Pensions risk transfer: current trends as market picks up

This chimes with the experience of the risk transfer team at Pinsent Masons, the law firm behind Out-Law: since June, we have advised on several major deals, worth over £1.4 billion in total.

While each deal has its own nuances, we are seeing an increased focus on several topical legal issues, from more bespoke contractual terms to increased engagement from pension schemes’ corporate sponsors and their advisers.

Requested contractual terms

It is already common practice to seek commitments from an insurer about the extent to which it can accommodate the key legal and commercial terms requested by trustees before exclusivity over the transaction is granted. The commitments sought are known as requested contractual terms (RCTs). As we see more intense competition between insurers on pricing, trustees are increasingly looking at insurers’ RCTs as a means of differentiating between similar proposals and selecting a preferred insurer.

There are various ways of doing this. Many of the leading benefit consultants and law firms have their own standard list of RCTs, with which the insurers are already familiar. This can be an efficient way of assessing how different insurers measure up.

However, on a number of recent transactions, we found it beneficial to prepare a more bespoke shortlist of RCTs, tailored to take account of the strengths and weaknesses of each preferred insurers’ standards terms. Although this requires some additional legal work upfront, there are several benefits to this approach.

First, it removes the need for the parties to engage on points which are largely addressed in the insurer’s standard terms, giving more focus to pre-exclusivity negotiations. This in turn gives greater transparency and clearly messaging to the insurers about how they can adopt their proposals to address the trustees’ main concerns. Provided that they respond in kind, this will give trustees a high degree of confidence in proceeding to exclusivity with their preferred insurer, reducing the risk of the transaction falling through.

A more bespoke approach can also help to maintain insurer engagement on the issues that really matter, for those trustees whose bargaining power is more limited.

Scheme sponsor engagement

We are seeing much more interest and engagement from pension schemes’ corporate sponsors and their advisers on risk transfer deals. This is unsurprising, given sponsors’ interests in maximising any surplus or minimising any funding gap.

However, governance here requires careful consideration: the decision to purchase a bulk annuity policy sits not with the sponsor but with the scheme trustees, who will need to be satisfied that a robust process has been followed to strike a deal which is appropriate for the membership. One example of where boundaries might become blurred is data sharing with insurers by a sponsor’s advisers. Trustees need to ensure that contractual relationships are structured appropriately. We recommend delineating roles and responsibilities at the outset, and recording this in the terms of reference of a joint working group.

In our experience, the earlier sponsors are engaged in the process the better. If this engagement doesn’t come until later in the process, it can lead to difficult last-minute conversations with trustees and insurers if the sponsor or its advisers are unhappy with any aspects of the deal that has been brokered.

We are also seeing greater scrutiny from company auditors on the accounting impact of risk transfer deals. This is particularly the case where all scheme liabilities are being insured on a full buy-in basis, with certain auditors seeking additional comfort that this will not necessarily lead to a full buy-out.

Insuring tricky benefits

Trustees naturally want to buy an insurance policy which reflects their scheme’s benefit structure as closely as possible. However, some scheme benefits can be difficult for insurers to administer or hedge against, making them difficult or prohibitively expensive to insurer. Examples which immediately spring to mind include DC underpins, benefits linked to the continuing employment status of the member and member options which present a selection risk to the insurer. We are seeing a greater focus on these benefit issues as more pension schemes prepare for a full insurance buy-out.

Where this is the case, it’s important to understand just how close the insurer can get to replicating the scheme benefits, as you may be pleasantly surprised. For example, we recently agreed a framework for an insurer to cover enhanced early retirement benefits for deferred members who were unable to continue their occupation due to ill-health. We worked closely with the insurer and the scheme administrators to set clear objective criteria for members to qualify for the benefit, and evidential requirements and protocols which would need to be followed to substantiate the claim. This gave the insurer the certainty it needed to be able to price and insure the benefit on a basis which was very close to that set out in the scheme rules.

Where the gap cannot be bridged, it’s important for trustees and sponsoring employers to understand the funding and risk implications for the remainder of the buy-in stage and buy-out. Trustees should also seek legal advice on other possible ways of aligning the scheme rules with the benefits which can actually be insured – including the extent of any powers to insure benefits on different terms and conditions, and how this interacts with laws and rules which protect the benefits that members have already built up.

Forfeiture and arrears payments

We’ve seen an increased focus on issues around forfeiture of benefits and arrears payments, following examination of these points in recent cases involving Lloyd’s Banking Group and Axminster. This can be relevant on any buy-in or buy-out: will a scheme member’s benefits be forfeited if they don’t claim them in time, and will the insurer apply a different approach to the trustee after buy-out?

This issue also arises where the insurer offers residual risks insurance. If a member can substantiate a claim to a higher level of benefits, so that the insurer has to top up those benefits, how far back in time does the insurer need to go? We expect to see further discussions and negotiations between the parties on these issues over the coming months.

Buy-out by assignment

We are currently involved in several buy-out projects where the insurer is being asked to convert the bulk annuity policy into individual policies in the name of the pension scheme trustee.

This is done so that the trustee can then assign these policies to members rather than the insurer issuing the policies to members directly. It is widely regarded as reducing the risks of pensioner members losing fixed protection for the lifetime allowance, and of overseas members losing protection from the Financial Services Compensation Scheme if the insurer fails to pay their benefits.

Although this structure adds a layer of complexity to buy-out project plans, we’ve agreed – and have helped insurers to develop – processes and paperwork to make this structure as efficient and legally robust as possible, while minimising changes to the terms of members’ individual annuity policies.

Residual risks, run-off cover and other solutions

The trustee run-off insurance market continues to harden, with providers leaving the market or reducing the level of cover offered. In response, some trustees are now looking to put in place layers of run-off cover with multiple insurers. This needs to be managed carefully to ensure that there is a clear delineation of responsibility between any insurers involved, and any other source of trustee protection on wind-up, such as an employer indemnity.

We are seeing a greater focus from trustees and scheme sponsors about how best to allocate residual risks after a scheme has been bought and wound up. We’ve worked with several clients to consider the various layers of risk protection on wind-up and to prepare a risk matrix, identifying where each material risk sits and whether there are any gaps in protection.

There has also been an increased interest in residual risks insurance, particularly from mid-sized schemes which may have been historically perceived as being too small to benefit from this. And as a result, we are also seeing some trustees and employers grappling with difficult risk issues which have been identified by the insurer in its residual risks due diligence processes, in some cases prompting the parties to explore alternative avenues to resolving defects in scheme documents or to find alternative ways of allocating the risk.

It is always worth considering at an early stage whether to carry out a ‘deep dive’ into historical scheme documents to identify and resolve any defects, while also ensuring that the benefit specification reflects any variations for members whose benefits might be governed by earlier scheme documentation. It might end up being a false economy not to do so.