Pensions risk transfer: trustees’ rights to use scheme assets

However, the liability-driven investment crisis of autumn 2022 highlighted how important it is for trustees to understand the underlying legal principles regarding the right of trustees to use scheme assets. These may be central to properly assessing and addressing the risks posed by a transaction.

The context

Questions about the right of trustees to use scheme assets to meet contractual obligations are most relevant to contracts where there is a concern as to whether pension schemes will remain good for the money to meet future cash flows. It is therefore primarily an issue for insured longevity swaps and also ISDA derivative contracts, such as interest rate and inflation swaps, which involve a long-term exchange of cash flows between scheme and provider.

The traditional way to deal with this risk is by posting collateral. However, the increasing trend to simplify and streamline these contracts, especially insured longevity swaps, by removing collateral means that fundamental, and sometimes overlooked, legal principles regarding the right of trustees to use scheme assets are becoming increasingly relevant.

Read more on pensions risk transfer

• Pensions risk transfer: achieving data protection compliance
• Pensions risk transfer: requested contractual terms
• 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: the endgame strategy
• Pensions risk transfer: tricky benefits to insure
• Pensions risk transfer: longevity transactions hedging risk trustee considerations

Some helpful legal principles

The default legal position is that where trustees are contracting with insurers, it is the trustees themselves who are liable for any payment obligations under the contract. The scheme itself does not have any obligations as it has no legal personality: the insurer is not directly contracting with a pot of money that it can directly access whenever it needs to.

On the face of it, this is potentially concerning – pension trustees are very unlikely to have any meaningful assets of their own in the context of, say, a billion pound-plus longevity swap. However, in practice, insurers and trustees can usually take comfort from the following legal principles:

• trustees have a statutory right to reimburse themselves out of the trust fund for ‘properly incurred’ costs and expenses. Expenses should include most payment obligations to third parties like insurers. This statutory right is often backed up by a similar right hardwired into the scheme’s trust documentation;
• case law also says that trustees benefit from a 'lien' over trust property to meet costs and expenses. This means the trustees can lawfully keep hold of scheme assets until they have discharged costs and expenses, before having to pay out benefits to members;
• critically, if there is insufficient money to cover both members' benefits and third-party costs and expenses, the trustees can lawfully prioritise paying costs and expenses before paying benefits;
• in terms of how an insurer will rank against other third-party creditors, an insurer can also take some comfort from the fact that, in general, it would need to agree to its claim against the trustees being subordinated to another third-party creditor's claim.

However, these principles still leave insurers exposed to risks in certain scenarios:

What if the trustees have enough money to pay all their third-party creditors?

In theory, insurers and other third-party creditors of the trustees can rest relatively easily for so long as the scheme has sufficient assets to cover all the trustees' payment obligations to third party creditors – even if there is not enough money to also secure members' benefits in full. This is because, as noted above, the trustees can usually use their lien to make sure that third party creditors are paid in priority to members' benefits.

However, if the scheme does not have sufficient assets to cover amounts owing to all third-party creditors, the insurer will be competing with the other third-party creditors.

Protections against this risk might include the following:

• protection often comes in the form of requiring trustees to post collateral for the insurer’s exposure. This is standard in most longevity swaps;
• A variant is that, in some transactions, the requirement to post collateral might only bite if certain trigger events occur. Trigger events might include the funding level of the scheme falling below a pre-determined level, and / or the trustees trying to give members' benefits priority over payments to third party creditors;
• termination rights often back up collateral protections and allow the insurer to access collateral if a, typically severe, trigger event occurs;
• an insurer might also seek a contractual right to access scheme assets directly if it is owed amounts. This could be an unrestricted right and not tied to whether expenses were properly incurred etc. This could also be backed up by an amendment to the scheme's rules confirming that this is permitted. The enforceability of this sort of protection is yet to be properly tested in the English courts – but that should not necessarily stop an insurer seeking this sort of protection anyway.