UK: Insuring Scheme Benefits - An Attractive Option

Last Updated: 29 June 2010
Article by Peter Maher

Due to buyout costs becoming more agreeable and recent product developments, securing liabilities with insurers is now a worthy option for schemes.

The most straightforward method of discharging scheme liabilities is to secure, or buyout, benefits, for both deferred and pensioner members, with an insurance company. Indeed, on wind-up of a defined benefit scheme, this is the ultimate means by which the scheme can guarantee to meets its liabilities.

In general, however, the cost of such a buyout is much higher than the normal assessment of a live scheme's liabilities, referred to as the technical provisions under valuation regulations. As such, the cost is generally viewed as prohibitive.

However, recent market turbulence and, in particular, historically high corporate bond yields, have led to buyout costs becoming much more attractive. Combined with relatively recent product developments, including the option of buy-ins as opposed to buyouts, this has led to more schemes considering securing some or all of their liabilities with insurers.

Changes to affordability

Over the two-year period from June 2007, the overall affordability of a typical pension scheme buyout has risen by about 10%. This figure is made up of two components, the affordability for deferred members, who have not yet reached retirement age, and that for pensioner members who are already in receipt of pensions. The Pension Insurance Corporation Risk Transfer Index, August 2009, compared the relative costs of two typical groups of deferred and pensioner members respectively from June 2007 to June 2009.

The statistics for the relative cost of a deferred member buyout demonstrates that, over the last two years, although the cost of a buyout at the end of the period was similar to that at the beginning, the cost is volatile, with changes of over 15% occurring over a three-month period.

The relative cost of pensioner member buyout shows a somewhat different picture, with a relatively steady decrease in the cost to secure pensioner members by up to 15% to the end of May, although as bond yields have dropped the costs have crept back up.

Activity in the pensioner market in particular has grown significantly. Many more schemes are seriously considering securing pensioner liabilities than in 2009.

How long will this opportunity last?

The cost of securing liabilities is very closely linked to the bond markets, with insurers now more likely to factor corporate bond yields into prices. Bond yields were at historically high margins over government securities for much of 2009. Some of these margins have relaxed as markets gain greater confidence about the risks of defaults. There will be ongoing volatility in the terms available, especially if ongoing quantitative easing and increased government borrowing conspire to push gilt yields higher over time.

Access to terms

One issue facing trustees considering securing liabilities is access to terms. Given the increasing attractiveness of the market, and that insurers can usually only make capital available to write a fixed amount of business (this is capital hungry in the medium term to meet solvency requirements), insurers will often set minimum and maximum case sizes. Some will only quote for cases over £20m and we have experienced one who will not write anything over £50m. This can change from day to day, however, adding to the volatile nature of the market.

Solvency II – costs might increase

There has been much discussion in insurance circles of late about the impact of European requirements, known as Solvency II, on the capital security required by insurers to write guaranteed annuity business. This has led to some commentators suggesting that the cost of such business might increase by up to 20% over the next two years to meet these requirements. This is another potential reason to seriously consider securing some or all of a scheme's liabilities sooner rather than later.

Buy-in vs buyout

One objection in the past to securing pensioner liabilities was that, if benefits for particular members were secured in full, did that treat them more favourably than those members left behind, without secured benefits, who remained dependent upon the sponsor's covenant?

The use of a buy-in arrangement for pensioners resolves this issue, making the decision primarily an investment one. Whereas a buyout secures benefits in a member's name, the buy-in secures benefits in the trustee's name and pays all instalments via the trustee. Therefore, if, for any reason, payments to individuals need to be reduced in the future (for example to meet a pension protection fund level of benefits instead of full benefits), the balance of any instalments are still there as an asset to be distributed to meet other members' benefits.

So what does this mean?

The cost of insuring liabilities has fallen considerably recently and an opportunity may still exist for some schemes to take advantage of this. Rates are potentially rising again, but for many the use of a pensioner buy-in in particular may well be worthy of consideration.

The variation in annuity terms will, from time to time, change the commerciality of a buy-in exercise. What does not change, however, is the ability of such a process to de-risk a pension scheme in terms of both future mortality and investment risks.

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.

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