Legal & General Bets High-Yield Bonds Trump Octogenarian Threat

Legal & General Group Plc, the U.K.‘s third-largest insurer, has a solution to the problem of aging: high-yield corporate bonds.

Four months ago it took over a $475 million pension fund at Smiths Group Plc, betting it can improve returns enough to pay off 7,000 pensioners and turn a profit. Smiths, the world’s biggest maker of airport bomb detectors, was happy to rid itself of what insurance companies call ``longevity risk.’’ Longer life expectancies mean a 65-year-old man in Britain will probably live to 82 and claim payments until 2025.

Legal & General is among a dozen insurers counting on corporate bonds, which yielded the most this year since Merrill Lynch & Co. began tracking data in 1999, to squeeze more out of $1.9 trillion sitting in U.K. pension accounts. Most analysts remain skeptical, with the majority tracked by Bloomberg rating Legal & General ``hold’’ or ``sell,’’ even after Chief
Executive Officer Tim Breedon said pension-fund buyouts were key to better- than-estimated earnings this year.

``This is a fast growing and potentially very large component of our risk business,’’ Breedon, 50, said in his first- half report to shareholders on Aug. 5 ``There is a strong pipeline of future buyout opportunities.’‘

High yields and increasing competition among insurers mean they are offering the most favorable terms in years for companies eager to offload the risk. Firms typically transfer assets, which may include a final cash payment, equal to about 110 percent of long-term pension obligations, according to a report by London- based actuaries at Lane Clark & Peacock LLP.

`Compelling Proposition’

``If the price of buying an annuity to match pension liabilities is less than the technical provisions being held by the trustees, it becomes an extremely compelling proposition,’’ said Tom Pearce, vice president at Rothesay Life, the two-year-old insurance arm of Goldman Sachs Group Inc.

Rothesay completed its first buyout in February, taking over a 700 million-pound plan owned by Rank Group Plc, the U.K.‘s second-largest casino owner.

Startups backed by Deutsche Bank AG and J.C. Flowers & Co. are also vying for a share of what Lane Clark & Peacock forecasts will be 10 billion pounds ($19 billion) of pension-fund buyouts this year, triple last year’s level. Almost all the deals are in the U.K., which has a large concentration of smaller firms with pension obligations.

``There’s a lot of competition, which is reducing prices and helping treasurers and trustees make up their minds,’’ said Mark Wood, founder of London-based Paternoster Ltd., one of the startups. Wood, 55, left Prudential Plc after he was passed over for CEO and started Paternoster in 2005 with 500 million pounds of seed capital from Deutsche Bank and Eton Park, a New York- based hedge fund.

Paternoster, Lucida Losses

Paternoster, which plans to list shares on the London Stock Exchange next year, now holds 2.5 billion pounds of pension assets after buying funds run by media group EMAP Plc and ports operator Peninsular & Oriental Steam Navigation Co.

Even so, the insurers have yet to prove they can do better at managing longevity risk and profiting on pension buyouts.
Paternoster posted a 58.7 million-pound loss for 2007. Lucida Plc, the U.K. rival led by former Prudential CEO Jonathan Bloomer and backed by Cerberus Capital Management LP, reported a full-year loss of 15.5 million pounds on start-up costs.

``It strikes me as being a relatively thin-margin business,’’ said Kevin Ryan, a London-based analyst at ING Financial Markets who has a ``hold’’ rating on Legal & General. ``And if pensioners live to 100, they could skew the profit. We won’t know for 20 years whether they have got the longevity estimates right.’‘

While London-based analysts at Keefe, Bruyette & Woods Ltd. raised their estimate this month for Legal & General’s pension buyouts and annuity sales, it cited the ``recently increased risk profile’’ as it rated Legal & General ``underperform.’‘

`Sell’ Ratings

Among 20 analysts who track Legal & General, seven say ``buy,’’ eight say ``hold’’ and five say ``sell.’’ Analysts are more bullish about larger rival Aviva Plc, with 83 percent recommending investors buy the stock, and Prudential, with 68 percent saying ``buy.’‘

Legal & General is down 24 percent in London trading this year, valuing the company at 5.9 billion pounds. The decline this year is slightly less than the FTSE All-Share Life Insurance Index, which fell 25 percent.

Hugo James, annuities sales development director for 172- year-old Legal & General, said the company can make ``adequate returns’’ on pension buyouts because is has ``the expertise to assess and manage the risk.’’ Legal & General holds about $34 billion in pension assets from more than 200 U.K. companies.

Sales of group annuities more than tripled to 1.4 billion pounds in the first half, the company said this month. Operating profit rose 3.6 percent, beating analysts’ estimates.

Credit Crunch

The credit crunch is driving both supply and demand for pension-fund buyouts. Before the U.S. subprime mortgage collapse froze worldwide credit markets, companies could raise cash by selling bonds that yielded only slightly more than government bonds. The average corporate yield was 26 basis points more than government bonds as recently as July 2007, according to data from Merrill Lynch.

That spread swelled to 187 basis points this year because banks are reluctant to lend and investors are hoarding their cash. A basis point is equal to one-hundredth of a percent.

The credit crunch has also prompted investors to dump stocks and real estate, bringing down the value of assets held in most company pension plans. U.K. pension funds slipped from a 12 billion-pound surplus last year to a deficit of 41 billion pounds at the end of June, according to Lane, Clarke & Peacock.

Scant Opposition

``Trustees are concerned,’’ said Edmund Truell, CEO of Guernsey-based Pension Corp., which was started three years ago with backing from J.C. Flowers, Swiss Reinsurance, HBOS Plc, Royal Bank of Scotland Group Plc and Duke Street Capital. ``We’ve got inquiries valued at more than 75 billion pounds and have provided 30 billion pounds of quotes.’‘
Opposition to pension buyouts has been scant, even though insurers aren’t backed by the U.K.‘s Pension Protection Fund that steps in when companies go bankrupt. Instead, insurers are regulated by the Financial Services Authority and have to show they have adequate capital reserves to back the pension risks, said Jeff Hunt, head of London pensions at KPMG LLP.

They typically ``have a much higher level of security’’ than the companies offloading liabilities, he said.

Insurers say they are compelled to make prudent longevity estimates. They profit when pensioners don’t live as long as the estimates. Legal & General set aside an additional 214 million pounds in reserves last year after forecasting more pensioners will hit 90.