Pricing Buy‐Ins and Buy‐Outs

• Date: 01 April 2017
• Author: Yijia Lin,Ayşe Arik,Tianxiang Shi
• DOI: http://doi.org/10.1111/jori.12159
• Published date: 01 April 2017

©2016 The Journal of Risk and Insurance. Vol.84, No. S1, 367–392 (2017).

DOI: 10.1111/jori.12159

Pricing Buy-Ins and Buy-Outs

Yijia Lin

Tianxiang Shi

Ays¸e Arik

Abstract

Pension buy-ins and buy-outs have become an important aspect of managing

pension risk in recent years. As a step toward understanding these pension

de-risking instruments, we develop models for pricing investment risk and

longevity risk embedded in pension buy-ins and buy-outs. We also bring

a contingent-claims framework to price credit risk of buy-in bulk annuities.

Overall, our model can be used to assess the pricing of investment, longevity,

and creditrisks being transferred in pension buy-in and buy-out transactions.

Introduction

The phrase “pension de-risking” has recently become part of the pension plan lexicon.

According to a survey by the Association of Consulting Actuaries, 40 percent of UK

employers with defined benefit (DB) plans indicated that they hoped to buy-in or

buy-out all of their pension liabilities in the next 10 years (Association of Consulting

Actuaries, 2012). Such a trend of pension de-risking is driven by pension deficits due to

the latest market downturns, low interest rate environments, new pension accounting

standards, and prolonged life expectancy of retirees.

The 2007–2009 credit crisis and the subsequent drop in discount rates caused serious

funding deficits of many DB pension plans. Despite corporate contributions and a

rebound in equities afterward, pension deficits persist as is evident by the fact that

the plans of FTSE 100 companies were only 91 percent funded in 2013 (Lane Clark

& Peacock LLP, 2013). In reaction to this, more stringent accounting standards set

out new approaches to reflect changing circumstances and to promote transparency.

For example, effective on January 1, 2013, the revised international pensions standard

IAS19 requires that interest on pension scheme assets be calculated using a discount

Yijia Lin is at the Department of Finance, College of Business Administration, University of

Nebraska–Lincoln. Tianxiang Shi is at the Department of Risk, Insurance, & Healthcare Man-

agement, Fox School of Business, Temple University. Ays¸e Arik is at the Hacettepe University

in Ankara, Turkey. Lin can be contacted via e-mail: yijialin@unl.edu. Shi can be contacted via

e-mail: Tianxiang.shi@temple.edu. We are grateful to David Blake and the two anonymous ref-

erees for very helpful comments. Wealso thank Andrew Hunt from the Case Business School,

City University London, and David Lang from Prudential Financial for very helpful discussions

on the UK and U.S. buy-in and buy-out markets.

367

368 The Journal of Risk and Insurance

rate based on corporate bonds, rather than an expected return based on the actual

assets held. Due to this, using 2012 data to illustrate possible effects from this change,

Lane Clark & Peacock LLP (2013) shows that total 2012 profits of FTSE 100 companies

will be £2 billion lower when recalculated under the new version of IAS19. In addi-

tion to market and regulatory risks, longevity risk has recently emerged as another

significant concern for DB plans. Unanticipated mortality improvements increase the

value of pension liabilities through longer lifetime annuity payments.

As pension liabilities become increasingly visible on the balance sheet following more

stringent accounting standards, fluctuations in financial markets and increases in life

expectancy can have a major and immediate impact on a firm’s share price. Growing

pension deficits reduce internal financial resources and make the firm riskier and

more difficult to access credit. As a result, the firm may have to forgo otherwise

profitable projects. Rauh (2006) finds that mandatory pension contributions reduce

a firm’s investment in desired projects. Campbell, Dhaliwal, and Schwartz (2012)

document a positive relationship between mandatory pension contributions and the

cost of capital. Their results imply that mandatory pension contributions increase a

firm’s borrowing cost and limit a firm’s ability to access credit. Consistent with this,

Lin, Liu, and Yu(2015) find a positive relation between pension exposures and cost of

debt. In response to those challenges, capital markets have developed a few solutions

for DB plans to off-load risks such as pension buy-ins and pension buy-outs (Lin,

MacMinn, and Tian, 2015). Indeed, 2013 had a strong start with buy-in and buy-out

deals worth more than £5.5 billion, including the record buy-out of £1.5 billion by

EMI with Pension Insurance Corporation (Hawthorne, 2013).

There exists a rich literature that explores pension buy-in and buy-out activities

(Deutsche Bank, 2011; LCP, 2012; Coughlan et al., 2013; Geddes et al., 2014; LCP, 2014).

Both buy-ins and buy-outs involve pension plans buying bulk annuities from insur-

ance companies. A market for buy-ins and buy-outs will develop if they are effective,

economically affordable, and transparently priced. A difference between pension

buy-outs and pension buy-ins arises from credit risk.1Pension buy-outs are the most

direct way to take pension liabilities off balance sheets. Thus, firms sponsoring DB

plans with buy-outs are not subject to counter-party risk. However, a buy-in bulk

annuity is written in the name of the pension trustee and the liabilities remain in the

firm. As obligations of buy-in insurers are usually not fully collateralized and guaran-

teed by third parties, credit risk arises (Roy, 2012). Jerry Gandhi, the Group Pensions

director at RSA Insurance Group, highlights the impact of credit risk on firms with

buy-ins: “Our largest concern was the risk of the counter-party defaulting and this

of course was a concern for the trustees and the company. The trustees in their own

1There are other differences between a buy-in and a buy-out: a pension plan sponsor can pay

recurring premiums for a buy-in deal over a period of time, whereas it has to pay a single

lump sum premium to purchase a buy-out. With buy-ins, pension participants do not see any

change in the administration of their plans (Procter, 2014). In contrast, buy-outs transfer the

administration and associated costs to insurers. In this article, we do not explicitly model these

differences between a buy-out and a buy-in as they are more firm or deal specific. In reality,

pension plan sponsors can readily extend our model by incorporating these differences to fit

their specific needs when they try to decide upon their buy-in or buy-out insurance providers.