Lucida PLC

Bulk Buy out, why should you consider it.

Jan 01 2008

View all News Articles

In the old days,managing a company pension scheme was relatively straightforward. Running a pension scheme is now big business, with annual adviser and administration costs absorbing a surprisingly large portion of the fund; and this cost is rising by at least 10% every year. The more hidden costs of poor data and mistakes add considerably to this burden.

Many schemes are bigger than the sponsoring employer. Trustees have to worry about the strength of the employer’s covenant. How long will the company be around to support the scheme; will they try to change the benefit basis; will members get everything they are entitled to when the time comes?

Volatility

At the end of 2007, deficits had reduced, although not for all schemes. Some schemes are in surplus and contribution holidays are again being considered. Many advisers are rightly cautioning that what goes up may come down again. Companies have made significant payments to bolster funding (often more than they have paid in dividends to shareholders) but often in exchange for agreement to maintain more aggressive investment strategies. Volatility will therefore be a key risk of pension schemes going forward.

At best, only one third of final salary schemes is open to new entrants. However, scheme closure does not remove the volatility and disclosure risk. Neither does it remove the more serious longevity risk.

Longevity

People are living longer, but few schemes are taking account of this in their valuation assumptions. Trustees are being led slowly towards increased provision against this risk, but one day soon will have to face up to the fact of higher contributions or lower benefits. A pension scheme will cost what a pension scheme will cost; it’s all a matter of timing.

What is bulk buy-out?

Bulk buy-out is not new. Bulk policies have been around for many years as the end step in a scheme wind up. Recently it was recognized that schemes could buy-out their liabilities with a regulated insurance company without being in distress and the modern bulk buy-out was born. The emergence of new players has brought new money and new approaches and has changed the landscape dramatically and for now, this is good news for the consumer.

Bulk buy-out covers a number of different approaches. By paying a premium to an insurance company, the trustees transfer the risks of the scheme to that insurer. Bulk buy-out is normally a three stage process:

1. An insurance policy is purchased in the Trustees’ name. The assets are now insured and therefore guaranteed, but the trustees and employer continue to have legal responsibility.
2. The scheme winds up. This can take several years, especially if the member data is poor, but with good management, can be completed within a year. The trustees can then be discharged.
3. The trustees’ policy is replaced by individual policies in the members’ names and those members become policyholders with the insurer. The trustees and company have no further responsibility (although they need to watch out for continuing liability for data errors and beneficiaries missed out in the transfer to the insurance company).

There are many ways to achieve buy-out, including stopping at stage one where the insurance policy becomes another asset class. Some schemes decide to buy-out only part of the scheme, which could be older pensioners, all pensioners or certain deferred members. Phased buy-out may start with older pensioners and contract to transfer the remaining members over a number of years. In some cases, trustees insure longevity risk, for example, to limit the duration of pensions from the fund – for example, they may insure against the risk of pensioners surviving beyond the age of 90.

As the objective of employers and trustees alike is to get rid of liability in a safe way as soon as possible, a new solution has emerged that is changing the market rapidly - the full risk buy-out. In this solution, the buy-out company replaces the current sponsoring employer and becomes responsible for the scheme, including for data and the wind up. Substitution of sponsoring employers is a common practice born out of company sales and purchases, but has become more complex due to regulations aimed at protecting against bad employers. The scheme rules may need to be amended and the regulator must be satisfied about the security of the new employer, but as the assets will be protected by an insurance policy, this is less of an issue. 2008 will see a number of such transactions.

What should trustees consider before buy-out?

• Risks to be transferred or retained
• Value for money
• Financial strength of insurer
• Member service
• Transaction effectiveness

The inevitability of buy-out?

By doing their homework, companies and trustees can find a solution which is right for them. Perhaps one day all schemes will be insured and we will wonder what all the fuss with pensions was about.

Margaret Snowdon is Operations Director at Lucida plc
She can be contacted on 020 7647 1610, or at
margaret.snowdon@lucidaplc.com