The defined benefit pensions landscape has seen a fundamental shift from deficits to surpluses over the last few years.
This has led to a substantial increase in the number of schemes buying in (and, in many cases, ultimately buying out) their liabilities with an insurer, with many more actively considering their endgame options. However, before launching a buy-in project, there are a number of questions that trustees and employers should be asking.
What is a buy-in?
Buy-ins (or bulk purchase annuity contracts) are increasingly used to manage risks in defined benefit pension schemes.
Under a buy-in, the scheme trustees hold an insurance policy, with the cashflow stream provided by the policy matching the payments of the benefits insured. Buy-ins can be undertaken as a long-term scheme investment or, where trustees intend to secure all liabilities and wind-up the scheme, as a transitional stage prior to the endgame of a buy-out.
On buy-out, liability for the benefits transfers from the scheme trustees to the insurer, with the members receiving individual insurance policies.
What is the scheme's funding position?
Any risk transfer decision will be influenced by the trustees' endgame target and how close the scheme is to that target.
If a scheme is at, or close to, full funding on a bulk-annuity basis, then trustees are likely to view a buy-in as a pathway to a full buy-out and winding-up of the scheme. For less well-funded schemes, partial buy-ins, which cover some of a scheme's liabilities, can be used to reduce risk as a scheme moves towards its endgame.
What are the advantages of a buy-in?
The advantages of a buy-in include:
- the removal of investment, inflation, and mortality risks for the members covered by the policy;
- the trustees retaining governance responsibility and exercise of discretionary powers;
- the scheme still having recourse to the employer covenant; and
- creating a step on the path to buy-out endgame.
What about the downsides?
Trustees should also consider the potential disadvantages of a buy-in, such as:
- the scheme gaining exposure to significant counterparty risk, in the form of the insurer;
- a reduction in investment diversification;
- partial buy-ins potentially increasing the cost (and timescale) of reaching full buy-out endgame;
- costs of transacting and ongoing administration and monitoring costs.
What are the legal issues?
While, in our experience, this is rarely an issue, trustees should consider whether the investment power under the scheme's trust deed and rules allows them to enter into a buy-in contract and undertake their obligations under it.
Where schemes provide discretionary benefits, such as discretionary pension increases, an insurer will not step into the trustees' shoes and exercise discretions going forward. These discretions must therefore be identified and codified, so the benefits can be insured. Trustees will need to take into account past practice and members' legitimate expectations when considering how to codify discretions under a buy-in.
Trustees and employers should also consider whether the scheme provides hard-to-insure benefits, such as deferred benefits with a final salary link for employed members. Where a salary link is being crystallised, with a view to preparing a scheme for buy-in, trustees will need to factor in sufficient time for the employer to conduct the required consultation process and for amendments to be made to scheme rules.
What about alternatives?
The previous government's consultation proposals on options for defined benefit pension schemes, which include making surplus extraction easier for well-funded schemes, are expected to lead to greater flexibility for dealing with scheme surpluses.
This is likely to make scheme run-on potentially more attractive to employers, compared with a buy-out endgame, but the key focus for trustees will remain the security of members' benefits.
With more insurers now entering the bulk annuity market, there is likely to be more scope for well-funded, well-prepared schemes to fully secure their liabilities.
For more information on preparing for buy-out, see our three top tips for preparing for buy-out.
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.
