The pension fund transfer business needs urgent scrutiny

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There is a general consensus in the UK pension sector that the funding of pension systems has improved so much recently that they can safely move into what is called a final phase.

This occurs in two ways: one is through the transfer of risk to an insurer through an annuity purchase, where a pension plan takes out an insurance policy that pays all the liabilities made to its members; the other is through an annuity purchase, where the plan transfers all its liabilities to the insurer.

The risk transfer market is in full swing. Actuarial consultancy WTW predicted earlier this year that 2024 would be the busiest year ever, with annuity transactions worth £60bn. However, this boom is paradoxical.

Admittedly, this psychology is understandable after years in which sponsoring employers poured billions into their pension funds to cope with growing deficits. Shifting the risk of future deficits is one way to ensure a favourable funding position. The longevity risk is also transferred to the insurer.

There is, however, a real question about whether sponsoring companies and trustees have colluded in what William McGrath, chief executive of C-Suite Pension Strategies, calls a damaging excess of de-risking.

According to the Pension Protection Fund, pension schemes were in surplus by March 2023 of £359bn, with their liabilities valued at benefit levels equivalent to those of the PPF. This was a funding ratio of 134%. More than 80% of schemes were in surplus. On the strictest valuation basis, in line with takeover market prices, the surplus was still a sizeable £149.5bn, or 111.9%.

It should also be noted that past deficits were arguably a fiction, the bizarre product of ultra-low interest rates following the financial crisis, which caused the value of future pension liabilities to soar as they were discounted due to lower rates. With rates normalising, a transfer of risk to insurers would now preclude benefits such as paying discretionary increases to plan members and reducing company contributions.

In particular, if pension funds continue to bear the responsibility for meeting pension liabilities – known as “leakage” – any surplus could be recycled into substandard defined contribution schemes.

At the same time, a run allows pensions to be funded with a healthier risk appetite across a broader range of asset classes than insurers tolerate, highlighting the broader economic consequences of transferring risk to insurers.

Graham Pearce and John O’Brien of the consultancy Mercer say the risk-transfer transaction process is inefficient and costly. Most schemes have to revise their investments in advance to meet insurers’ demand for a low-risk, highly liquid fixed-income portfolio, then potentially reinvest them in illiquid fixed-income after the transaction. Pension schemes are thus deprived of the opportunity to earn an illiquidity premium for some time. Insurers, they say, have to add the cost of delays in reinvesting assets to their initial premium.

These risk transfers reinforce the UK financial system’s bias against capital. To make matters worse, the Prudential Regulation Authority has raised concerns that the insurance sector has absorbed too many assets too quickly, leading to risks to financial stability. The concentration of the business in just nine insurers also points to the risk of one-way markets.

It is difficult to determine whether acquisitions and buybacks have offered good value for money because the market lacks transparency. What is clear is that the dramatic increase in demand is creating capacity constraints, creating an adverse pricing environment for pension funds.

Turning the Page, a policy think tank recently set up by Michael Tory, one of the founders of Ondra Partners, estimates that the gains to date made by defined benefit pension funds from total risk transfers amount to between £12bn and £15bn. These gains, by the way, include those from the acquisitions of the big insurers’ own pension schemes.

This is a very generous reward for such a low-risk business. Given that just four firms account for around 80 per cent of the market, according to industry sources, there are clear reasons for the Competition and Markets Authority to take a look. And McGrath argues that the government should introduce a tax on insurers’ windfall profits.

Extra taxes are usually bad for the economy, but in this case a tiny oligopolistic group of insurers operates in a highly distorted market, where their actions have consequences for the wider economy. This should give Chancellor Rachel Reeves pause.

john.plender@ft.com