Out-Law Analysis 6 min. read
19 May 2023, 1:15 pm
Competitive insurance pricing is helping many pension schemes move closer to being able to buy-out all of their liabilities with an insurer.
While scheme members, trustees and sponsors will welcome this, the successful execution of a full scheme buy-out requires careful planning, and a clear vision for the entire process – from the planning stage through to the eventual winding-up of the scheme.
Setting clear objectives and having robust governance arrangements from the outset is important, but there are also wider practical points that trustees and sponsors should be thinking about, as they begin to form their vision of a successful buy-out.
The starting point is that trustees will expect the benefits set out in their scheme’s rules to be replicated precisely under any insurance arrangement. However, things are not quite as simple in practice. Some benefits are tricky to insure, such as benefits which are difficult for insurers to administer; or to hedge against in a way that is capital-efficient.
A fundamental question is whether all remaining benefit accrual has been closed off in the scheme. Most schemes considering a full buy-out will have already closed to future accrual, but it is not uncommon for schemes like this to continue to provide special benefits to members affected by the closure for as long as they remain employed by the sponsor. This could include an ongoing link between the benefits they have accrued and their final salary, or special benefits on death in service or ill-health early retirement.
These special benefits cannot be insured efficiently, so the sponsor needs to give thought to how it deals with these in the run-up to buy-out. Trustees need to consider what role they have in this process, and how the process interacts with the timing for the wider transaction.
Certain benefit structures simply cannot be insured, at least at a viable price. Benefits involving trustee discretions or complex underpins are good examples. There are various ways of dealing with these benefits, but the trustees and sponsor should agree some guiding principles at the outset.
An approach to fix these benefits in a way which minimises the cost of the transaction can often be a reasonable starting point – but this does not necessarily mean adopting the least-generous approach for the members. Depending on the circumstances, it can make more sense to agree subtle benefit improvements for members so that the benefit structure is more efficient to insure and will attract the best possible engagement and pricing from the insurers.
If defined benefit (DB) schemes have a defined contribution (DC) section attaching to them, trustees and sponsors will need to prepare a plan for dealing with this section. If members are still building up benefits in the DC section, thought needs to be given to whether this is still the right vehicle for them, or whether they would be better off in a master trust or personal scheme. Closing the DC section and transferring members' accrued pots elsewhere is a project in itself. Careful consideration will be needed as to how this can be integrated into the wider buy-out project.
If the DC section is to be retained, there should be an assessment carried out of the implications for winding-up the DB section. It may be necessary to amend the scheme rules to create a legally segregated DB section which can be wound-up independently. Even then, there could be some surprising implications – including potential difficulties in paying winding-up lump sums in respect of the DB section.
Trustees will also want to understand what rights attach to members' DC pots. For example, the right to use a DC pot as the first port of call for a tax-free cash lump sum can be valuable for members, as this means they don't have to exchange as much of their DB pension towards the cash lump sum. If trustees want members to retain these rights, the tax rules mean that the DC pots will have to be bought-out with the same insurer as the DB benefits.
Most buy-out insurers offer solutions to enable this, but the solutions differ from insurer to insurer – some offer fairly comprehensive DC arrangements, others have different offerings more akin to investing in a cash fund. Those insurers without a full DC facility may feel that they are at a disadvantage, which might affect their engagement in the pricing process. This will also affect the insurer's commutation assumptions, increasing the buy-out premium. These considerations may lead trustees and sponsors to consider alternative options, such as compensating members outside the scheme for the loss of these rights.
In a perfect world, a full scheme buy-out would ensure a clean break from the scheme for the trustees and the sponsor. However, trustees and sponsors should consider making provision for if mistakes are discovered after the buy-out, if a beneficiary can prove that they are entitled to a higher benefit than that secured for them, and for missing beneficiaries that might come forward after buy-out.
There are various measures that can be put in place to protect trustees and sponsors against these risks. These include insurance options, such as trustee run-off cover from the commercial insurance market or residual risks cover from the chosen bulk annuity insurer. These two insurance options protect trustees and members in very different ways. Where both options are viable – in practice, residual risks insurance tends to be viable only for larger deals – trustees and sponsors should take appropriate advice, to ensure they understand the differences in cover and the relative value of the two options.
A decision to purchase residual risks insurance is likely to depend on several factors, including the risk tolerance of the trustees and the sponsor, the parties' objectives and bargaining power, and the perceived value for money of such a policy – once the scope of any exclusions arising from the due diligence process have been taken into account.
Any decision on residual risks insurance should be taken at an early stage of the process, as this will have a bearing on the insurer selection process – some insurers do not currently offer residual risks cover – as well as the timing, complexity and structure of the transaction.
Various communications will need to be issued to beneficiaries during a buy-out process. This includes things such as insurer privacy notices, information and regulatory disclosures about the winding-up process, and confirmation of the benefits to be insured.
Some trustees will want to write to members with details of the benefits they will be insuring and ask the members to confirm that there are no errors in those details.
Depending on the circumstances of the scheme, it may also be necessary to run one or more consultation processes with certain members. For example, those consultations may relate to:
These processes need to be planned and choreographed carefully to fit around timetable for the buy-out and wind-up, whilst ensuring that members are not overwhelmed by the volume of communications or left with consultation fatigue.
Full scheme buy-outs are complex, fluid projects, but there is value in trustees and sponsors investing time at the outset of a buy-out project, planning their transaction and building a clear vision for the entire process. Those that do this can expect to reduce their execution risk, have greater certainty over their professional advice costs, improve insurer engagement and pricing, and create a smoother journey to buy-out for all concerned – not least the scheme members.