Given the trend for U.K. pension funds over recent years has been to increase alternatives allocations and take advantage of the so-called illiquidity premium, moving to a buyout more quickly than expected could cause a headache for some trustees and their advisers.
“While insurers often hold illiquid assets in their portfolios, these are usually very specific investments which meet underwriting criteria and are matching-adjustment eligible for the insurer. This means that insurers don’t typically like to take illiquids from pension schemes,” Mercer’s Mr. Ward warned.
That means one of the earliest considerations for pension funds when looking at their path to a buyout is when and how to divest from illiquid holdings — without being forced sellers and having to take haircuts on their positions.
“As there’s more complex schemes coming to market, we’re seeing more with material illiquid asset holdings,” said Dominic Moret, head of origination and execution-pension risk transfer at Legal & General Group PLC in London. “Those that have been on a longer-term journey have already started the process of dealing with them. But because of funding level improvements, we’re seeing more schemes having this problem to solve.” This is where the partnership and collaboration comes in among pension fund, adviser and insurer, Mr. Moret said.
Pension fund trustees shouldn’t necessarily let fears over illiquid assets in their portfolios set them back in their journey, sources said. And this is where being prepared and having a good relationship with an insurer can help.
“If it (the illiquid investment) can’t be transferred to the insurer, and provided it isn’t a huge proportion of the liability, most insurers are open to structuring a contract that allows for the proceeds of that (illiquid sale) to be paid after the transaction,” said Ian Aley, London-based head of transactions at Willis Towers Watson PLC. Effectively, the premium is deferred for the next couple of years “so that the scheme doesn’t incur a loss for the fire sale of that asset,” Mr. Aley said.
Another option is for the adviser or insurer to look at whether another pension fund might be looking to buy such an asset at fair value.
But in some cases, the allocation to illiquids is too big to defer or trade out of. Mathew Webb, head of U.K. insurance solutions and strategy at Legal & General Investment Management, also in London, said a number of the $1.8 trillion manager’s clients have bought into illiquid programs “assuming they have eight years to roll off” the positions. And these are hefty exposures — 20% to 30% in private equity assets, for example.
In that case, deferring the premium is not an option or is too expensive to do. Then the manager will look at immunization of the other assets in the portfolio, locking down other investment risks and then unwinding the positions until they can be transferred into an insurance-friendly portfolio.
There is also the potential that insurers will, in the future, be able to take illiquids and other assets beyond the current favorable assets, such as corporate bonds and gilts. At the moment, insurers are somewhat hamstrung as to what assets they can hold on their books by the Solvency II directive. Reforms to the directive are under consultation, and “there is arguably an opportunity to help address this inefficiency” over the types of assets that are acceptable, Mercer’s Mr. Ward said.
