Buy-outs have been the traditional answer to securing benefits of defined benefit (“DB”) pension schemes in wind-up. Historically up to £2 billion of business was written annually by two established insurers, Prudential and Legal & General. The margins on annuity business have been attractive enough to entice many new entrants to the market who have developed bespoke products which appeal to trustees and sponsors of ongoing DB schemes who are keen to control funding volatility. This article highlights some of the issues trustees and sponsors will need to consider in navigating their way through an insurance buy-out process.
Buy-out or buy-in?
At their most basic level “buy-outs” and “buy-ins” are investment decisions made by pension scheme trustees. A buy-out involves the application of pension scheme assets by trustees towards the purchase of an annuity policy written in the name of the beneficiary whose liabilities that policy (in whole or in part) secures. Once purchased, the responsibility for providing the benefits secured by that policy passes from the trustees to the insurer and those liabilities cease to be liabilities of the pension scheme. A buy-in involves an annuity policy being purchased which is written in the name of the trustees and which is held as an asset of the pension scheme, exactly matching the liabilities it secures. Unlike a buy-out, the trustees will not be legally discharged from the corresponding liabilities, even though the economic substance of the transaction is that those liabilities are satisfied.
Unless a specific reference is made to the term buy-in or the context otherwise requires, any reference in this article to buy-out should be taken as a reference to a buy-out or buy-in.
The lure of the buy-out
There are many factors fuelling the interest of sponsors and trustees in a buy-out of their ongoing scheme’s liabilities, including:
- the introduction of the FRS17 accounting standards and later IAS19, which require scheme deficits to be recognised on the sponsor’s balance sheet, which can impact its value and saleability. A ‘true’ buy-out (or a buy-in followed by an assignment of policies to individual members) would discharge the trustees from liability for providing the corresponding liabilities, thus removing the requirement for those liabilities to be recognised on the sponsor’s balance sheet;
- the burden of increased regulation of DB schemes in recent years, driving up cost and management time;
- funding volatility caused by investment risk, increasing longevity (and other demographic risks) and expense risk. Although a liability driven investment strategy can manage some investment risks, trustees and sponsors remain exposed to longevity risk. Whilst there are products in the market for mitigating longevity risk (see Andrew Reid’s article below), the interactions between investment and longevity risk can be difficult to manage.
- as noted above, competitive pricing (due in part to the increasing number of players in the market competing for market share) making buy-out more affordable; and
- greater confidence that the benefit promise of a scheme will be met in full over the life of the member when underwritten by an authorised insurance company rather than the employer sponsor.
Back to basics: exercising the power of investment
The extent of trustees’ investment powers will be set out in the governing documentation of their scheme, which will typically include the power for trustees to purchase contracts or policies with an authorised insurance company, either in their own names or in the name of individual members. The trustees’ exercise of any power of investment is, however, subject to certain duties derived from common law (including the requirement to take such care as an ordinary prudent man would) and statute, in particular:
- Trustee Act 2000 – to have regard to the suitability of the investment and the need for diversification of investments, so far as appropriate to the circumstances of the trust;
- Regulation 4 of the Occupational Pension Schemes (Investment) Regulations 2005 -to take into account the best interests of members and beneficiaries and to ensure the security, quality, liquidity and profitability of the portfolio; and
- Section 36 Pensions Act 1995 – to obtain and consider advice from an appropriately qualified adviser as to whether a proposed investment is satisfactory having regard to the suitability of investments and the contents of the scheme’s Statement of Investment Principles (“SIP”). If the scheme’s SIP does not permit buy-out, it should be amended, after consultation with the sponsor, before a buy-out takes place.
Trustees will need to discuss with the chosen insurer, which of the scheme’s assets it will accept in satisfaction of the premium and will need advice as to which assets to retain to ensure compliance with the above common law and legislative framework. Transition management may be required to sell such assets or transfer them in-specie to the insurer, and legal advice will be needed to settle terms with the transition manager.
Post buy-out, trustees will need to review the scheme’s investment strategy, in light of the scheme’s different liability profile and to update the SIP accordingly
Duty to act impartially between different classes of beneficiary
Depending on the structure of the proposed buy-out and whether it is full (i.e. all liabilities being bought out) or partial, implementation of the proposal by trustees might bring them into conflict with their trust law duty to act impartially between the different classes of beneficiaries (pensioners, active members, deferred members and contingent beneficiaries) and to act fairly as between individuals.
Although the cost of buy-outs has become more affordable due to a number of factors, not least competition (with numerous insurance companies now vying for this business and other players offering non-insured solutions), a full buy-out remains relatively expensive, which means that in most buy-outs trustees have to select which class or classes of liability will be secured. Pensioner-only buy-outs by ongoing schemes have been partly responsible for the recent surge in buy-out business transacted. However such deals favour the members whose benefits are bought out by requiring a significant proportion of scheme assets (often over 120% of a scheme’s FRS17 funding level in respect of those liabilities which are to be bought out) to be applied towards the purchase of the bulk annuity policy. This has the potential to weaken the security of benefits of the members whose benefits have not been secured. How real a risk this is will depend upon the covenant of the scheme sponsor and the likelihood of a scheme entering wind-up. The risk is that if a scheme were to enter insolvent wind-up, the trustees would be found to have allocated a disproportionate share of the scheme’s resources to some members and not others and may face criticism for their actions. The treatment of bought out benefits on wind-up is discussed in more detail below.
In considering any buy-out proposal, trustees must consider the interests of all beneficiaries of their scheme. However, that is not to say that all classes of beneficiaries must be treated in an identical manner. In the case of Edge v The Pension Ombudsman (1999) the duty to act impartially was discussed. It can be summarised as a duty upon trustees to take into account all relevant factors, to exclude from consideration any irrelevant factors, to ask the correct questions of themselves, to direct themselves properly as to the law and not to come to a decision that a reasonable body of trustees could not reach.
If trustees make their decision in this way then they should not be found liable for reaching a decision, which, on the face of it, appears to prefer the interests of some members over others. The trustees’ legal adviser will help steer a course through these difficult issues.
The insurer’s covenant
On an insured buy-out the trustees of a scheme transfer the risks of that scheme to the chosen insurer. Until this time the trustees should have been monitoring the covenant of the sponsor of their scheme to ensure its willingness and ability to pay scheme benefits as they fall due. Since 6 April 2005, they will also have been aware of the availability of PPF assistance in the event of a qualifying insolvency in relation to the sponsor, where the scheme is funded below PPF compensation level. In contemplating a buy-out their focus on covenant should also take in the covenant of their preferred insurer.
Under FSA rules all UK insurers must hold capital reserves that ensure there is at least a 99.5% probability of them being able to meet their liabilities over a 12-month period. When valuing those liabilities insurers usually adopt longevity assumptions of 2-3 years more than average UK DB schemes, plus a margin for prudence. On top of this is added a reserve of up to 6% for multi-line insurers (insuring a wide range of risks) and often more for mono-line insurers (i.e. providing life-only insurance).
In addition to understanding the insurer’s reserving requirements trustees should, with the assistance of their professional advisers, undertake further due diligence into their preferred insurer’s levels of free assets and its ability to raise new capital in order to write new business or to support adverse claims experience. Also, the trustees will wish to weigh the relative merits of choosing to transact with a mono-line insurer or a multi-line insurer as well as the track record of their preferred provider and administration capability (if benefits are being bought-out).
On top of having to meet what are more stringent reserving requirements than the funding requirements of an ongoing UK DB scheme, a policy of an authorised insurance company has the backing of the Financial Services Compensation Scheme (“FSCS”). This should be the case whether there is a buy-out or a buy-in. As discussed in Clifford’s article on ‘Investment firm insolvency’ above, the compensation available where the subject of the policy is a long-term insurance contract is 100% of the first £2000 plus at least 90% of the remaining value of the policy. Provided that a policyholder has no more than one policy with the same insurance company, there is no upper limit on the 90% cover.
The FSCS therefore has the potential to offer greater protection to certain policyholders (typically those under normal pension age) than is likely to be available under the PPF, although it does, of course, leave a 10% margin which is uncovered. However, unlike PPF there is no FSCS compensation ‘fund’. One aspect of FSCS that is untested (because there has not been a significant call on it) is whether the insurance industry will answer a call to compensate policyholders of a failed insurance company by meeting the demand in full and without delay and uncertainty for policyholders.
The claimant under the FSCS will, in the case of a buy-in, be the trustees as policyholder and not the pensioners as beneficiaries. It would then be for the trustees to apportion any compensation that became payable among the pensioners. On a buy-out, individual members (as policyholders) would be the claimants.
Buy-out, winding-up and PPF
In considering any buy-out proposal, other than a true buyout of all liabilities, trustees will wish to avoid taking any action which might prejudice the prospects of their scheme entering the PPF in the event of a sponsor insolvency.
If a scheme winds up and its sponsor(s) cannot pay any section 75 Pensions Act 1995 debt in full, the scheme will enter a PPF “assessment period”. Trustees must be careful not to compromise the section 75 debt at less than the full amount as doing so would risk their scheme’s eligibility for PPF assistance. Once a PPF assessment period has commenced trustees cannot transfer or secure benefits outside of the scheme e.g. by the purchase of annuities written in the names of individual members i.e. a ‘true’ buy-out. However, under current law there is no prohibition on buying-out benefits before a PPF assessment period begins. Therefore, a buy-out of some of an ongoing scheme’s liabilities will not prejudice its eligibility for PPF protection at a later date.
When a DB scheme is wound-up, section 73 of the Pensions Act 1995 will apply to determine the order in which the liabilities of that scheme are satisfied and where there are insufficient assets to satisfy those liabilities in full the proportion of those liabilities that are satisfied. The detail of this section provides that irrespective of whether a scheme enters PPF, satisfying PPF-level benefits from a scheme’s assets will be a priority second only to satisfying liabilities secured by pre-1997 annuities.
Trustees must also consider what effect any decision to buyout now will have in the event of any future scheme sponsor insolvency. In general terms, if after a buy-out a scheme winds up at a time when it:
- is funded below PPF-level - the scheme, its assets and liabilities would be accepted into the PPF. If the liabilities had been secured by a buy-in, the bulk annuity policy would be subsumed into the PPF and a prescribed level of PPF compensation would be payable. If, however, trustees had secured liabilities through a true buy-out, such policies would not be available to the PPF. Therefore on wind-up members whose benefits had been bought out would receive disproportionately greater benefits than they would be entitled to from the PPF than the members whose benefits had not been so secured.
- is funded between PPF-level and full buy-out level - if some liabilities have been secured by a buy-in, then the annuities should be capable of surrender and applied by trustees in accordance with section 73. If poor surrender terms are available, trustees could face criticism about their allocation of scheme assets. If benefits had been secured through a buy-out, those policies will not be capable of surrender (but it will not matter as they are no longer assets or liabilities of the scheme). As discussed above, trustees can mitigate the risk of such criticism by a proper decision-making process.
A buyer’s market
Increased competition in the insured buy-out market means trustees can sometimes stipulate the terms on which they are prepared to contract and insurance companies are responding with bespoke products. Trustees who want a clean-break from the liabilities being secured may also be able, for a premium, to pass certain residual risks to the insurer e.g. that legislation will be introduced setting out how to achieve equalisation of guaranteed minimum pensions or the risk that data errors materialise leaving an unsecured liability. In addition, many deals have been struck guaranteeing terms for buying-out new retirees for a fixed period or offering trustees the ability to share in any upside experience enjoyed by the insurer or the scheme sponsor, as a result of buying-out liabilities.
How long will the trend last?
How long the trend towards securing pension scheme liabilities with bulk annuity policies will last remains to be seen. There is evidence that the recent crisis in world markets has acted as a dampener to a number of deals which were in the final stages of agreement, as the current climate restricts insurers’ ability to raise capital to support new business. Equally, depressed asset values in schemes which were not matched in the sorts of assets that insurers would be interested in taking (index-linked gilts as an ideal for a pensioner population) must inevitably drive up the price of buy-outs. The other unknown factor is the corporate appetite and means to inject cash into a Buy-out; if there is to be a deep and lasting recession in the economy, there will be competing demands for what might until recently have been seen as spare capital. Also the implementation of the EU Solvency II Directive in 2012, which means insurance companies’ capital requirements will be strengthened as one way to mitigate failure, is likely to drive up the cost of buyingout in the medium term. All of these factors are beyond the control of insurance companies and may frustrate the development of the market.