Many pension funds are finding themselves at a point where they could buy out much sooner than expected, but some might still have illiquid assets in the portfolio that could prevent them from doing so. What are the pros and cons of the emerging solutions to this dilemma? 

 

The rise in gilt yields since last year has reduced the liabilities of many defined benefit pension funds, pushing up their funding position to levels they had not expected to reach so soon.  

 

Some of those DB schemes still have exposure to illiquid assets in their portfolio, which may even have increased in proportion to the other assets as schemes sold down liquid assets to meet collateral calls last year. Their trustees now find themselves having to make a decision on what to do with these assets if they are to lock in the recent funding gains. 

 

 

Schemes have multiple options, says Tiziana Perrella, a professional trustee at Dalriada Trustees and former risk transfer adviser. They can take the simplest route and sell the assets to fund the buyout. However, she warns that the secondaries market is a specialist market – and selling in it can come at a cost.  

 

“You can end up with a discount to the actual asset value. We’ve seen as much as 70%,” she remarks. 

 

Such a big haircut might not be acceptable to many trustees, but it can be if the trustee wants to reduce risk and there is a good opportunity, she says. 

 

Another option is passing the illiquid assets to an insurer, but this can be tricky as some illiquids are, paradoxically, more liquid than others and can be sold in a matter of months rather than years, while others are very illiquid and hard to dispose of. Mainly, however, the trustees might want to consider if it makes any difference, as the insurer might just sell the asset anyway. 

 

“If [the insurer] sells them themselves, there may not be much value in doing that,” finds Perrella. “In a lot of cases you’re actually better off having control of that sale process.” 

 

A growing number of insurers are also offering deferred premiums, where the trustees essentially receive a loan from the insurer. As they pay down the deferred premium, chunks of liabilities are tipped from the deferred premium into the main policy. Perrella says this approach has been tried and tested, but notes that requesting a deferred premium will influence insurer appetite. 

 

"It could be something that tips some insurers into not quoting for the case,” she cautions.  

 

This is because as a separate policy, it falls outside the matching adjustment, which might require negotiations with the Prudential Regulation Authority. As the insurer cannot offer pricing advantages, it also makes the deal more expensive.  

 

“For that proportion of the premium you end up paying slightly over the odds,” Perrella explains. 

 

However, it has been done, she notes – and some insurers have even offered deferred premiums for transactions of no more than £200m. 

 

A loan to bridge a short to medium-term liquidity issue does not necessarily need to come from the insurer. Sponsors, provided they have the appetite and deep pockets, can also step into the gap. 

 

Any such arrangement needs to be a commercial contract with a full schedule in place, with interest payment and the loan repayment being made at the pace at which the illiquid assets are sold. 

 

This solution is cost effective but “a little bit painful”, says Perrella. 

 

“When you have done a buyout or you're very close to doing a buyout, to keep the scheme running just to repay, it's a little bit painful but you kind of reduce 99% of the costs associated. So that may be quite an attractive solution,” she says.  

 

If the scheme does not realise the full value of the asset in the end, the sponsor can agree to forego the rest of the loan, which then acts like an additional contribution.  

 

But “what you need to be careful of is the tax efficiency, because obviously you cannot get tax relief,” Perrella cautions. 

 

If the value to be foregone is high, the sponsor might agree to take over the asset itself - if it can and is ready to keep it on its books. But, as with the entire process, both the sponsor and scheme would need to get in-depth advice to check the legality and tax implications of such an agreement. 

 

"It’s all very doable, but each solution has pros and cons, and obviously there is this associated cost as well, both advisory and potentially from a tax perspective,” says Perrella. 

 

 

Employers can be helpful with illiquids either by purchasing the asset or providing a short-term loan to the scheme, agrees Shelly Beard, managing director pensions transactions at WTW.  

 

“We’ve seen both in recent months. The key things to work through are typically tax consequences and whether it’s possible for the sponsor to own the illiquid, as some of them are designed specifically for pension scheme ownership,” she notes. 

 

Many schemes are also currently selling illiquids on the secondaries market, she says. This large, global market was particularly busy at the end of last year and early 2023, she says, with “relatively high haircuts as a large number of schemes sought to sell illiquids as part of rebalancing”. More recently, the team has seen these haircuts coming down, however. 

 

There is also movement when it comes to deferred premiums – Beard says a recent survey her group ran showed all insurers now say they offer this, albeit with varying size restrictions. 

 

“Of course, this comes with an interest charge, and also the need for the trustees to be completely certain they can meet the deferred premium amount when it becomes payable,” she remarks. 

 

While insurers are getting more comfortable with offering deferred premiums, taking on illiquids from pension schemes is still not their preferred option, it seems. 

 

Beard says whether an insurer would take on an illiquid asset depends on the size of the illiquid, the size of the deal and what type of illiquid it is.  

 

“For larger deals we’ve seen insurers take the illiquids to make the deal happen – they will then either hold on to the asset or sell it themselves. For smaller deals the insurers will typically only take the illiquid if they’re interested in holding it themselves, which is relatively rare,” she observes. 

 

 

Legal considerations play a role with all of the options for buyout out with an illiquid asset. A loan from the employer to the scheme, for example, can only be made on a short-term basis and “presents challenges”, says Beth Brown, a partner at law firm Arc Pensions Law. 

 

Deferred premiums meanwhile are still a fairly new concept, and where this option is used, thought must be given to the structure of the transaction, she stresses. 

 

This could include agreeing if the liquid assets are used to secure certain benefits while the illiquid assets, once they have been sold, would be used to top up those benefits, with essentially two separate but connected transactions on the same pricing basis, she explains. 

 

But 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, she warns. 

 

Although a buyer of any illiquid assets would likely be lined up before the buyout contract is 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”, Brown adds. 

 

Such an arrangement would therefore need to set out in the buyout documentation a long stop date for the sale of the illiquid assets, she says, as well as what happens if the illiquid assets are sold for less than expected or cannot be sold, such as whether there would be a haircut on the benefits to be secured. 

 

It also needs to specify what would happen if the illiquid assets are sold for more than expected – whether additional benefits can be secured or if the surplus would be returned to the employer.  

 

Which of the options described do you think are most attractive or viable for a scheme having to dispose of illiquids while trying to buy out?