To say that 2022 has been a turbulent year for financial markets would be an understatement. One consequence is that many defined benefit pension plans have seen a significant increase in funding levels, with rising gilt yields and widening credit spreads bringing them closer to their end goal faster than expected.
However, for pension plans that are at an early stage in their de-risking journey – and for which redemption remains out of reach despite funding level gains – increased market volatility may be more of a foe than ‘a friend.
One of the ways these pension plans can quickly lock in their improved funding position and protect themselves against a reversal of fortune is to hedge against investment risk. In 2019, Legal & General introduced a new solution, the Assured Payment Policy (APP), which allows pension plans to do just that.
Enable pension schemes to lock in to improved funding levels
PPAs provide pension plans with a pre-determined series of future cash flows (fixed or inflation-linked), in exchange for an upfront premium. They have many similarities to a buyout, but are generally around 10-15% more affordable when used to insure liabilities associated with deferred members. This is primarily because the policy cash flows provided under a PPA will not vary with longevity or other demographic experience (as they would with a surrender or surrender). Instead, the APP protects against asset returns, interest rates and inflation – in effect, all market and reinvestment risks are transferred to Legal & General, at a rate of return above gilts. At the same time, the APP gives pension plans the right to add longevity risk protection to the APP (i.e. convert the APP to a buyout or a full buyout) when they are ready to do so.
APPs have additional bespoke features designed to benefit trustees. For example, PPAs can meet short-term cash flow needs, and trustees can periodically adjust PPA cash flows to match their last projected member benefit payments.
Additional key benefits for pension schemes below £100m
APPs can be used in different circumstances to meet the specific needs of a pension plan. Legal & General wrote six applications ranging from around £10m to around £900m. APPs can work for pension plans of any size and for a variety of purposes. For example, they can allow a pension plan to “build its own bond”, as cash flows can be tailored to meet the needs of the pension plan. More generally, they are considered a buyout with flexibility as to when the element of longevity protection is added.
A great example of an APP in action is the recent APP of around £10 million that we negotiated with the Flour Milling and Baking Research Association pension and insurance scheme, which is a partner in our business of investment management, LGIM, for nearly twenty-five years. The transaction demonstrated the benefits of APPs for pension schemes below £100m:
- The pension scheme will now benefit from access to the scale and asset sourcing capabilities of Legal & General’s annuity portfolio of tens of billions of pounds, a particularly pronounced advantage given the pension scheme’s standalone assets. ;
- Accessing our investment portfolio in this way offers the opportunity to minimize the gap between the cost of a global annuity and the assets of the pension plan. We invest in the same assets to back APPs as we do for surrenders (premiums are invested in the same portfolio), which means an APP provides good hedging against fluctuations in wholesale annuity prices;
- Trustees and the sponsor should now benefit from the reduced time and cost of managing the pension plan; and
- Trustees are entitled to a future quote from Legal & General to convert the APP into a buyout, which will likely be valuable in an increasingly busy market.
The cost of adding longevity risk protection to the APP should, all else being equal, decrease over time as members age.
Conclusion: An opportunity to reduce risk for pension plans approaching redemption
For pension plans that now find themselves much closer to redemption but still with a funding shortfall, an APP represents an inescapable opportunity to lock in recent funding gains. The APP then provides a safer and more secure route to redemption for trustees and their corporate sponsor.
To learn more about APPs and how they can support your retirement plan, please see the Legal and general site or contact me at [email protected].
This position is funded by Legal and General