Managing illiquids during a BPA transaction: what are your options?

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From deferring premium, making a secondary market sale through to delaying the time of a buy-out, there are many ways to remove illiquid assets before completing a buy-in or buy-out. But there is no perfect solution for all schemes. 

Illiquid assets often represent a much larger proportion of asset strategies than expected for pensions schemes reaching buy-out affordability. 

This is due to an unexpected improvement in funding positions, primarily driven by rising interest rates shrinking pension scheme liabilities more sharply than the value of assets.

In fact, over the past year around 40% of schemes approaching the market had illiquid assets to manage. 

And most employee benefit consultants (EBCs) and professional trustee firms say that illiquids have delayed a transaction, according to research featured in Standard Life’s report, Managing illiquid assets during a bulk purchase annuity transaction .

Trustees therefore need to plan carefully for dealing with their illiquid assets before approaching the insurance market.

 

Long-term objectives 

Most pension schemes have broadly selected one of two long-term objectives: 
1) to 'run-off' the scheme with a low-risk investment strategy
2) to buy-out with an insurer once it can afford to 

Holding excess illiquid assets may present an issue in both scenarios.
 
For schemes planning to run-off with a low-risk strategy, too much illiquidity means it may take them longer to get to their desired low risk portfolio. They could also be running elevated levels of risk in the meantime.
 
For schemes aiming to buy-out, insurers may not accept some illiquid assets as part of a transaction, or would only accept them at a material haircut. Therefore, many schemes will have to remove their illiquid assets before completing a buy-in or buy-out.
 
All else being equal, this may make completing a partial buy-in much less attractive for many schemes. If the premium is funded by liquid assets, the remaining portfolio would have an even higher percentage allocation to illiquids, potentially amplifying this issue. 

In practice, this means that a greater proportion of deals today are full scheme buy-ins rather than partial buy-ins. 

How schemes are managing illiquids

Below are the broad options we see schemes considering when deciding whether they can afford to insure benefits. 
 
There is no perfect solution for all schemes – the right choice can vary depending on factors such as the sponsor covenant strength, the specific illiquid assets involved, and the scheme's funding level and appetite for complexity. 

Approach	Explanation	Pros	Cons
1.Use illiquid assets as premium payment	The insurer accepts the illiquid assets as premium payment. Insurers may use the illiquid asset to back the BPA, or find uses elsewhere on their balance sheet (for example, with profits funds). This is likely to be at a discounted price.	• The simplest solution, which avoids the complex structuring of the BPA. • Avoids interest payable on deferred premiums or loan arrangements. • Avoids complexity of introducing new service providers.	• The scheme may not get the best value relative to allowing the illiquid asset to run off or a more orderly secondary market sale. • May require restructuring of cashflows or more complex solutions, such as securitisation. • Difficult to achieve within typical exclusivity windows of six-to-eight weeks. Early engagement is beneficial and may be crucial.
2. Arrange a deferred premium with an insurer	The insurer allows the portion of the premium related to the illiquid assets to be paid at an agreed later date, allowing the illiquids to roll off naturally. The deferred premium loan can be paid down gradually as cashflows from the illiquid assets come in.	• May avoid the need to take a 'haircut' on the value of assets. • Or provides time for schemes to consider the sale of illiquids at a haircut if the funding position is strong enough. • Relatively straightforward and widely used approach. • Removes market risk on the liquid assets. • Avoids complexity of introducing new service providers.	• No guarantee the scheme will have the required cash by the end of the deferment period – for example, illiquid funds could fall in value or may extend and take longer than expected to roll off. In this case, the sponsor may need to contribute the difference. • The scheme pays interest on the deferred premium for the period. • Potential currency hedging issue to be solved (more detail below). • The insurer may only have capacity to provide a deferred premium up to a certain value and not cover all the illiquid assets.
3. Sell illiquid assets on secondaries market	Selling some or all the illiquid assets to another investor on the secondaries market – almost certainly at a discounted price.	• Greater certainty of paying the premium (assuming the secondary pricing is sufficient). • Reduces or eliminates interest costs. • Reduces/removes currency risk.	• Secondary sale prices may incur a material discount to the current value. • Complexity and cost of appointing a broker(s). • Typically takes six-to-twelve weeks in total.
4. Company loan (legal advice should be taken)	The company loans money against illiquid assets to fund the insurance premium upfront.	• Reduces/eliminates need for deferred premium solution. • Avoids complexity of introducing new service providers. • Could potentially be set up quicker than other options.	• The company may not have capacity/appetite to make the loan. • The scheme pays interest on the loan. • The company takes on market risk – for example, if the distributions from the illiquid assets are insufficient to cover the loan value.
5. Investment bank solution  (legal advice should be taken)	Structured arrangement with a bank to provide a loan and potentially a currency solution.	• Reduces/eliminates the need for deferred premium solution.  • May be able to solve funding and currency issues in the same solution.	• May introduce meaningful complexity. • The scheme pays associated interest and structuring costs. • May require several weeks to set up and agree the specific solution.
6. Delay the time to buy out	Allow the illiquids to roll off naturally before buying out.	• No additional complexity. • No need to take a 'haircut' on the value of assets. • No need to pay interest costs. • Buy-out position could improve – for example, as the scheme matures.	• Insurer pricing could get worse – for example, if market conditions change. • The scheme is exposed to sponsor covenant risk for longer. • Funds may extend and could take longer than expected to roll off. • The scheme retains investment and longevity risk.

There is no ‘one-size-fits-all’ approach, and trustees will need to think carefully about which option suits the requirements of their scheme best. In some cases, a combination of these options could be suitable. 

For example, if an illiquid asset is due to fully roll off within the next three-to-six months and would incur a big haircut if sold on the secondary market, a scheme could arrange a deferred premium only on this asset and sell the remaining illiquid assets on the secondary market.

For schemes aiming to execute insurance transactions, however, managing illiquid assets will remain a key focus for some time.

It is therefore advisable for schemes to actively manage their position in the leadup to a transaction, shifting towards earlier engagement with insurers regarding potential options, and having a clear strategy heading into a broking process and eventual transaction. 

This should lead to better outcomes for schemes and reduce the frictional cost of execution. 

This analysis is from Standard Life’s report, Managing illiquid assets during a bulk purchase annuity transaction. 

Special thanks to Redington, in particular Joseph Evans, Senior Vice President, who contributed to this article and the full report.