invest in solutions that can take time to develop.

It is our opinion that trustees who are charting a course toward a buy-out agreement with an insurance company will also need to be sensitive to how insurers invest, taking into account solvency capital, regulatory and accounting considerations, and other inputs to target better risk-transfer pricing. Conversely, trustees who see value in retaining control of their schemes, and have the investment capability to run on successfully, may have the opportunity to invest in areas of the market often eschewed by insurers, such as securitizations.

Value of Partnership

We think UK pension schemes are operating in an increasingly complex environment. In addition to economic uncertainty and geopolitical risks, trustees face new regulatory requirements, more vocal stakeholders and reputational risks from social and traditional media. The resources available to many schemes have not increased to match this complexity, however, leaving trustee boards and their corporate sponsors stretched.

In response, we think that many pension funds are seeking out a fiduciary manager to help them navigate these challenges. Fiduciary management involves the delegation of activities such as the setting and implementation of a pension scheme’s investment strategy to a specialist firm, usually an asset manager. We think this outsourcing is a logical step for many schemes because asset managers tend to have greater resources and the scale to develop expertise more efficiently. Fiduciary management is becoming a standard tool, with 18% of UK pension schemes using this service in some form.⁹

Every pension scheme’s path to endgame is different. We think a fiduciary manager’s job begins with understanding the scheme, including its investment objectives and constraints, risk tolerance and liquidity requirements. This understanding is then transformed into an investment strategy tailored to the scheme’s objectives and level of outsourcing needs. Implementation of this investment strategy requires robust risk management and the ability to adjust to evolving market dynamics.

Path to Endgame

As the UK’s defined-benefit pension schemes look to the future, they do so from a position of strength. With funding levels across the industry at historic highs, we think trustees can afford to consider their endgame options. Buy-out remains the most popular destination, but running a scheme on successfully can bring a variety of benefits for its members, trustees and corporate sponsor. Whichever path they choose, schemes are increasingly turning to fiduciary managers to help them achieve their goals.

¹ “The Purple Book 2023: DB Pensions Universe Risk Profile,” Pension Protection Fund. Data as of March 31, 2023.

² “PPF 7800 Index,” Pension Protection Fund. As of July 31, 2024. The PPF 7800 Index “tracks the level of underfunding risk in the PPF-eligible universe using the latest scheme return information provided to The Pensions Regulator and the roll-forward methodology used for PPF levy purposes,” according to the PPF.

³“Buy-outs, Buy-ins and Longevity Hedging – H2 2023,” Hymans Robertson. Data as of December 31, 2023. In a buy-in transaction, a pension scheme purchases an insurance policy that covers the benefit payments for a portion of the scheme’s membership. The insurer makes payments to the scheme, which then makes payments to the insured members. As a result, the buy-in is considered an asset of the scheme. In a buy-out, a scheme’s assets and liabilities are fully transferred to an insurer, which assumes the obligation to pay members’ pensions. Buy-in transactions are often an intermediate step toward a buy-out.

 ⁴“Risk Transfer Report 2023,” Hymans Robertson. As of March 2023.

⁵For example, M&G re-entered the market last year. See “M&G re-enters the bulk purchase annuity market with two buy-in transactions totalling £617m,” M&G press release. As of September 20, 2023. This was the first increase in the number of insurers in the market in six years, and more may follow suit. See “Risk Transfer Report 2024,” Hymans Robertson. As of February 2024.

⁶“Options for Defined-Benefit Schemes,” Department for Work & Pensions public consultation. As of February 23, 2024. The consultation closed on April 19, 2024.

 ⁷“Chancellor vows 'big bang on growth' to boost investment and savings,” UK Government press release. As of July 2024.

⁸“European Pension Survey: Finding Opportunity in Uncertain Markets,” Goldman Sachs Asset Management. As of February 20, 2024.

⁹“Latest trends in Fiduciary Management: 2023 Isio UK Survey,” Isio Services Ltd. Data as of June 30, 2023. The survey results are based on the responses from 16 fiduciary managers operating in the UK defined-benefit pensions market, including Goldman Sachs Asset Management.