Pension scheme buy-outs: what's it all about?
The pensions buy-out market, which was struggling to take off for much of 2007, is suddenly flying. Estimates suggest that over 4 billion of new business has been done in the first half of 2008 and the market is expected to more than triple this year.
This increase in activity is still gaining momentum as more companies look at the options for offloading their pension scheme liabilities, but organisations need to take care to ensure that it is the right option for them and keep an eye on employee relations fall-out from the process.
What is a buy-out?
A traditional pension buy-out is where an insurance company takes over responsibility for paying benefits built up in a pension scheme. The pension scheme pays an agreed amount to the insurer, which takes on all the risks from that point onwards. Ultimately, the insurer usually provides annuity policies to each individual pension scheme member and the pension scheme can be wound up.
The rationale for companies to offload their pension liabilities has become more compelling in the past few years. First, there was a strengthening in company accounting requirements for pension liabilities. Then a new Pensions Regulator was appointed who introduced a new regime for pension scheme funding. This has generally required significant increases in companies' cash contributions into their schemes, not only draining precious corporate resources but also improving schemes' funding levels to such an extent that buy-outs are no longer totally out of reach.
And, as buy-outs have come within range, the buy-out market has become more competitive. Many new providers have emerged, all keen to do business, and investment banks have started to get involved, developing new products. As a result, some people believe the market is currently undervalued and presents a unique window of opportunity for companies interested in this option.
The recent explosion in activity has been encouraged by a mixture of the current financial climate - with finance directors again worried about their pension liabilities being a drain on resources - and market momentum. Many companies did not want to be first to offload their pension liabilities in case it upset staff and unions or was viewed as a desperate step by the market. Now that the likes of Rank and Emap have completed significant pension liability transfers, others are more relaxed about following suit.
The three most important issues when considering a pension liability buy-out are security of member benefits, the provider's administrative capability to pay the benefits and the price of the buy-out. But the relative importance of these three issues has changed over recent years.
Today, companies are required by law to fully fund their pension scheme. Where the company is insolvent and scheme funding falls below a certain level, the Pension Protection Fund will step in. As a result, most new buy-out activity is from pension schemes with ongoing sponsoring employers. This means that both the company and the trustees are involved, with the company usually in the driving seat.
For companies, price is still the primary focus but their concerns about reputation mean that security and administration are important too. For trustees, whose agreement is needed for nearly all pension liability transfer exercises, priorities have begun to change from price to security of member benefits and administrative capability. They now know that the company must fund the benefits and so price can be given less prominence.
Today's client is also more demanding: they want to transfer their pension liabilities, but in the way that suits them best. This means that partial and staged buy-outs are becoming much more common.
Partial buy-outs involve the pension scheme buying out part of a scheme's liabilities, usually because it cannot afford to buy out everyone. The most common approach is to buy out only the pensioner liabilities - which often requires little or no cash injection from the company - and then hold the buy-out policy as an investment within the scheme.
Staged buy-outs enable the scheme liabilities to be bought out in stages, triggered by agreed events or dates. This usually transfers mortality risk to the provider at the outset and allows market risk to be matched. All liabilities are transferred over time, the price mechanism is agreed in advance and the company has less cash to pay upfront and more time to find the remainder.
Staged buy-outs can also be used to give a scheme time to clean itself up in the knowledge that, when it is ready, the buy-out terms are pre-agreed. It might simply want to cleanse membership data so that everyone knows what liabilities are actually being transferred to the provider. Alternatively, it might want to reduce the liabilities being bought out by first encouraging deferred members to transfer their benefits elsewhere.
Offering inducements for deferred members to transfer out is often viewed as part of a wider liability reduction exercise that is intended to culminate in buy-out. Inducements offered might be an enhanced transfer value or, more controversially, a cash inducement. Companies can offer a significant enhancement to a standard transfer value before it reaches the cost of a deferred annuity under a buy-out policy and so it makes good commercial sense for them to do so.
Don't forget the employees
Most traditional buy-outs are by defined benefit pension schemes that are closed - not just to new employees, but also to existing employees. This means the scheme is often viewed as having no link to rewards for the current workforce. However, it is important to remember that many of the members who were in the scheme when it closed will still be employees. In addition, the current workforce may become worried about their own pension arrangements if they hear rumours of the company abandoning its old defined-benefit scheme. Trade unions are also very wary of some of the more innovative buy-out solutions. It is therefore important to consider the impact of any buy-out on current and former employees.
In most cases, this just involves careful communication about what is happening. However, some types of buy-out allow more scope to shelter members and employees from what is happening.
One reason why partial buy-outs are popular is that they can take place without the members having to be told. The bulk annuity is held as an investment in the scheme and members may not see any change. They can also take place within the existing trust structure of the pension scheme. The trust structure is seen as a source of comfort for many pension scheme members. Retaining a board of trustees to look after the member's interests keeps a barrier between the member and the buy-out provider and avoids the appearance that the company is dumping its pension liabilities.
Despite the credit crunch, there is enough free capital committed to the pensions buy-out market for it to cope with continued high demand, and for innovative products and attractive pricing to continue. Given the current state of this market, all companies should at least consider whether it is sensible to off-load some or all of their pension liabilities, but it is important not to see this issue in isolation to the current workforce.
Keith Webster is a partner in the pensions team at international law firm CMS Cameron McKenna
To find out about issues facing the defined contribution pension market, click HERE