Many defined benefit schemes are finding their portfolios increasingly exposed to illiquid assets, having sold down liquid assets to meet collateral calls in the wake of last year’s LDI crisis. For those schemes in this position that are approaching buyout, trustees have to make a decision on what to do with these assets if they are to lock in the recent funding gains from soaring gilt yields.

Partner Beth Brown commented that “recent market movements have meant that many pension schemes that thought buy-out was not an option in the foreseeable future are now able to afford buy-out sooner than expected.”

However, Beth continued, “this does not necessarily mean that they can actually buy-out their scheme. The ability to buy-out is not just dependent on the price and affordability but also whether the scheme is ‘buy-out ready’ – whether the scheme data is in good form and the assets are ones that can be transferred to an insurance company, and whether there is an insurance company that has capacity and is willing to transact with the scheme.

“With more schemes being able to afford buy-out, insurance companies are increasingly setting conditions, particularly relating to data and minimum scheme size, before considering whether to transact with a pension scheme. Many insurers have introduced a stream-lined buy-out option whereby it will transact – usually with smaller pension schemes – if the pension scheme can sign up to the standard transaction terms, among other factors. On the one hand, this provides access to the buy-out market which would not be available to smaller schemes, which is welcome, but on the other hand, it can be difficult to transact as every pension scheme is different and one size does not fit all.

“If trustees do not have enough money for a buy-out, they could look to the sponsoring employer for a top-up payment to cover the short fall. In the unlikely case that this is through a loan from the employer, this presents challenges. Firstly, there are restrictions on the amount that an employer can loan to scheme/trustee. Secondly, and more importantly, on a buy-out, the intention is that the trustee eventually passes over all the scheme assets to an insurer and then, in due course, will wind up the scheme. Once a scheme is wound up, there are no more scheme assets.

“It may be that the trustee has illiquid assets which it intends to use for a buyout or to pay the employer back once it has been able to sell them. Trustees would need to take advice on how much an illiquid asset is likely to sell for and agree beforehand what happens if the illiquid assets sell for less than expected.

“As we all know, markets can be volatile and the price an illiquid asset is expected to fetch at the point the trustees decide to sell it can be very different to the price it actually gets when it is sold, if a buyer can be found. In reality, a buyer of any illiquid assets would likely be lined up before the buy-out contract was signed. The money from an illiquid asset is not the trustee’s until the asset has actually been sold, which brings with it some uncertainty. Therefore, any such arrangement would need to set out in the buy-out documentation a long stop date for the sale of the illiquid assets as well as what happens if the illiquid assets are sold for more than expected, such as if additional benefits can be secured. Can the surplus be returned to the employer? Likewise, there needs to be clarity regarding the possibility of the illiquid assets being sold for less than expected or not being sold at all – would there be a haircut on the benefits to be secured? This would need to be covered in the transaction documentation.

“The key takeaway is that trustees should engage with insurers early and will need carefully considered and joined up advice from their advisers including lawyers, actuaries and investment advisers.”

Read Beth’s comments in Mallowstreet, here.