Over the last couple of years, many defined benefit (final salary) pension schemes have sought to reduce the risks associated with their investments. One way in which this can be done is to secure the payment of a proportion of the benefits payable from the pension scheme through the purchase of annuities from an insurance company. Buy-ins and buy-outs both have the objective of reducing a pension scheme’s investment risk and volatility. Both have become increasingly popular recently in light of the convergence of implementation costs and pension scheme funding positions. However, different considerations apply in respect of whether the trustees of a pension scheme should proceed with a buy-in or a buy-out.
Buy-ins consist of the purchase of annuities with the pension scheme’s assets, often in respect of the benefits payable to a specific group of members (for example, pensioners). Buy-ins normally form part of a phased strategy to reduce risk within the pension scheme by way of passing a proportion of the pension scheme’s investment risk to the insurance company from which the annuities are purchased. The annuities that are purchased will be considered as investments of the pension scheme and will be held in the names of the pension scheme’s trustees. As such, the pension scheme will have the same liabilities towards members as it had prior to the buy-in and it will remain responsible for the payment of benefits to members. Recent examples of buy-ins include those carried out in respect of the pension schemes sponsored by Cable & Wireless (£1 billion), P&O (£800 million) and Friends Provident (£360 million).
Buy-outs are similar to buy-ins, insofar as they consist of the purchase of annuities with the pension scheme’s assets. This may be in respect of a specific group of members (known as a “partial buy-out”) or all of the members (known as a “full buy-out”), after which it is usual for the pension scheme to be wound up. The principal feature which distinguishes buy-outs from buy-ins is that the purchased annuities will not be held by the pension scheme trustees as investments, but will instead be held by the members. This structure entails the removal of the pension scheme’s liabilities towards the members in respect of whom the annuities have been purchased. Recent examples of buy-outs include those carried out in respect of the pension schemes sponsored by Thorn (£1.1 billion), Rank (£700 million) and Powell Duffryn (£400 million).
The trustees of a pension scheme must act in accordance with a number of duties. These duties include those set out below.
Governing documentation and legislation
Trustees must act in accordance with their pension scheme’s governing documentation, including its trust deed and rules. Under the Pensions Act 1995, the trustees have the same power to make an investment of any kind as if they were absolutely entitled to the assets of the pension scheme, subject to any restriction imposed by the pension scheme’s trust deed and rules. This power is usually reflected in a pension scheme’s trust deed and rules, giving the trustees the power to take unilateral decisions as to the investment of the pension scheme’s assets. The Pensions Act 1995 also sets out the requirements relating to consultation and obtaining appropriate investment advice, should the trustees wish to implement a buy-in or a buy-out, although such a decision may often involve specific discussion with the employer, as extra funding may be required.
Acting in the beneficiaries’ best financial interests
In reaching any decision to implement a buy-in or a buy-out, trustees must act in the best financial interests of the pension scheme’s beneficiaries. These include active members, deferred members, pensioners, prospective members and anyone else who may become entitled to receive payments from the pension scheme.
Effects of a buy-in for members
Although the annuities purchased as part of a buy-in are likely to reflect the benefits payable to a specific group of members (for example, all the benefits payable to the pension scheme’s pensioners), the annuities would be pension scheme investments. As such, the income from the annuities should be considered as being an asset of the pension scheme, instead of belonging to each individual within that specific group (although, in practice, this income is often paid directly by the pension scheme to the members of the group). Consequently, the annuities would be available to the pension scheme as a whole should a winding-up occur and, therefore, would be available to fund all members’ benefits.
Owing to the methods of calculating funding positions, it is possible that a buy-in will cause a pension scheme’s funding position on an on-going basis to deteriorate (although not on a buy-out basis). In spite of this, a buy-in may be considered not to have a detrimental effect on the overall level of security of members’ benefits. Factors which may influence this include:
- the continuing support of a sponsoring employer with a strong covenant;
- the continuing protection offered by the Pension Protection Fund (the PPF) should the pension scheme wind up with insufficient assets to secure the payment of all benefits;
- the reduction in the risk exposure and volatility of the pension scheme’s investments; and
- the protection offered by the Financial Services Compensation Scheme in respect of the purchased annuities (broadly, at least 90 per cent of the insured benefits, with no limit). A consultation on the level of cover provided by the Financial Services Compensation Scheme closed on 5 January 2009, although the results of the consultation have not yet been published. There has recently been some confusion as to the application of the Financial Services Compensation Scheme to annuities purchased as part of a buy-in, although the Financial Services Authority (the FSA) has confirmed that it will apply to such annuities.
Effects of a buy-out for members
Once the benefits of a group of members have been bought out, those benefits will become payable by the insurance company from which the annuities were purchased. In practice, the annuities are generally purchased in the name of the trustees and then assigned to the relevant members. The members of the group will then each hold their respective annuities, which will no longer be considered to be assets of the pension scheme. In addition, those individuals are no longer considered to be members of the pension scheme and the trustees have no further liability in respect of them.
If a pension scheme is not fully funded on the buy-out basis, it is highly likely that the purchase of annuities with the pension scheme’s assets to be held by a group of members as part of a partial buy-out will worsen the pension scheme’s funding position for members whose benefits have not been bought out. This is because a proportion of the assets that would otherwise have been applied towards the payment of benefits to members who have not been bought out will be applied towards the purchase of annuities which will only benefit the members who have been bought out. This will not be an issue where a full buy-out takes place, although it is almost certain that additional contributions will be required from the pension scheme’s sponsoring employer to enable a full buy-out to take place if the pension scheme is not fully funded on the buy-out basis.
Notwithstanding any deterioration in the pension scheme’s funding position, the purchase of annuities will reduce the pension scheme’s overall exposure to investment risk. However, the members in respect of whom annuities are purchased may be exposed to additional risk in the current economic climate (for example, the risk of failure of the insurance company from which the annuities have been purchased). Although such members will be covered by the Financial Services Compensation Scheme in the event of the failure of the insurance company, they will not be covered by the PPF, nor will the pension scheme’s sponsoring employer be required to make good any difference between those members’ accrued benefits and the amount payable from the Financial Services Compensation Scheme.
Effects for the sponsoring employer
The pension scheme’s beneficiaries may also include its sponsoring employer, although generally the sponsoring employer’s interests will be subsidiary to those of the pension scheme’s members. A sponsoring employer may be considered a beneficiary, as it is not uncommon for the governing documentation of pension schemes to provide for any disposable funding surplus to be returned to the sponsoring employer following a valuation or upon the termination of the pension scheme. The courts have also held that trustees should take account of the impact their investment decisions will have on their pension scheme’s sponsoring employers (Edge v Pensions Ombudsman  Ch 602). Consequently, a trustee’s decision as to whether to proceed with a buy-in or a buy-out should take some account of the sponsoring employer’s interests, particularly given the sponsoring employer’s obligation to make good any funding deficit within the pension scheme. Indeed, it is common for the sponsoring employer to be involved in the process of making the decision as to whether a buy-in or a buy-out should be effected, as the possibility of a buy-in or buy-out may have been raised by the sponsoring employer in the first place.
Trustees are under a duty to seek to act impartially towards the various classes of beneficiary and to consider their interests (Cowan v Scargill  Ch 270). Given the requirements relating to the distribution of a pension scheme’s assets under the Pensions Act 1995 on termination of the pension scheme, trustees should have regard to these obligations before making decisions relating to buy-ins and buy-outs.
On the basis that annuities purchased as part of a buy-in will form part of the pension scheme’s assets, the value of all the pension scheme’s assets (including the annuities) will be distributed evenly amongst the pension scheme’s members upon termination in accordance with section 73 of the Pensions Act 1995. The application of assets in this way will be made regardless of whether the annuities were purchased in respect of specific members’ benefits. However, if the pension scheme has insufficient assets to be able to provide benefits at or above the PPF level of benefits, the assets will be transferred to the PPF. If this happens, all members of the pension scheme will receive the level of benefits provided by the PPF, also regardless of whether the annuities were purchased in respect of specific members’ benefits.
It is also worth noting that the members in respect of whose benefits annuities have been purchased will still be able to participate in any surplus payments or benefit augmentations which may be given to members of the pension scheme in the future. This would not be the case if their benefits had been bought out.
As the position on wind up for the group of members in respect of whose benefits the annuities have been purchased would be unaffected following the implementation of a buy-in, the buy-in would not necessarily result in those members being treated more advantageously than other members of the same pension scheme.
On the basis that the annuities purchased as part of a partial buy-out will not be assets of the pension scheme, the value of the annuities will not be distributed evenly amongst all of the pension scheme’s members upon the winding-up of the pension scheme if it has insufficient assets to be able to secure all members’ benefits. As such, this could give rise to a situation where the benefits of the members who have been bought out will be fully secured, whilst the other members face the possibility of receiving a comparatively lower level of benefits on winding-up. The difference in levels of benefit security may also be compounded if the annuities were purchased at a time when the pension scheme was less than fully funded on a buy-out basis and the sponsoring employer has not supplied any additional funding. This is because the funding position for these other members will be worse than before the annuities were purchased.
Despite the resultant difference in the level of security of benefits payable in respect of different groups of members, it may be possible for trustees to agree to a partial buy-out, particularly if additional funding is provided by the pension scheme’s sponsoring employer. However, it will be more difficult for the trustees to show that they have complied with their duty to take account of all beneficiaries’ interests than if they were agreeing to a buy-in.
The trustees’ compliance with their duty to take account of all beneficiaries’ interests is likely to be unproblematic if they agree to a full buy-out, as all members’ benefits will be secured in the same way.
The current annuity market
In light of the current economic situation, many insurance companies have become more cautious in their provision of annuities. Despite reports in the press stating that the number of annuity providers has fallen dramatically since its peak at the end of 2007, there is still a range of providers for trustees to choose from. This is, in part, due to a continued willingness of pension scheme trustees and sponsoring employers to carry out buy-ins and buy-outs. This is reflected by a total value of annuities purchased during 2008 of approximately £8 billion. Although this value is less than the value of £10 billion that was estimated by some commentators at the beginning of 2008, it is still considerably more than the value of annuities purchased during previous years.
The insurance companies’ caution can be demonstrated by their change in approach to bidding for the provision of annuities to certain pension schemes. Whereas 12 months ago, it would have been probable that a pension scheme could obtain quotations from a number of different providers and these quotations would have been guaranteed for at least two months, some insurance companies are now more reluctant to give guarantees and may require exclusivity. Of course, quotations and guarantees will depend on the individual circumstances of each pension scheme; insurance companies may be more willing to provide annuities to pension schemes which match specific criteria (for example, size of fund).
Trustees and sponsoring employers
A number of groups of trustees and sponsoring employers have also started to take a more cautious approach to the purchase of annuities, particularly in light of the now real risk that an insurance company might fail. An example of this is the movement towards the collateralisation of annuity purchases; collateral for the payment of the annuity purchase price will be held by a third party, although a proportion of this will be returned to the pension scheme upon specific trigger events, such as change of control of the insurance company, insolvency or loss of FSA approval. We understand that collateralisation is likely to be available for annuity purchases in excess of £400 to £500 million, as insurance companies are reluctant to do this in respect of smaller purchases. A further way in which annuity provider risk could be managed in the future is the syndication of annuity purchases; this is something which could become a popular option for larger buy-ins and buy-outs given the spread of risk over two or more insurance companies. We are not aware of any buy-ins and buy-outs that have been structured in this way, although we understand syndication is being offered in principle.
Valuations and funding documentation
Under the Pensions Regulator’s code of practice on funding defined benefits, trustees should call for an actuarial valuation of their pension scheme to be carried out where events have occurred which make it unsafe to continue relying on the results of the previous valuation. This may be the case if trustees consider that the buy-in or buy-out has caused their pension scheme’s on-going funding position to have changed or if the level of security of members’ benefits has changed. Alternatively, the trustees may amend their pension scheme’s funding documentation if this is considered more appropriate.
Before an out-of-cycle actuarial valuation is carried out, the trustees should consult the pension scheme’s sponsoring employer. In addition, the sponsoring employer’s consent will in many cases be required before any changes to the pension scheme’s funding documentation can be made, either following a valuation or more generally.
In deciding whether to proceed with a buy-in or a buy-out, the advantage of reducing investment risk and volatility for a pension scheme is clear. However, trustees should be aware of their duties and the other issues surrounding these courses of action before reaching any decision, particularly those relating to the impact of buy-ins and buy-outs on the beneficiaries of the pension scheme.