This briefing will be of interest to finance directors, pensions managers, trustees and anyone else responsible for managing the costs and risks associated with pension schemes and insurers who transact with them.
The de-risking market has faced a consistently high level of demand in recent years, with insurers writing over £10 billion worth of annual business to insure pension scheme liabilities. Buy-ins and buy-outs have become increasingly attractive as more schemes close to future accrual, corporate sponsors look to reduce the volatility of scheme deficits and trustees seek to resolve outstanding liabilities.
- outlines how trustees and employers should prepare their schemes for de-risking, by setting out the key due diligence they should undertake in relation to their data and what legal advice they may need in relation to trustee discretions and powers to transact;
- details negotiation strategies trustees should consider, from preparing requested contractual terms to obtaining protections for any future buy-outs;
- gives an update on key current and upcoming trends affecting this market, including Solvency II, the Insurance Act 2015 and Brexit; and
- outlines legal issues arising from innovations such as phased buy-in strategies, topslicing and medical underwriting.
It will be of interest to finance directors, pensions managers, trustees and anyone else responsible for managing the costs and risks associated with pension schemes and insurers who transact with them.
We have extensive experience advising trustees, employers and insurers on high value and complex buy-ins and buy-outs. Our cross-disciplinary practice can help you prepare for, structure and manage this type of transaction in a way that deals with the full spectrum of legal issues and appreciates the commercial priorities and perspectives of all parties.
What are buy-ins and buy-outs?
A buy-in is a term used to describe a bulk annuity contract purchased from an insurer which secures the benefits specified in that contract.
The insurer agrees to meet specified liabilities to pay benefits under the scheme each month in return for an up-front premium payment. This can take the form of cash or an agreed schedule of assets (i.e. fixed income securities or swaps).
Although the liabilities covered by the policy are based on individual members’ benefits, the policy itself is held as an asset of the scheme. The trustee retains its obligations to pay benefits to the relevant pensioner members, which should in turn be matched by the payments it receives from the insurer.
This type of investment is a way to transfer some (or all) of the scheme’s longevity, investment and inflation risk from the employer and trustees to an external insurer.
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Buy-outs involve the trustee purchasing individual annuity policies in the names of scheme members, or transferring the benefit of an existing policy to the members directly. This will usually discharge the claim that the member has on the scheme, if certain statutory conditions are met.
Buy-ins are often the first stage in a full buy-out process, or at least anticipate a buy-out taking place at some stage in the future. Because of this it is common for bulk annuity policies to contain terms providing for them to be converted into individual policies for the scheme members at a later date.
Buy-outs are usually followed by a winding-up of the scheme, though partial buy-outs sometimes occur.
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Besides the more straightforward insurance buy-in and buy-out transactions, there are a range of other ways in which scheme liabilities can be discharged and assumed by a third party. These can cater for the different characteristics of pension schemes (such as size, member profile and funding level). The main alternative strategies available include:
- Phased buy-ins: trustees may choose to insure the benefits payable to members of the scheme in tranches (e.g. so that each policy only covers the benefits of members who retired by a particular date, or a percentage of the benefits of a particular group of members). This arrangement can help a scheme transition towards buy-out in stages and encourage competition between insurers.
- Umbrella buy-ins: the trustees agree an overarching arrangement with an insurer under which they enter into successive buy-ins to insure different tranches of liabilities, on same terms and security arrangements.
- Partial buy-outs: under a partial buy-out, only part of the accrued benefits are bought out (e.g. pensions in payment). These are relatively uncommon due to the funding strain that can arise, though they can be achieved in appropriate circumstances.
- Top-slicing: the policy insures the benefits payable to a selection of members involving the largest liabilities (e.g. high earners). This type of arrangement can reduce the volatility of scheme funding needs where a high proportion of risk (e.g. longevity) is concentrated in a small number of members. These types of arrangements are often medically underwritten.
- Medical underwriting: under medically underwritten contracts, the insurer will look at medical and lifestyle information for the specific individuals whose benefits are to be insured. It will use that information to gain a more informed view of the life expectancy of the people to whom those benefits are payable, and to price the contract accordingly.
- All-risks buy-out: this arrangement is intended to remove all ongoing risks relating to a pension scheme from the sponsoring employers and trustees upfront, removing any residual benefit liabilities in the scheme and often without the need for a trueup payment after completion. It gives the policy-holder certainty at the time it transacts, but will usually involve more detailed due diligence into membership data and the scheme rules and benefit administration prior to signing, and can be substantially more expensive.
- Non-insured arrangements: these include bulk transfers to a new scheme set up by a third party, or the replacement of the principal employer by a new sponsor from that group. These most often take place in the context of M&A transactions where the buyer is taking on pension liabilities, but they can be combined with insurance transactions (e.g. if the transfer is to a scheme set up by the insurer, to enable the insurer to take care of the winding-up process or to facilitate an all-risks transaction).
- Captive insurance: for some very large schemes, it may be economically attractive to set up a captive insurer (owned by the trustees or the sponsor) which enters into a bulk annuity policy with the trustees, and then negotiates reinsurance directly with a third party reinsurer.
- Longevity swaps and other swaps: the trustees would enter into a derivatives transaction with an investment bank, under which the bank would assume the risk on benefit payments increasing above a certain agreed level. In their broad effect, these can be very similar to buy-ins, depending on the actual terms that are agreed. They have usually only been appropriate for larger pension schemes, and would normally involve the provision of substantial collateral by both parties in accordance with the normal practice of derivatives providers. Such swaps can be combined with insurance in some transactions.
The remainder of this briefing focuses on conventional insured buy-ins and buy-outs, though it is useful to bear in mind the wider range of options that may be available, in case they may be more appropriate for the scheme in question.
Roadmap for de-risking: preparing for and managing the process
The amount of time it takes to complete a buy-in or buy-out depends on various factors including: quality of scheme data, market demand for de-risking products and the capacity of insurers to provide them, the value and type of policy chosen and the level of experience of the trustee and their advisers.
The following timeline is an illustrative guide to the key steps and typical timeframes for completing a traditional buy-in or buy-out. The length of steps will vary depending upon the specific circumstances of the scheme and the deal. For instance, a scheme with poor member data, or which is seeking to enter into an all risks buy-out, is likely to need additional time to prepare. Alternatively, it will take longer to gain quotes from insurers on a medically underwritten buy-in, which requires insurers to collect individual medical information.
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Preparation is key to any buy-in or buy-out. Most providers will expect a trustee to be able To transact quickly once they have approached the market for quotes and taken a decision to select a provider. Thorough preparation is one of the main ways that trustees can improve engagement from insurers, achieve better pricing and increase the likelihood of transactional success.
Buy-ins and buy-outs are, in essence, a way of managing the risks associated with a pension scheme. Trustees should therefore ensure that they have quantified the various risks that they are seeking to transfer to an insurer (such as longevity, interest rate, inflation and investment risk) so that they can take an informed decision about whether transferring risk n this way is appropriate and achieves value for money for the beneficiaries of the scheme (including the Employer).
Key steps that a trustee can take to prepare include:
- Due diligence into data and benefits: buy-in policies should match the liabilities of the scheme as closely as possible. Some trustees may need to conduct audits and take legal advice on the nature of benefits provided by the scheme in order to confirm the form of liabilities that they are intending to insure (see contractual negotiations – data risk, below).
- Adapt investment strategy: trustees may need to make alterations to their investment strategy to ensure that they hold assets which are sufficiently liquid to be realised (or transferred directly to the insurer) in time to pay the premium to their chosen provider. If collateral is to be held by the scheme, the strategy may need to be adjusted to allow for the holding of suitable assets (such as sovereign or corporate bonds).
- Governance arrangements: Managing the buy-in process will require specialist knowledge, regular assessment of new information and a number of key decisions. Trustees should decide who is best placed to assume responsibility for this role and Report back to the remaining trustees. Some trustees establish a specific subcommittee, or instruct an existing investment sub-committee, to approach the market, review proposals and take specialist advice, before the trustees decide collectively whether to proceed with the transaction.
- Line up advisers: Trustees are likely to need specialist advice at an early stage in the process to ensure they are able to transact quickly and on informed basis. Usually, insurance broking, investment, actuarial and legal advice will be needed.
- Engage with insurers: Trustees are more likely to achieve value of money if they are able to encourage competition between insurers and adapt quickly to market movements and changes in insurers’ capacity to take on new business.
As buy-ins and buy-outs have become increasingly common, insurers in this market have developed standard terms, which they may be reluctant to vary.
Trustees will usually have more commercial leverage earlier in the process, before they have granted exclusivity to any individual insurer. One way to take advantage of this position is to provide requested contractual terms up front. This can make it easier for the trustee to obtain concessions from the insurer’s usual position.
Key issues that the trustee may seek to address include:
- Payment obligations – e.g. trustees should consider:
- Can they meet the time limits for paying premiums?
- What scope does the insurer have to adjust the premium?
- Does the trustee have a right to review the insurer’s calculations?
- Should the trustee request that the insurer provide any collateral (which could increase the cost of the transaction)?
- Termination and variation of contract – e.g.
- What rights does the insure have to cancel the contract, and how are cancellation payments calculated?
- In what circumstances can the contract be amended? Does this require trustee consent?
- What events will constitute a material change, and what rights do the parties have in these circumstances?
- Does the contract provide for the trustee to request that the insurer issues individual policies to members? Do any conditions apply before moving to buyout?
- Data and benefits – e.g.
- What terms apply to updating data and correcting errors after the contract has been executed?
- Does the contract allow the trustee to request changes to benefits to reflect pensioner divorce, winding-up lump sums and trivial commutation?
- Disclosure and warranties – e.g.
- What is the trustee’s duty of disclosure and how does this compare to the default statutory position (see Update on duty of disclosure and warranties, below)?
- What is the scope of the warranties given by the trustee and the insurer?
- Liability and recourse for breach of contract – e.g.
- Are there any limits on the trustee’s liability under the contract?
- Can the trustee recover costs if the insurer breaches its payment obligations?
- Is the insurer required to comply with data protection legislation?
- Scheme administration – e.g.
- Would the trustee have the right to transfer payroll arrangements?
- If so, would the trustee have a right to inspect and audit of these arrangements, once these functions have been transferred?
On both buy-ins and buy-outs, the parties will need to agree the benefit specification and data file, which detail the benefits to be covered by the policy. When preparing this document, trustees will need to consider:
- Does it match the benefits? Does the data provided by the trustees to the insurer match the actual level of benefits under the scheme? In practice, it may be almost impossible that there will be no factual errors (e.g. age of a member, amount of pension) that could have crept into the records. Trustees often seek to reduce this risk by arranging a “data cleanse” (i.e. a check of the data records) as part of the pre buy-out arrangements.
- How is the risk allocated: Is the insurance company taking on all the benefits in full (whatever they are) – i.e. taking the data risk? Or is there recourse to the trustees so that liability for any additional benefit that may later emerge remains with the trustees? Are the trustees giving warranties or confirmations to the insurance company about the accuracy of the data?
- Responsibility for data cleanse: Part of the two stage buy-out process may be to allow the insurer to carry out some data checks (and adjust the final premium accordingly).
Update on duty of disclosure and warranties
The Insurance Act 2015, which came into force on 12 August 2016, introduced a number of changes which will affect new buy-in or buy-out arrangements (or variations to, or renewals of, existing arrangements) entered into after this date. The old regime continues to apply to contracts which took effect before 12 August 2016.
Broadly speaking the changes rebalance insurance law in favour of policy holders. Key developments include changes to the duty of disclosures and warranties.
Duty of disclosure
Under the old regime, the insured had a duty to disclose every material circumstance known to them. Further, they were deemed to know every circumstance which, in the ordinary course of business, ought to be known to them. Insurers were able to avoid contracts where this duty had not been met. This standard has been replaced by an obligation to make a “fair presentation” to the insurer of the risk covered by the contract and a new system of “proportionate remedies”.
This means that insureds have a duty to:
(a) disclose every ‘material circumstance’ which the insured knows or ought to know;
(b) give the insurer sufficient information ‘to put a prudent insurer on notice that it needs to make further inquiries’ for the purpose of revealing those material circumstances;
(c) make that disclosure in a format that is reasonably clear and accessible to a prudent insurer; and
(d) ensure that material representations on matters the insured knows (or ought to know) are substantially correct or on other matters (e.g. representations of their expectation or belief) are made in good faith.
If the insured fails to meet this standard, the insurer's remedies are now limited to the actions they would have taken had such failure not occurred. Where the insured has acted dishonestly, the insurer will still be able to avoid the policy (and retain the premium). In relation to negligent conduct:
- where the insurer would have declined the risk altogether, the policy can still be avoided with a return of premium (although, where a policyholder has acted deliberately or recklessly, the insurer need not return the premium);
- where the insurer would have accepted the risk but would have included a certain contractual term, the contract should be treated as if it included that term; and
- where the insurer would have charged a greater premium, the claim should be reduced proportionately.
Insurers will therefore need to consider what evidence they have available to show how they would have responded if information which was not disclosed had been revealed during fair presentation of risk. For instance, they may need to maintain records showing the basis on which they agreed to certain terms, and alternative provisions they would have sought had different disclosure been made.
Warranties are terms by which an insured:
- undertakes to do (or not do) a particular thing;
- undertakes that some conditions shall be fulfilled; or
- affirms or denies the existence of a state of facts.
Under the old regime, if an insured breached a warranty, the insurer would be discharged from liability, even if there was no causal connection to loss. Such breach could not be remedied.
Under the new regime warranties operate as suspensive conditions. The insurer has no liability during the suspended period for any loss occurring which is attributable to something happening during the suspended period.
This change is less likely to affect bulk annuity policies, where warranties are often limited to statements of fact as at the time of inception. However, they may have greater implications for warranties to be repeated prior to the parties entering into a buy-out.
For more information please see our recent Insurance and reinsurance newsletter:Insurance Act 2015 - are you prepared?
Can you proceed?
Trustees will need legal advice to confirm whether the buy-out will comply with the terms of the scheme and pensions law. Key questions include:
- Is the transaction allowed under the rules of the scheme and are there any constraints on the trustee power (e.g. do they require consent from members or the employer)?
- In the case of buy-outs, does the policy comply with the preservation and contracting-out laws (in particular the requirement that the payment made to the insurance company is at least equal to the value of the members’ accrued benefits)?
- Is the assumption of the benefit promise by the insurance company treated as a “recognised transfer” to a registered pension scheme, and hence as an authorised payment for tax purposes?
Should you proceed?
Buy-in policies are a popular way of reducing the funding volatility associated with pension schemes by transferring a range of risks (e.g. longevity, investment and inflation) to an insurer.
A buy-out would normally offer trustees the opportunity to ensure greater security for the past benefits of members, because:
- they may be able to obtain an additional funding injection from the employers in order to enable the transaction to occur;
- benefits will no longer be reliant on the employer’s financial strength, as the members will have a claim directly against the insurer; and
- scheme running costs will be reduced or removed entirely.
However, as an investment, a bulk annuity policy will usually be substantial, illiquid and not generate any returns other than matching certain benefit liabilities. They are also very difficult to unwind.
Trustees, in particular, will have a number of key concerns, including whether:
- the interests of all members have been properly considered and addressed;
- the insurer’s financial covenant is sufficiently strong, bearing in mind the long duration of the contract;
- any buy-out and subsequent winding-up process have been rigorously implemented to reduce risk of continued trustee exposure in relation to the scheme; and
- the trustees have adequate protection in respect of any remaining risks.
Impact on members
Trustees will need to understand the implications of the buy-in or buy-out and its impact on scheme members. If a buy-in is being considered, important factors for the trustees to consider include:
- the strength of the insurance company covenant. Trustees often instruct a financial adviser to give a report on this issue;
- whether they should seek security from the insurer? This is more common on buy-ins and then only if very large. It can increase the cost of the premium payable to the insurer. Alternatively, trustees may seek to pay the premium in instalments, or to have a right to repayment of the premium if the insurer’s covenant deteriorates; and
- the power to adjust benefits. Trustees should confirm whether they will have the power under the policy to adjust benefits prior to buy-out (e.g. to reflect commutation or pension sharing or changes in the law, such as indexation requirements; see contractual negotiations – key terms, above).
If a buy-out is being considered, the strength of the insurance company covenant would also be equally critical. Other important factors for the trustees to consider would include:
- loss of access by the members to discretionary benefits (e.g. discretionary pension increases, some dependant’s pensions and early retirement pensions);
- change in levels of insolvency protections. Prior to buy-out the member’s benefits are secured by the fund and the funding obligations on the employers. The final back-up is the Pension Protection Fund (PPF). After a buy-out, the benefits would be secured by a regulated insurer, with the Financial Services Compensation Scheme (FSCS) potentially being available in the event of failure. Before proceeding with a buy-out transaction, trustees should get advice on the different levels of protection (between the PPF and the FSCS) and confirmation that the policies qualify for protection under the FSCS;
- whether the buy-out affects the tax treatment of members (e.g. any transitional protection for members entitled to take enhanced lump sums or take their benefits before age 55); and
- on a partial buy-out, whether it is fair to be treating different groups of members differently.
Discharge of liability
A key concern for trustees on a buy-out is their own level of protection.
Trustees will usually look for protection against any claims arising after the scheme assets have transferred to the insurer (e.g. from beneficiaries claiming that they are not receiving the benefits they are entitled to or individuals who were omitted from the list of members given to the insurer). Usually this is a combination of:
- an indemnity from the employer;
- run-off insurance or trustee liability insurance; and
- statutory discharge (there are a number of legal requirements arising from contracting-out and preservation rules).
Issues can arise on this and the agreed position needs to be clear:
- Are there any limits (time, amount etc.) on any protections?
- How much will insurance cost? Unlimited insurance with a long claim period can be expensive.
- Will any insurance cover the trustees and the sponsoring employer or only insure the trustees (i.e. if the employer does not pay)?
- Who will pay for any insurance – the fund or the employer?
Interests of sponsoring employer
Even if the trustees have a unilateral power to enter into a buy-in or buy-out, they will usually seek to obtain the support of sponsoring employers before proceeding as:
- the scheme may require additional funding in order to be able to afford the premium payable to the insurer;
- additional amendments may need to be made to the trust deeds (e.g. to discharge the trustees of ongoing liability); and
- trustees need to exercise their investment powers for a proper purpose (i.e. the purpose for which it was envisaged). This will usually involve having regard to the interests of the employer.
The UK electorate’s vote to leave the European Union has had an impact on a number of key issues which affect the availability and appeal of de-risking for pension schemes, including:
- pension scheme investments;
- the employer covenant;
- the regulation of insurers; and
- the regulation of pension schemes.
Please refer to our briefings:
- Brexit: What is the impact on UK pension schemes?
- Brexit: Key issues for insurers
- Brexit: What does it mean for the regulation of UK pensions?
Recap and update on GMP equalisation
Following Brexit, the UK could also adopt a more flexible approach in relation to the way sex equalisation has been implemented in relation to pension schemes, as set out in EU caselaw. However, the Government has recently signalled that it retains its previous position that the European Court of Justice’s ruling in Allonby means that schemes will need to equalise for the effect of the guaranteed minimum pension (GMP) rules. The Government published a further consultation seeking views on a proposed methodology that schemes could use to equalise GMPs last month (November 2016), which will close on 15 January 2017. Schemes will not be required to use the proposed method of GMP equalisation set out in the consultation paper and trustees will need to consider whether the proposed method is appropriate for their scheme. In July 2015, the Pensions Ombudsman ruled that the trustees of a defined benefit scheme are entitled to defer taking any action to equalise GMPs until required to do so by the Government.
However, equalisation of GMPs will remain an issue when purchasing buy-in and buy-out policies, as:
- Trustees will want to retain discretion to vary the benefits covered by bulk annuity policies to reflect any benefit changes that equalise GMPs.
- Trustees will need to comply with certain statutory restrictions in order to be discharged of their liability to provide GMPs.
- It is commonly held view that an insurer will only assume the liability to equalise GMPs where agrees to do so under the terms of the relevant policy. In practice, the standard terms of most insurers exclude liability for changes in law.