|
OPDU
Report 26 October 2009
Advisory Service Forum
Insurance buy-outs, buy-ins and longevity
swaps - What are the issues for Trustees?
Mark Howard & Kathryn Breslin
The last few years have seen a growth in the volume of
liabilities of defined benefit pension schemes secured by insurance
policies. There have been a number of large and high profile
transactions such as the £1 billion Cable & Wireless pensioner
“buy-in” with Prudential in September 2008 and the £1.1 billion
Thorn pension scheme “buy-out” with Pensions Corporation which both
involved around £1 billion of liabilities being secured. Employers
and trustees of smaller schemes have also been considering the
options available to them to reduce the volatility they face from a
defined benefit scheme.
What are the insurance options available?
At one extreme, there is the “buy-out” of benefits. The members
bought out cease to be members of the pension scheme. Instead they
will have their own individual annuity policy and direct contractual
relationship with the insurance company for the payment of the
pension. Buy-outs are, of course, not new - schemes have been
winding up and securing pensions in this way for years. Since June
2003, a solvent employer deciding to wind up the scheme has had to
fully fund the scheme to allow benefits to be bought out. But prior
to the Pensions Act 2004, windings up of schemes were typically due
to employer insolvency and schemes were unable to fully secure the
benefits promised.
More common in recent years than a full buy-out of all the
benefits is what has become known as a “buy-in”. The trustees
purchase a group annuity policy to cover the liabilities for a group
of named individuals. Often this will be the pensioners only,
because the cost of securing deferred members will usually be
relatively more costly (because it is harder to predict for deferred
members, who will usually be younger, when the pension will come
into payment). The policy is simply one of the investments of the
pension scheme.
The economic turmoil since the collapse of Lehman Brothers in
September 2008 has meant that fewer buy-out/buy-in transactions have
completed, but the market has developed further with longevity
hedging. The concept of longevity hedging is well known in the
insurer-reinsurer sphere - for example, Abbey Life completed a
£1.5 billion longevity hedge of its annuity book in February 2008 -
and has been discussed as a possibility for pension schemes for
sometime. In June 2009, the Babcock International Pension Scheme
entered into a longevity swap with Credit Suisse which was the first
example involving a pension scheme. Shortly afterwards, the RSA
Pension Scheme announced it was entering into a longevity swap with
Rothsay Life (a subsidiary of Goldman Sachs).
A longevity hedge involves the cash flows for a group of
pensioners being projected over a set period or the remaining
lifetime of the scheme. The scheme undertakes to pay the predicted
cash flows (plus, of course, a fee for agreeing to the hedge) to the
counterparty. The counterparty, in return, agrees to pay based on
the actual experience of the scheme. In practice, these sums are set
off against one another. If members live longer than expected then
the counterparty will pay out more and the hedge is “in the money”
for the trustees. Conversely, if mortality is greater than expected
then the swap will be “out of the money” for the trustees and they
will have paid out more than they receive, but nevertheless will
have benefited from reducing volatility in the funding. A longevity
swap can be set up either under International Swaps & Derivatives
Association (ISDA) documentation (with an investment bank as the
counterparty) or as an insurance contract.
What are the issues for trustees?
As for the exercise of any discretion, the trustees will need to
be sure of their powers under the trust deed and rules and
legislation, and considered all of the factors relevant to the
decision (and ignored irrelevant ones). The overriding question for
trustees is whether the de-risking is in the best financial
interests of the members. Put another way, will the decision make it
more likely that their benefits will be paid in full?
Selection of counterparty
Trustees need to consider carefully which is the most suitable
counter-party for the de-risking. This will depend on the option
taken and the overall long-term objective for the scheme. It would
involve consideration of such matters as price, administration and
communication to members, financial resources and previous track
record. Some of the transactions to date have involved rounds of
bidding between providers before entering into an exclusivity period
during which the final contract is negotiated. However, trustees
should think carefully about how far to push on price and the time
this could take. Whilst a further round of negotiations is held with
the aim of pushing down the premium by 1% to 2%, the market could
easily move in the wrong direction increasing the overall price by
10%!
Buy-outs
Any pensioners bought-out cease to be members of the scheme which
means they lose the prospect of future discretionary pension
increases. This could be significant for members with pre-1997
service who are reliant on trustee and/or employer discretion for
any increases to their pension. If this is a full buy-out of all
members then this may be less of an issue: winding-up of the scheme,
which will lead to a buy-out, can usually be triggered by notice
from the employer. However, partial buy-outs will usually require
member consent in order for the trustees to be discharged from their
liabilities towards the bought out members.
Bought out pensioners will benefit from the security of their
pensions being backed by an insurance company - subject to
regulatory capital requirements and which will also carry capital in
excess of those requirements - rather than the employer covenant.
Trustees will need to consider the impact though on the members
remaining in the scheme. Schemes are rarely funded at a buy-out
level, so buying-out a group of members will reduce the funding
level for the remaining members. Trustees will need to think
carefully about this and in particular whether they should obtain
extra funding, or other security, from the sponsoring employers to
ensure that the remaining members are not prejudiced by the buy-out.
Buy-ins and longevity hedges
A buy-in or longevity hedge are both forms of investment.
The trust law duty of a trustee in selecting investments has been to
take such care as a prudent man of business would in investing for
someone they felt morally obliged to. However this prudent person
test has been recast in the context of pension schemes by the EU
Directive on Institutions for Occupational Retirement Provision, and
is incorporated into English law by the Occupational Pension Scheme
(Investment) Regulations 2005. The Regulations require trustees to
invest in the best interest of members and beneficiaries and, in the
case of potential conflict of interest, in the sole interest of
members and beneficiaries. The drive for de-risking solutions may
well come from the employer who will benefit from the reduction in
volatility of the funding. Indirectly this can benefit members in
the form of an improvement to the strength of the employer and its
covenant towards the scheme. But this could take time to feed
through to the scheme and trustees need to address carefully how the
management of risk is benefiting members.
The Investment Regulations also require trustees to ensure that
the fund is invested to ensure the security, quality, liquidity and
profitability of the portfolio as a whole and that the assets of the
scheme are properly diversified. An investment in a long-term life
assurance policy is deemed to satisfy the requirement for proper
diversification.
Investments in derivative instruments must contribute to the
reduction of risk or facilitate efficient portfolio management, but
must also avoid excessive risk exposure to a single counterparty.
Trustees contemplating entering into a longevity hedge with an
investment bank will need to consider this requirement - which will
not be an issue if the longevity hedge is in the form of an
insurance contract with an insurance company. It may be that the
security structures established with a longevity hedge are
sufficient to satisfy this requirement.
Security
Until relatively recently the issue of obtaining security from an
insurance company would have been unthinkable. Pre-Pensions Act
2004, annuity policies were usually purchased on the winding up of a
scheme, typically with an insolvent employer and with the scheme
underfunded on a buy-out basis. There was an effective duopoloy of
Prudential and Legal & General and the main issue for trustees was
to obtain the most benefits possible for the members - in other
words, price was the main issue. As for security, the trustees would
rely on the fact that an insurance company would not only be subject
to regulatory requirements but would also hold considerable assets
in excess of those requirements. In addition, the trustees would be
discharged on completion of the winding up, so there would be no-one
to hold any security.
The collapse of Lehman Brothers changed the landscape regarding
financial counterparties, but even before then the buy-in
transactions between the Friends Provident Pension Scheme and Aviva
and the Cable & Wireless Scheme and Prudential both involved the
insurer providing security to protect the trustees in the event of
the insurer failing. On a buy-in, trustees will be contracting with
an insurer for possibly 40 or 50 years and that exposes them to the
credit risk of the insurer for a very long time.
A detailed description of the security options is beyond the
scope of this article, but essentially they use mechanisms borrowed
from the insurer - reinsurer market. One option is to pay the buy-in
policy premium into a designated account of the insurer which is
subject to a floating charge in favour of trustees. There is a
regular valuation of the account with either the insurer paying
assets into the account if there is a shortfall compared with the
liabilities or surplus being released to the insurer. On designated
termination events - including insurer insolvency - the charge over
the account crystallises allowing the trustees to recover the funds
in the account. A more complicated option involves the premium being
deposited back into a designated account with the trustees as soon
as it is paid. Again there would be regular valuations of the
account and releases of surplus or a top-up from the insurer as
appropriate. On insolvency the escrow account would belong to the
trustees, subject to a set-off of the amounts the trustees would owe
the insurer under the deposit back structure.
Longevity hedges will also involve security being given for the
present value of future payments. If the contract is “out of the
money” for the insurer, then it will be required to post collateral
to an account held by a custodian and vice versa if the contract is
out of the money for the trustees.
FSCS and PPF
Trustees should also have an understanding of how the Financial
Services Compensation Scheme (FSCS) and the Pension Protection Fund
(PPF) would apply to the chosen option.
The FSCS applies to contracts of long-term insurance issued by an
insurer in the UK, EEA, Channel Islands or Isle of Man. Individual
policyholders and trustees would be covered, so it would apply on
both a buy-in or buy-out. It would also cover a longevity hedge with
an insurer, but not one under ISDA documentation with an investment
bank. The FSCS would apply on the insurer being in default and its
first approach would be to obtain continuity of cover through the
transfer of the policy to another insurer. Failing that, the
compensation payable would be £2,000 plus 90% of the remainder of
the value of the policy.
The PPF applies on employer insolvency and the compensation is
broadly 100% of the pension for pensioners over normal pension age
(and ill health early retirees and dependants’ pensions) and 90% of the pension subject to a cap of £28,742.69 at age 65 for other
members.
On a buy-out, the bought-out members would cease to be covered by
the PPF, but would be covered by the FSCS. An early retiree, who is
still under the scheme’s normal pension age, may be better off under
the FSCS if they would otherwise be caught by the £28,742.69 cap.
There is a court case due to be heard this autumn which will
consider trustees’ duties in buying out such members at a time when
the scheme is likely to enter the PPF.
On a buy-in, the trustees would have cover under both regimes.
The PPF on employer insolvency and the FSCS on the insurer becoming
insolvent. The extent of coverage from the FSCS also influences the
decision about security on a buy-in. If the FSCS would provide 90%
of cover, is the price to be paid for the security (typically 1-2%
of the total premium) worth it for protecting 10% of the premium? Of
course, it needs also to be remembered that the buy-in policy is a long term arrangement and the protection
of the FSCS can be amended in the future by the Financial Services
Authority.
Executing the transaction
Trustees should think carefully about the process for execution
of the transaction. Are any conflicts of interest being properly
managed? Often these deals will be driven or encouraged by the
desire of the sponsoring employer to reduce risk. Although there
will usually be an alignment of interests, trustees nevertheless
should be alive to the possibility of conflicts occurring. Secondly,
the trustees need to understand how the transaction will work. These
can be complex trans-actions and professional advisors will play a
key role in making sure that trustees understand the structure and
the issues and satisfy their “trustee knowledge and understanding”
requirements. Third, it is very easy for trustee boards to defer such difficult decisions. As
mentioned above this may mean the market may move against the
trustees. This was demonstrated when the market collapsed at the end of last year
resulting in at least one £1 billion plus buy-in, that we are aware of, collapsing after several months of consideration. Trustees should consider establishing a
sub-committee – perhaps co-opting an employer representative (subject to
addressing any conflict issues) and giving that sub-committee
authority to execute the transaction.
Data
Even if the scheme is not in a position to undertake one of these
options immediately, it can still takes steps towards it by
undertaking a data cleanse and existence checks. It will allow more
accurate pricing when a quote is sought, and could easily pay for
itself if it is discovered that members have died.
Conclusions
The market for de-risking defined benefit schemes is developing
at pace. An increasing number of sponsoring employers are focussing
on the removal of risk from their balance sheets and trustees will
need to keep up to ensure that they understand fully the structure
of a proposed de-risking strategy and the effect that it will have
on members. Trustees need to focus on the key issues to equip
themselves to act in the best interests of their members.
Mark Howard, Partner
mhoward@blg.co.uk
Kathryn Breslin, Associate
kbreslin@blg.co.uk
Barlow de & Gilbert
020 7643 7257
www.blg.co.uk
|
