Safety measures: de-risking pension schemes

With the majority of final salary pension schemes now closed to new entrants and a sizeable number closed to future benefit accrual, many trustees and ­employers have one eye fixed firmly on the end game – winding up and securing ­members’ benefits.

Employers and trustees are therefore increasingly looking for ways to ‘de-risk’ pension schemes – including removing longevity risk. Successfully completing a de-risking project has a number of potential upsides:
• the scheme’s funding position and, correspondingly, the employer’s balance sheet will be less volatile;
• longevity risk is taken out of the pension scheme – in other words, the risk that a scheme’s liabilities increase if members live longer than expected; and
• the employer and trustees are less reliant on investment performance, as assets will be better matched to liabilities.

De-risking is not cheap. Whether it is affordable will depend on the scheme’s ­funding position and/or the willingness and ability of the employer to make funds available. Very few schemes have enough money available to secure all of their liabilities.

However, over the past year the emergence of a new buyout (and buy-in) market, competitive pricing and other inventive approaches to dealing with pension scheme liabilities have provided employers and trustees with genuine opportunities to de-risk all or part of their liabilities.

As ever, there is a host of legal issues ­associated with such opportunities that
will need to be ­considered as part of any de-risking exercise.

Buyouts

A buyout involves the purchase of individual annuities with an insurance company in the members’ names. Once bought out, the ­pension scheme obtains a full discharge in respect of the bought-out benefits. If the pension scheme is in deficit the sponsor will need to make a contribution to enable the buyout. If the buyout is of only some of the benefits in the scheme, the trustees must ensure that the buy-out does not make ­members who remain in the scheme any worse off in terms of security for their ­benefits.
Buyout can present tricky technical issues around how to value the members’ benefits for the purpose of calculating the cost of the annuities. The quality of scheme data is also important. A full data reconciliation may be needed, or it may be possible to pay an extra premium to the insurance ­company to take specific data risks.

Buy-ins

A buy-in is simply the purchase of a bulk annuity policy as an asset of the pension scheme. The trustees remain responsible to the member to provide the benefit but have a ‘matching asset’ that produces an income stream, which should be the same as the benefit they pay out.

If the pension scheme goes into wind-up, the employer remains responsible for making up any funding deficit. Consequently, both the employer and trustees will be concerned to ensure that the policy is entered into with an insurer with a good covenant. Specific advice will also be needed on whether or not the ­Financial Services Compensation Scheme backs up the policy.

Buy-in is usually a quicker process than buyout and, for those considering this option, speed may be of the essence to avoid the risk of the market moving against the pension scheme. A buy-in may have the facility to move to a buyout at a later stage by splitting the bulk annuity policy into ­individual policies.

Longevity insurance

Longevity is rising, and longevity risk is often the major pension scheme risk. It is possible to insure against the risk of ­members living longer than expected, but this can be costly. Premiums are typically measured on the size of benefits payable and the insurer’s estimate of life ­expectancies.

Employer covenant insurance
This type of insurance protects against the risk of employer failure. If the employer fails, the policy pays out the insured benefits. Such policies can allow greater investment freedom, encourage the continuance of schemes and may relieve employers from paying Pension Protection Fund levies.

The future?
Our experience is that there is growing interest in exploring the options for de-risking. Analysts have predicted the buyout market alone will be worth up to £10bn in 2008. The above strategies are likely to be attractive to those employers and trustees for whom they are affordable – although it remains to be seen what impact the recent turbulence in the financial markets will have.

Ian Cormican is a partner and Caroline Legg an associate at Sacker & Partners