A bulk annuity quotation strained by matching adjustment eligibility
Northgate Life recently entered the bulk annuity market. It has been invited to quote for a £1.1bn pension scheme buy-in covering 9,200 members, roughly 60% of them already in payment. To win on price the firm would need to quote at about 60bps above gilt yields. Its matching adjustment (MA) portfolio stands at £4.2bn, of which 88% of assets are MA-eligible, and the portfolio currently generates an MA benefit of 118bps. The pricing model says the deal needs an MA benefit of about 145bps to clear the hurdle rate. Two asset options are on the table: £180m of 12-year fixed-rate private placement notes issued by an infrastructure borrower rated BBB-, and a sale-and-leaseback property structure with rent reviews linked to RPI and break clauses at years 10 and 15. The scheme's own assets include illiquid credit, it has a £90m deficit contribution schedule, and the trustee wants price certainty within six weeks. The actuarial function has warned that a single ineligible asset or a cash-flow mismatch can put the whole MA benefit at risk, and that a breach not rectified in time prevents use of the MA for two years.
1. Assess whether Northgate Life should bid, setting out the MA conditions the transaction would have to satisfy and the consequence of failing them.
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Test the structure against the MA conditions first, then look at the hurdle rate
The MA can only be applied to a ring-fenced portfolio of assets whose cash flows are fixed and match the liability cash flows, with credit risk handled through the fundamental spread rather than through the matching test.
- Fixed cash flows. The BBB- private placement notes can qualify if they are fixed-rate, non-callable, and the borrower's default risk is captured in the fundamental spread. The sale-and-leaseback is much harder: RPI-linked rent with break options at years 10 and 15 gives cash flows that are neither fixed nor certain, and the break dates create a cliff. Unless the lease is restructured into fixed, non-cancellable rent with no break for the life of the liability, it is likely ineligible.
- Matching. Twelve-year notes against a scheme with a materially longer duration leave a reinvestment mismatch. The MA benefit depends on the extent to which asset cash flows replicate the liabilities, so a short portfolio under-delivers against the 145bps required.
- Ring-fencing and governance. A separate documented matching portfolio, monitoring of the conditions, and immediate notification to the PRA of any breach. The cure period is short and, if a breach is not rectified, the firm loses the MA entirely - with a multi-year prohibition before it can resume. That is a firm-wide capital event, not a deal-level inconvenience, and it would hit the whole £4.2bn book, not this deal.
The arithmetic points to no-bid
The gap is 27bps on a £1.1bn deal while 12% of the existing portfolio is already ineligible - the basis is strained before this deal is added. Adding £180m of notes cannot bridge 27bps across the portfolio. My advice is to decline at the required price unless four things hold: (i) a dedicated, fully eligible, ring-fenced portfolio is built for this deal; (ii) its cash flows are matched to the scheme's payment profile; (iii) there is a buffer above 145bps to absorb the fundamental spread and credit migration; and (iv) the board has explicitly modelled the consequence of a breach.
A no-bid is a credible commercial outcome. The reputational and capital damage from a mispriced first deal exceeds the value of the premium, and the trustee's six-week deadline is a reason to be more cautious, not less.
2. The investment committee proposes funding the price with the private placement notes. Evaluate that proposal and set out the alternatives for closing the MA shortfall.
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Why the private placement alone does not work
- Size. £180m is about 4% of the MA portfolio and roughly 16% of the assets backing the new deal. It cannot generate 27bps of additional MA benefit across a £4.2bn portfolio.
- Term. Twelve years against a long-dated, in-payment liability concentration creates spread duration and reinvestment risk. When the notes mature the portfolio must be re-matched, and there is no guarantee that eligible assets will be available then at an acceptable spread.
- Concentration. A single BBB- borrower adds idiosyncratic credit risk that the fundamental spread may not fully reflect, and a downgrade to sub-investment grade raises eligibility questions precisely when the firm can least afford them.
- Liquidity. Private placements are illiquid. If the scheme does not proceed, the assets are stranded in the MA portfolio and the firm is forced to hold them to maturity.
Alternatives to close the shortfall
- Buy eligible yield. Amortising infrastructure or corporate bonds with fixed cash flows profiled to the scheme's payment pattern. Slower to execute but delivers MA benefit across the whole portfolio.
- Fix the existing portfolio. Sell or let mature the 12% of assets that are ineligible and replace them with eligible credit. This raises the MA benefit on the existing book and improves every future quotation - the highest-value option in the medium term.
- Ring-fence the deal. Structure a dedicated portfolio for this scheme, price on a lower achievable MA benefit and renegotiate the premium with the trustee rather than stretching the basis.
- Share the risk. Co-insure or reinsure part of the deal, or partner with a larger insurer and retain administration - capturing fee income without full capital strain.
- Decline and preserve capacity for a better-priced opportunity once the portfolio is cleaned up.
Recommendation. Pursue 1 and 2 in parallel, treat the private placement as a marginal addition at most, and do not present it to the investment committee as the funding solution. The real prize is the eligibility ratio of the existing portfolio.