Defined benefit (DB) pension schemes seeking an insurer-led buy-out will, in many instances, have to divest themselves of any illiquid assets they hold in their investment portfolio. With buy-out activity almost touching £50bn in the UK’s bulk purchase annuity market in 2023, the divestment of illiquid assets has become a frenzied process.
In the last 20 years, the secondary market for illiquid assets – one of several ways schemes can offload their holdings – has grown to £100bn, according to the Setter Capital Volume Report FY 2023. But since September 2022, many DB schemes may have been selling their illiquid assets too early.
“The need for liquidity has spiked since the gilt market crisis of 2022, which dramatically reshaped the funding positions of many defined benefit schemes,” said André Kerr, Partner at XPS Group.
Standard Life said its research found 40 per cent of schemes wanting to de-risk had illiquid assets to offload and worryingly two out of three of the consultants it spoke to said issues with illiquid assets had delayed a transaction.
“While many schemes can afford to buy-out on paper, lots of them are holding illiquid assets that are generally not a good fit for insurers’ annuity portfolios due to their regulatory requirements,” said Kunal Sood, Managing Director for Defined Benefit Solutions at Standard Life.
Illiquid assets, ironically, have helped fund many schemes. Joe Evans, Senior Vice President at Redington said many had a “meaningful allocation to illiquid assets – sometimes as large as 50 per cent”.
The problem is they may have performed too well. Schemes had set the time horizon of their illiquid assets to roughly align with when they were projected to become fully funded but many schemes have closed most, or all, of their deficit much sooner than expected. Asset managers had also extended the time horizon of private debt investments, mainly as a result of tough economic conditions after the Covid-19 pandemic.
“The companies they have loaned to may default if they aren’t given more time or follow-on capital, which may result in a worse economic outcome for investors,” Evans added.
Also, rising gilt yields in the wake of the 2022 mini budget had changed the shape of scheme asset allocations.
“Because liability driven investment portfolios were generally much more sensitive to interest rates than illiquid assets, the percentage of assets allocated to illiquid assets increased for many schemes,” said Evans.
Illiquid assets are far from risky if the pension scheme is planning to run on, but for schemes looking for the umbrella of an insurer, they can become a millstone.
“An illiquid asset is also one that is not readily convertible to cash potentially, without a significant loss in value, for example, real estate,” said Sood.
Disposing of illiquid assets is becoming a business in itself, with many schemes taking early action. Standard Life’s survey found that a quarter of schemes looking at buyout had started talking to an insurer earlier than expected about the best ways to manage the disposal of their illiquid assets.
There are several options for schemes wanting to offload their illiquid assets. None are mutually exclusive, and some schemes are choosing a combination of all three.
The first is that they can choose to use illiquid assets as a form of premium payment; the insurer then uses the illiquid asset to back the bulk purchase annuity, or it may use it somewhere else on its balance sheet via a with profits fund for example. In any case, such a disposal will be done at a discount and the scheme may not get the best value and it also be a complex and lengthy process.
Another option is taking a deferred premium – when the insurer allows the portion of the premium related to the illiquid assets to be paid at an agreed later date. But there is no guarantee the illiquid funds will not fall in value.
Then there is the third option, which is to sell some or all of the illiquid assets on the secondary market. This can take up to 12 weeks and involve the expense and complexity of a broker.
For some schemes, none of these options are preferable. But for schemes who are considering using the secondary market for illiquid assets have, this year, been able to take advantage of two new platforms: XPS Group’s i Xchange and Isio’s Fund Liquidity Options or i-FLO tool. Both claim to save on the cost of a broker by finding the best price for a scheme looking to offload its illiquid assets.
Last month, Isio said the Britannia Pension Scheme had become the first client to use the platform, using it to sell a c.£72m investment in a private credit fund on the secondary market.
Activity in the divesting of a scheme’s private assets is set to continue apace. These investments have largely been a positive, but times change, and despite innovations in the space, for schemes looking to divest their illiquid asset portfolio en route to an insurance buy-out, change will not be immediate.
“While private markets asset classes have provided excellent sources of alternative income and growth for pension scheme investors in recent years, the fallout of the liability-driven investment crisis and being closer to the endgame is prompting many of them to sell,” said Ajith Balan Nair, Head of Asset Class and Manager Research at Isio.
“Unfortunately, this is often easier said than done, and the process for exiting illiquid assets can be slow and expensive.”
Sood expects more schemes to take a circumspective view of their illiquid holdings going forward which he says should help them as they enter into their journey to buy-out. That said, solving the illiquid assets conundrum is not the only issue that schemes, and the market overall, will have to figure out in the coming months.
“We expect schemes to more actively manage their position in the lead up to a transaction, shifting towards earlier engagement with insurers regarding potential options, and having a clearer strategy heading into a broking process and eventual transaction. This will lead to better outcomes for schemes, reducing the frictional cost of execution,” said Sood.
“Of course, managing illiquid assets isn’t the only challenge facing the bulk annuity market, there are other ones ahead, not least market capacity and regulatory reform.”