As life expectancy increases, so too does the cost of securing an annuity. For a defined benefit scheme looking to wind-up, changes in mortality can have serious implications on an already fragile asset/liability balance. To put things into perspective: in 1911 only 100 people lived to the age of 100, in 2007 this number had increased to 9,300 (Source: Office for National Statistics).
So what is the solution? An immediate buy-out of all members' benefits through individual insurance policies would be the natural way to remove all the risk, but, in today's world, most schemes cannot afford the large premiums often associated with a sudden wind-up.
The industry has recognised the problem and has developed a number of solutions to hedge against the financial impact of people living longer. As you would expect, there is diversity among the products available and the exact level and duration of cover can vary. Two of the most recently introduced products are longevity insurance policies and asset/liability matching insurance policies.
Longevity insurance policies
A longevity insurance policy will reimburse the pension fund for the cost of any future pension payments which arise from pensioners living longer than expected. Generally speaking, they provide comprehensive cover as the policy remains in force until the death of the last remaining pensioner or dependant.
As the policies have no expiry date (providing of course premiums are maintained), this may suit schemes that have no immediate plans to wind-up.
Asset/liability matching insurance policies
An asset/liability matching insurance policy employs a sophisticated 'liability driven investment' strategy that can be used to guarantee that scheme assets do not fall below the value of the liabilities, regardless of market movements or changes in longevity.
The policy usually has a fixed, agreed term and may be best suited to schemes looking to wind-up over a period of ten years.
A policy to suit your liability
However, the bulk of these new products are aimed at large FTSE 100 and FTSE 250 companies with defined benefit liabilities in excess of £100m. With schemes of that size making up only a small percentage of defined benefit schemes in the UK, the trend may be about to change.
There are now longevity insurance products specifically aimed at schemes falling into the £10m-£100m liabilities bracket. Such plans allow trustees to guarantee the future actuarial basis that will be used to calculate the price for buying out the scheme's liabilities, for a fixed agreed term. These schemes allow trustees to remove one of the 'known unknowns' from the scheme's exit strategy.
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.
