Defined benefit (DB) pension schemes that are looking to buyout should prepare for major delays as rising demand for bulk annuity deals is threatening to overwhelm the market’s capacity, AXA Investment Managers (IM) has warned.

AXA IM noted that buyout interest had soared after the gilts crisis and favourable market moves improved DB schemes’ funding positions over recent months.

The investment manager estimated that more than a quarter of DB schemes are now fully funded on a buyout basis, but added that ‘anecdotal evidence’ suggested this figure could be far higher.

Although this is positive news for trustees with schemes in this position, AXA IM head of fixed income investment solutions, Lionel Pernias, warned that widespread demand for full risk transfers has created a growing gap between supply and demand, with the market “potentially more constrained than many realise”.

“Forecasts suggest that record numbers of risk transfers will be completed in the coming years as more schemes become fully funded on a buyout basis, but the market has limited capacity,” he continued.

“Not only are there just eight insurers in the market and high barriers to entry, but there are other major hurdles to buyouts happening on the scale being assumed.

“Trustees have been told for a long time that a buyout is contingent on their funding status and little else, but the reality now is there is an unprecedented supply crunch, which means they could find themselves at the back of a queue that they didn’t know existed – and which is only getting longer.”

One of the major hurdles highlighted was that insurers only have so much capital to underwrite deals to meet their solvency ratios, and the assets they will receive from pension schemes will not cover this.

Additionally, insurers may have difficulties sourcing suitable assets, as Pernias explained: “Insurers need to put their capital to work in high-quality public and private debt markets to ensure that cash flows match the liabilities under the matching adjustment framework.

“But there is a limited number of these assets and a shallow supply pipeline given the end of the unwind of the Bank of England’s corporate bond purchase programme.

“To make matters worse, there are fewer issuers coming to the GBP market with insurer-friendly new supply in 2023. If insurers cannot source those assets, they will not be able to underwrite the deal.”

AXA IM added that, even if insurers are able to source the necessary capital and assets, schemes still have to contend with several challenges that could impact their ability to transfer as soon as they intend to.

These challenges include member data cleansing, which Pernias warned would take a significant amount of time, and that insurers may become more aggressive on pricing due to demand or leave a margin of risk for data uncertainty and start to take a more selective approach amid closer regulatory scrutiny of deal volumes.

“It should not be overlooked that many schemes, even if they are well funded, might still have long dated and illiquid assets that they can't easily sell, and insurers may not want those because they could be unsuitable for matching adjustment or the overall risk profile,” Pernias said.

“That could add significant cost, but also be time consuming, as schemes are forced to sell those assets.

“Schemes need a Plan B if a buyout is not going to happen as quickly as they anticipated. That means making sure the scheme becomes or remains buyout-friendly, while maintaining the desired funding ratio and putting any surplus to work.

“In our view, the most effective way they can achieve this is by allocating to credit through cashflow driven investment strategies, which can offer good liquidity, attractive return potential, stable and timely cashflows that could appeal to insurers in future, and ideally a climate-integrated approach that would help differentiate them in a competitive market where ESG risks and commitments are increasingly central.

“Credit is also a much better place to be if there is a more severe economic downturn than expected, as funding levels are not calculated on a corporate bond basis.

“It is clear that the buyout market has changed. Today, schemes simply cannot afford to sit on cash for unknown years while they wait to achieve a full risk transfer. Trustees must prepare themselves for a longer wait now.”

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