| Pension scheme buy-out 101 |
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| 16/09/2007 | |
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Mark Wood, CEO of Paternoster, answers this week's questions on pension scheme buy-outs. 1. What is the history of the buy-out market and how big is it? The defined benefit pension buy-out market has traditionally existed to serve the trustees of schemes being wound up, allowing them to transfer their members to an insurance company when the sponsoring employer has become insolvent. Over the last eighteen months, this market has fundamentally changed as solvent companies increasingly seek to contain their defined benefit pension liabilities, allowing them to concentrate on their core businesses. A number of drivers, namely changes in pension regulation, increased life expectancy and disclosure requirements, have caused many corporate directors, company owners and scheme trustees to look to the buy-out market as a component of their defined benefit risk management strategies. As the number of providers and users of defined benefit risk management increases, the new entrants have brought capital, focused business models and innovation to the market. The overall market of buy-out defined benefit pension schemes has grown sharply, whilst we estimate the total size at up to £250 billion, others estimate that it could be up to £400 billion, compared to historic sales of £1-2 billion annually. 2. How does a buy-out or partial buy-out work? Full buy-out is the traditional buy-out solution that involves a complete transfer of scheme assets and liabilities to an insurance company, allowing the sponsoring employer and scheme trustees to be completely discharged of their liabilities to the scheme. This usually requires that either the scheme is well-funded in comparison with its FRS17 liabilities as currently measured, or the sponsoring employer makes a one-off contribution to the scheme (the "premium"). Some providers offer programmes for buying-out scheme members over time. These progressive buy-outs can be structured with a mortality guarantee over (say) five years that allows the employer and trustees to execute a series of buy-outs on a constant mortality basis, effectively locking-in mortality risk during the term of the guarantee. For some companies with defined benefit pension schemes, full buy-out and progressive buy-out are neither affordable nor desirable. It may be desirable to adopt an equity strategy in respect of certain scheme assets or take time managing down certain parts of the liability through liability management or identification of "gone away" members. As companies seek to manage their defined benefit scheme risks over time, they may be content holding some level of equity, member benefit or interest rate risks - some of which might be naturally hedged by offsetting risks in other areas of their business. In such circumstances, insurers are starting to structure partial buy-outs that leave some risk within the scheme. Additionally, there are mechanisms being offered which allow sponsoring employers to recover part of the premium they pay to purchase annuities over time if scheme experience results in the release of surplus profits. This scheme experience can include members opting to take tax-free cash on retirement at rates that result in a reduction in the liability for the insurer. It could also include scheme members not living as long as was estimated in the original evaluation of the buy-out cost. 3. What kind of pension schemes should consider buy-outs? More and more strong and solvent companies wishing to focus their financial assets on running their business welcome the option of making a transfer of risk of the often very significant financial distraction of a defined benefit pension plan. Trustees and pensioners are actively encouraging their employers to consider the buy-out option. A defined benefit pension scheme held on a corporate balance sheet has no solvency capital to support the promise to pay pensions. Securing a pension fund with an insurer ensures the pension promise is supported by solvency capital, FSA regulation and ultimately the Finance Services Compensation Scheme. 4. What are the pitfalls for a pension scheme considering de-risking through a buy-out? Not locking in the position on assets at the earliest possible time. The overlay of derivatives to match the post buy-out portfolio structure can remove market risk early in the process and ensure that the transaction is not frustrated by an unexpected shift in markets just prior to assets being transferred. Remember that the scheme members are at the heart of all processes - an early start and subsequent frequent communication with pensioners will reduce the issues which arise during the transition process. The buy-out of a pension scheme can be achieved within a few weeks. |
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