Pensions risk transfer: the endgame strategy

This is particularly important at a time of growth in the pensions risk transfer market. A report (10-page / 651KB PDF) by LCP revealed that the UK pension risk transfer market reached £44.7 billion across buy-ins, buy-outs and longevity swaps with continued demand expected to prompt record-breaking volumes over 2023-2025.

Despite attractive pricing to secure pension scheme liabilities with bulk annuity policies, trustees and sponsors must be careful not to focus solely on the pricing opportunity for the buy-in transaction. They should also take a broader view of what the right end goal is for their scheme and whether a buy-in is the right step towards that.

In developing an endgame strategy, trustees need to consider the risks for the trustees and members. They also need to consider how their plans for the scheme could impact the sponsor and what they might want to ask for from the sponsor as part of the buy-out and wind-up process. There are also practical points to consider when planning ahead beyond a full buy-in to the winding-up stage.

Read more on pensions risk transfer

• Pensions risk transfer: achieving data protection compliance
• Pensions risk transfer: requested contractual terms
• Pensions risk transfer: trustees’ rights to use scheme assets
• Pensions risk transfer: getting governance right
• Pensions risk transfer: the value of a clear vision for full scheme buy-outs
• Pensions risk transfer: reinsurer requirements
• Pensions risk transfer: company wind-up indemnities
• Pensions risk transfer: the risks of residual risk insurance
• Pensions risk transfer: PPF+ deals
• Pensions risk transfer: discretionary pension increases
• Pensions risk transfer: GMP equalisation and bulk annuities
• Pensions risk transfer: data warranties
• Pensions risk transfer: material change
• Pensions risk transfer: insurer buy-out requirements
• Pensions risk transfer: tricky benefits to insure
• Pensions risk transfer: longevity transactions hedging risk trustee considerations

Options for the endgame

The two obvious choices are to buy-out a scheme with an insurer or reach a low dependency funding position and continue to run the scheme on. So, even if a full or partial buy-in has suddenly become affordable, it is important to decide that is the right step towards the scheme’s endgame destination.

For those schemes that can afford a full buy-in, it is important to recognise that invariably this will mean buy-out and wind-up of the scheme. The trustees must think through the implications of that and whether wind-up is the right end goal and, if so, start planning ahead for that.

Since the LDI crisis, it may be that for many schemes it has become all or nothing – they either do a full buy-in or not at all, if that is not affordable. This is because a partial buy-in may leave the scheme with inadequate liquidity for the LDI strategy and too much risk with the scheme’s remaining assets.

There is also the question of what the sponsor wants. The trustees’ preferred destination may not be the right result for the sponsor and the members may have a different view again.

Full buy-in – trustee, sponsor and member perspectives

The trustees, sponsor and members will all have different perspectives on buy-out and wind-up.

The trustees’ focus will be on discharging their legal duties, i.e. obtaining maximum security for members accrued legal entitlements to benefits. However, there may be circumstances, such as where there is a strong sponsor covenant or a high probability of upside for members – surplus, discretionary benefits, inflation proofing – where it would be in members’ best interests for the trustee to take a wider view.

From a sponsor’s perspective, the focus will be to shut down the risk, volatility, management time and cost of a defined benefit (DB) pension scheme. This is amplified by the worry that the regulatory goalposts will constantly be moved. However, some employers will have a strong view about not handing over a large premium to an insurer and be happy to carry the DB risk themselves or have very clear accounting reasons why wind-up is not an option. Alternatively, they may be keen to get their hands on a surplus.

When it comes to members, it is unreasonable to expect them to see it in the same way as the trustees and sponsor without careful communication. Rightly or wrongly, they may have more confidence in the name of their past employer than an insurer who they have not heard of before. In addition, members may focus on the loss of a paternalistic trustee board and the possibility of discretionary benefits, particularly if there has been any history of discretionary indexation even if discontinued. Issues of customer experience with the insurer and admin capability will also be a priority – particularly if they see any surplus returned to the employer.

Considerations for trustees

Given that members may not necessarily see a full buy-in, buy-out and wind-up as good news, there are risks that trustees will face claims and complaints if there are failings in their decision-making and governance.

The starting point for trustees is to recognise that a full buy-in will invariably mean wind-up. Once a full buy-in is completed, a sponsor can trigger wind-up without risk of triggering a ‘section 75’ debt. As part of the decision-making process, the trustees should:

• ask the question of whether it is the right endgame destination and in members’ interests;
• ·obtain the necessary advice on insurer covenant and admin capabilities;
• consider the balance of powers in the scheme and how wind-up will affect that;
• address conflicts of interest; and
• consider what opportunity there may be to get what they need from the sponsor.

It is also right for trustees to think about whether at the point of the full buy-in they will have an opportunity to ask the sponsor for things that will improve the position of the members and the trustees. Some of the trustee “asks” will be considered self-serving for the trustees, such as indemnity/run-off cover. However, other requests will be beneficial to members, such as sharing any surplus with members, getting residual risks cover, agreeing discretions, and building in additional inflation proofing.

Practical considerations for wind-up

Price will inevitably be the key determining factor for which an insurer is selected but there are other factors which will be important looking beyond the immediate buy-in transaction to wind-up:

• can the insurer accommodate any usual benefit features or can they be removed? Member options to surrender pension for dependant’s pension, DC underpins, salary links, and links to employment?
• member experience – price is often the priority but it’s important to remember that the chosen insurer will also be the long-term provider of members’ pensions.
• insurers do not exercise discretions. The trustees will need to decide at buy-in stage how discretions will be fixed. The employer may also need to be involved.
• what are the insurer’s options for DC benefits/AVCs? Insurers offerings vary. Whilst the overriding consideration is usually keeping AVCs with pension for the tax-free cash advantage, it is important to think more carefully with full buy-out and younger deferred members.
• are there good DC/AVC accumulation options?

Ultimately, trustees will only be discharged for what they correctly secure. It is therefore important to start thinking at an early stage about whether the scheme’s liabilities are correct.

Trustees must take a forward-thinking strategic approach early on at full buy-in stage to recognise the issues which will need to be addressed to achieve liability discharge at the end of the wind-up.