2023 was a bumper year for insurance of pension scheme benefits in terms of volume and value of transactions. The trend of final salary schemes taking advice on their 'end-game' by insuring all benefits with an insurance company looks set to continue into 2024. Reasons for this are varied but the key driver is that many schemes have seen significant improvements in their funding position due to the rise in gilt yields (and are closer to buy-out level funding making the costs of the insurance solution more affordable than ever before). This briefing sets out our insurance transaction "essentials".
- What do we mean by an "insured
solution"?
A typical insured solution essentially consists of two parts: buy-in and then buy-out. The buy-in is an investment exercise to purchase an insurance policy (which can secure some or all of the benefits of the scheme) under a bulk purchase annuity contract (BPA). A BPA is a scheme asset and provides an income stream to schemes to match their commitments to pay member benefits. A buy-out occurs after data verification and payment of any top-up premium, before individual policies are issued by the insurer, and the BPA falls away.
- Is insurance the right option for the scheme?
Whilst often seen as the 'gold standard' end-game, the first step is for all parties to consider whether this solution is right for their particular scheme and alternatives may exist. A consolidator may be a better option where affordability remains tricky. Where there is a strong employer covenant and the scheme has achieved buy-out funding, running the scheme on (with employer support) may be viable and the Mansion House reforms suggest this is an area trustees should consider (and employers may be interested in if surplus return rules change). Overall, trustees must ensure that in reaching any decisions they have regard to their fiduciary obligations and consider all relevant factors.
- Who is involved?
While a buy-in is technically a trustee investment decision, project meetings will concern: (1) the trustees as the purchaser of the BPA; (2) the employer who will often need to assist with any scheme changes to facilitate the transaction or make a cash injection to the scheme to enable the BPA purchase; (3) the insurer, as the annuity provider, who in return for the premium agrees to guarantee the payment of pensions covered by the BPA; (4) a broker/consultant, as the intermediary with insurance market connection to advise on pricing and cover; and (5) scheme (and employer) advisers. In our experience, a successful exercise will be more likely if these participants are engaged early and work collaboratively throughout the process.
- Planning is key
For the participants to deliver the exercise they need a clear vision of what is to be achieved from the outset. What is appropriate will depend on a scheme's funding plan and objectives. The pathway can be set out in a Memorandum of Understanding (MOU) between the trustees and the employer or it can be mapped out in a carefully drafted steps plan. Any MOU or steps plan should cover all budgetary or commercial considerations such as monitoring/payment of costs or expenses, payment of any cash injection and provide a legal framework for the journey.
- What are the main steps involved?
The typical steps include:(1) considering whether the scheme is ready in terms of its data quality and funding position. This may involve a series of pre-transaction steps to clean up or streamline benefits; (2) preparing the benefit specification (see below); (3) approaching the market. This will involve requesting and considering offers from a variety of insurers (and possibly whether to transact on an exclusive basis with a preferred insurer); (4) once a preferred insurer is chosen the process of contract negotiations, policy inception and risk transfer will begin; (5) after the BPA takes effect, a secondary data cleanse and true-up of the benefit specification will take place, followed by: (6) preparing for buy-out following payment of any top-up premium and finally; (7) (usually) scheme wind up.
- Understanding what is and isn't
covered
Insurers will want to see a clean scheme data set that corresponds to member benefits to understand what they are to insure. This will require the trustees to prepare a detailed benefit specification. This is the key document recording the scheme benefits for coverage (also capturing relevant scheme discretions and practices to be insured). Insurers may exclude some benefits from coverage e.g., special benefits for active deferred members (e.g. where they have a final salary link for accrued benefits), and any historic equalisation issues or other benefit changes which subsequently may prove to be invalid (e.g. resulting from lack of appropriate actuarial certification (per the recent Virgin Media case)). Schemes which have addressed scheme data and benefit issues up front are likely to attract better engagement from insurers.
- Advice on the documentation
Trustees (and the employer) will require legal advice and input from their other advisers to agree the BPA. Key terms may include those on the data verification timetable, repricing, disclosure, termination, and payment (including ability to augment benefits under the BPA e.g. in case of a scheme surplus) as well as other commercial terms for example on residual risk and publicity. Trustees will need to carefully consider all repricing terms particularly those that allow repricing on a significant or material change at different points during the process. They will also need to ensure that they understand all standard terms in respect of disclosure, warranties and indemnities and may wish to negotiate appropriate indemnity capping. The employer will also want to understand repricing terms to consider under or overpricing risk, payment terms, termination risk.
- Continuing protection and employer
indemnity
Depending on how 'clean' scheme data turns out to be and any uncertainties identified during the insurance process, trustees may be keen to secure residual risk cover to protect against future claims after full buy-out. Most insurers offer this at typically 1% of the BPA premium cost but this will also involve further in-depth scrutiny of the benefit specification and scheme data and may be subject to carve-out of certain known issues. There may well therefore be consideration of how this should be funded, and if this protection could be funded from any projected surplus after buy-out or whether the employer will pay for it (usually in addition to any standalone employer indemnity). It is helpful to consider residual risk early in the process and how any issues can be factored in.
- Considerations after buy-in and getting ready for
buy-out
It is not always the case that a buy-in exercise proceeds immediately to buy-out. While the BPA is likely to facilitate this, it will not usually specify a particular timeframe and will be at the initiation of the trustee. Liabilities of trustees (and the employer) to the scheme are only fully discharged once the buy-out has completed (and the scheme has been wound-up). Before full buy-out and wind-up trustees will remain responsible for ensuring administration and governance of the scheme, compliance with all legal obligations applicable to occupational pension schemes e.g. triennial valuations, resolving disputes, compliance with regulatory codes etc. The trustees will need to work closely with the employer, the insurer and their advisers to consider how administration of and legal responsibility to discharge the benefits will ultimately transition to the insurer.
- Wind-up of the scheme
The final step once buy-out has been achieved will usually be to wind-up the scheme, this will be a detailed process to agree between the trustees and employers and proceed in line with the rules of the scheme which may specify notice periods, use of any surplus assets etc. There are also various statutory reporting requirements to the Pensions Regulator, HMRC and to the extent any remain, members (e.g. where members are outside of the insurance process because they may be eligible for winding-up lump sums etc.) to factor in. The trustees will also need to put in place final scheme valuation and accounts and take steps to ensure that they get appropriate statutory (and contractual) discharges of liability.
Closing thoughts
Preparing for and implementing an insurance solution and scheme wind-up of an occupational pension scheme is a very complex and involved process. It will be the most significant event in the life of a pension scheme and it is therefore important to ensure objectives are clear from the outset and there is a feasible and attainable plan in place.The insurer market is and looks likely to continue to be buoyant as more and more schemes approach insurance level funding. This has led some insurers to be selective over which schemes they wish to transact with and now, more than ever, proper preparation is crucial.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.