Pensions risk transfer: options for dealing with illiquid assets

Types of illiquid assets

Illiquid assets are assets that cannot be quickly realised in cash. This reflects the nature of their underlying holdings, which can include interests in real estate, private equity, private credit, or infrastructure. Typically, illiquid assets are interests in one of two types of investment funds.

Semi-liquid open-ended funds

Whilst these open-ended funds permit investors to exit or withdraw via redemption rights, the ability to redeem out of these funds is limited by the fund manager’s use of liquidity management techniques, including:

• fixed redemption dates, annually or quarterly;
• extended prior notice periods; and/or
• “gating”, or delays, where there is a high volume of investor redemptions.

Closed-ended funds

These do not offer investors the ability to redeem or withdraw. Instead, strict transfer restrictions can mean investors are effectively “locked-in” for the life of the fund unless a willing and eligible buyer can be identified. The initial term of the fund can also be extended by the fund manager, either at its own discretion or following investor approval, in order to have more time to realise the value of the fund’s assets.

In both scenarios, it is important that pension trustees understand the anticipated “run-off” timings of the fund and whether these can be extended, despite the pension trustees’ own liquidity needs.

Impact of illiquid assets on risk transfers projects

Should pension trustees be relying on illiquid assets to fund a bulk annuity insurance premium, then it is vital to consider what solutions there might be to this so-called “liquidity barrier” at an early stage.

Standard Life’s recent ‘Thinking Forward’ report highlighted why this is important – it confirmed that two in three employee benefit consultants believe illiquid assets had delayed a bulk purchase transaction they had advised on.

Trustee options for dealing with illiquid assets

Pension trustees should be aware of all the options available to them for dealing with illiquid assets. Broadly, these options fall under four categories.

Portfolio run-off

Some pension trustees may prefer to wait for their illiquid assets to be realised before speaking to insurers. Whilst avoiding the need to pay interest or take “haircuts”, this approach can mean timings will be uncertain and opportunities to realise potential favourable pricing are missed in the meantime.

Deferred premiums

Insurers could agree to have a residual amount of their insurance premium, together with additional interest, payable later when the illiquid assets have been realised. For those illiquid assets which provide regular income, a schedule of payments can also be agreed which will pay down the deferred premium gradually. However, in case there are any delays in realising the illiquid assets, or the cash received is less than expected, it would be prudent to either have the ability to extend such deferral or for the sponsor to underwrite these obligations.

Secondary sales

Any transfer of ownership in any existing fund interest is known as a “secondary” transaction. These can take different forms:

• Insurer secondary sale – insurers are often subject to strict rules on what assets they can hold themselves and therefore are not always able, or willing, to accept illiquid assets instead of cash to pay an insurance premium. Even if an insurer is able to take on particular assets, they will likely also apply their own valuation and request a “haircut”;
• Sponsor secondary sale – before a scheme’s sponsor can agree to acquire a fund interest, it will need to ensure that it can: fund the purchase in cash; take on any outstanding obligations, including meeting any drawdown requests on a timely basis; and also take on the risk that this investment may not perform as well as expected.
• Sponsor group pension scheme secondary sale – the sponsor could also consider transferring the illiquid assets to its other group pension schemes. In addition to the above considerations, the trustees for these other schemes also need to ensure that acquiring the illiquid assets will be consistent with their own duties and powers.
• Third party secondary sale – the pension trustees can instead engage a broker to identify potential third-party buyers and also negotiate a favourable market price. In addition to any buyer “haircut”, there will also be brokers’ fees and costs to consider as well.

Sponsor loan agreement

Some sponsors may agree to provide a short-term bridging loan to the pension trustees to fund an insurance premium whilst they are waiting for the illiquid assets to be realised. Typical loan conditions include requiring the terms to be on an arms’ length basis – for example, by imposing additional interest payments. Any sponsor agreeing to lend will also need to take into account certain risks, such as the time taken to realise the illiquid asset and any fluctuations in valuation during that period.

Surplus illiquid assets

Should a scheme already have sufficient liquidity to fund an insurance premium, the pension trustees may, rather than waiting for those illiquid assets to be realised, instead consider a potential return of this “surplus” to the sponsor. Any such “authorised” surplus payment requires to be permitted under the scheme rules and/or applicable legislation and will also likely be subject to a separate tax charge, which was reduced from 35% to 25% from 6 April 2024.

However, should either the scheme rules and/or applicable legislation prevent such a surplus return, this will instead result in a “trapped surplus” scenario. Such a scenario could mean that, until those illiquid assets are finally realised, this will hold up the scheme’s eventual winding up.

A role for legal

Recent improvement in funding levels has led to an increase in the number of schemes looking at their risk transfer options. Legal advisers can advise trustees on key terms and offer strategic guidance on the options available. By taking a more proactive approach at an early stage, pension trustees will be in a genuinely stronger position when speaking to insurers and in seeking to achieve the best outcome for their scheme.