Comparing Buyout vs Run-On through an Options lens

If there is no such thing as a free lunch then what are the trade-offs with different run-on strategies for DB pension schemes?

Coming from an options background you cannot hide from the no free lunch principle – options strategies force you to look at where you benefit and what you sacrifice to pay for that benefit.

As a result I have been wondering whether you can think of run-on options through this lens. So I am going to have a go using the comparison of buyout vs run-on.

Caveat – I am not an expert on insurance pricing and this is very much back of the envelope and illustrative so would be interested to see if anyone has done similar or alternative thinking using proper numbers.

Firstly the benefits. To my mind, there are three main benefits (options) being bought with a buyout:

1.??????“Protection” from longevity improvement

2.??????“Protection” from poor investment performance

3.??????“Protection” from cost inflation (i.e. fees etc)

4.??????This protection is provided through a secure regulatory setup

Secondly what are the sacrifices (options being sold) being made to get these benefits? Unsurprisingly the two main benefits I think of are the opposite of 1 and 2 above:

1.??????Sacrificing future investment return

2.??????Sacrificing any benefits from longevity deterioration

Finally if the sacrifice and benefit are not of equal value then there will be a net payment in one direction or another.

Let me throw some numbers out there :

-?????????Assume scheme is fully funded on buyout

-?????????Assume buyout pricing is Gilts + 0.5% p.a.

-?????????Assume Matching Adjustment for the insurer is 1.5% p.a.

-?????????Assume scheme duration of 15 years

I am not going to look at longevity for now, just the investment piece.

Let us assume that the scheme chooses an investment strategy with the same risk/return profile of the insurer. In this situation the scheme will have a surplus of c 15% of assets relative to liabilities valued using the Matching Adjustment discount rate (1% difference between Matching Adjustment and buyout pricing multiplied by duration). Put another way, very roughly the value of the investment return being sacrificed is c15% of the assets.

Clearly the principle of buyout is that the protection being offered by sacrificing these returns provides more certainty from the downside risks.

Now my understanding of the Matching Adjustment is that it is taking credit for investment returns AFTER taking into account default risk etc. As a result if the scheme thinks that such a strategy has a lot of downside risk then surely the insurer will have the same level of downside risk concern?

Aha, I hear you say, but the insurer has capital backing its promises so there are actual assets supporting that protection. This is true but two things go through my mind here:

1.??????Part of the insurers assets supporting this are to do with the 15% surplus above

2.??????The rest of the capital is from capital providers (who in technical speak are selling a put option). If those capital providers thought there was a real chance of drawing on their capital then they wouldn’t provide the capital/sell the option.

I understand that a different view of pricing that downside risk is what makes the market but it is important, I think, for schemes to understand what they think the value of this protection actually is.

Longevity risk is an interesting one for me as (unlike investment risk) it is a lot harder for schemes to manage and therefore might be a key reason for buyout. Specifically what interests me is a scenario where there is a massive step change in longevity improvement (cancer cure, mental health breakthrough etc). In this scenario can insurers survive and therefore is there effectively a counterparty risk for pension schemes? I know the FSCS is meant to step in at this point but my understanding is that it hasn’t been tested let alone in such a systemic scenario. In such a scenario one might wonder whether the government steps in.

Which brings me to my final point which touches on a post I did a few weeks ago – if the ultimate implicit protection is around the government stepping in then a government supported consolidator might well look like an attractive option (excuse the pun).?