Finance Directors' Guide to Pensions
Buy-outs and buy-ins
For many sponsors, the cost of running a defined benefit (DB) pension scheme has increased dramatically over the last decade; mainly due to poor investment returns, increasing life expectancy and additional layers of compliance introduced by new regulatory regimes.
As a result, many sponsors have switched to offering defined contribution (DC) arrangements for their employees, as they are typically cheaper and do not expose the employer to the risks they are exposed to with a DB scheme. However the sponsor is still responsible for the legacy defined benefit scheme which, even though few or no current employees are members, could still represent a significant cost and potential risk far into the future.
To remove the risk of further rising costs, sponsors are increasingly looking to insure some or all of their pension scheme obligations with a specialist insurance company. A premium is paid to the insurer to complete such a transaction. These types of transactions are known as bulk annuity policies and can be structured in two ways: through either a buy-out or a buy-in.
With a buy-out, the scheme's liabilities are transferred to the insurer and the sponsor's obligation to the members is extinguished. The terms of the insurance policy are required to precisely match the form of the members' benefits under the scheme. Securing such a policy arrangement can be a long, protracted process. A buy-out normally precedes a wind-up of a scheme and involves the entire scheme membership being covered by the policy. A buy-out of only part of the membership is rare due to the fact that the scheme's trustees could be seen to be favouring one group of members by providing them with increased security (i.e. those covered by the bulk annuity policy) over the remaining members.
Under a buy-in, the policy is held by the trustees and is effectively a scheme asset which pays the members' benefits. In other words, the ultimate obligation to pay the members still remains with the scheme. A buy-in policy does not reduce the security of those members whose benefits are not insured by the policy, as income from the insurer can in theory be allocated across all the beneficiaries.
The cost of purchasing a bulk annuity policy will sometimes be greater than the value of the liabilities on a Scheme Funding basis, and will include a profit and expense margin for the insurer. If a sponsor wishes to go down the partial buy-out or buy-in route, they may need to contribute an additional amount to fund such a policy. This could be required up front or could be left to feed through at the next actuarial valuation. The sponsor will therefore need to weigh up whether this extra cost is justified by the removal of risk and how this fits with the sponsor's overall corporate objectives and objectives for the scheme.
The difference between the premium and the Scheme Funding liabilities is typically larger for non-pensioners and reduces with age for pensioners. As a result, some schemes have completed buy-ins for a section of their pensioner membership at levels close to or even cheaper than the Scheme Funding reserve. This can be achieved by considering which assets are sold to fund the buy-in.
Since 2006, several new insurers have entered the bulk annuity market which has increased levels of competitiveness in the market. Sponsors looking to explore such an option may be able to obtain quotes by running an "auction" process between insurers although this may not be possible for very small transactions. However, it is important to appreciate that changes in market conditions could force prices up making the policy unaffordable. Therefore running an efficient auction process and being prepared to transact quickly can be key to successfully completing a deal. It is recommended that careful preparation is completed and an estimate of affordability is obtained before formal quotes are requested.
There are a limited number of insurers who specialise in this market. Some are household names, some less so. All of them are regulated by the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA). The PRA requires insurers to hold significant capital reserves to back the policy contracts written. In theory, these reserves should be sufficient to protect the insurer, and by extension the pension scheme members, against very extreme ("1 in 200") adverse events.
If the financial position of an insurer falls below an acceptable level, the PRA will exercise its power and instruct the insurer to stop writing new business in order to protect the existing business. Ultimately the insurer may have to raise new capital. The PRA keeps up-to-date with insurers' solvency margins through regular reporting and may take more extreme action if it believes it is required.
In the event that an insurer does become insolvent, attempts may be made to transfer the liabilities to another insurer. If these fail, the Financial Services Compensation Scheme (FSCS) should step in to provide compensation of the pension amounts in full. The FSCS has never been tested for the insolvency of a large insurer but its existence should provide some comfort to sponsors and trustees.
Although there are considerable protections for members against the possibility of insurer insolvency, employers may still wish to carry out a review of the preferred insurer as a safeguard. Our Insurance Actuarial Team can provide detailed reviews into each insurer as required. See here for more details.
The purchase of a bulk annuity policy requires planning; some processes have ended without a deal being completed because delays to resolve data issues have caused a pricing opportunity to be missed. An important part of this process is reviewing and 'cleaning' the scheme's membership data; for some schemes getting the data into a reasonable state can even take years! If insurers are provided with data that is incomplete or inaccurate, they may be forced to incorporate wider uncertainty margins into their pricing, resulting in more expensive quotes. Sponsors should also be wary of unknown members coming out of the 'woodwork' as a result of data validating exercises which will increase the cost of a wind-up.
Obtaining quotes requires careful consideration. Which insurers should be approached? How should the process be run? Which members should be insured? What is an acceptable price? Insurers may also offer a variety of options or payment structures. It is also important for the sponsor, trustees and advisors to work together so that decisions can be made quickly with the agreement of the other parties.