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Buying in bulk

DEFINED BENEFIT pension schemes have become a financial burden and an area of uncertainty for finance directors. As a result, there has been an increase in the number of companies looking to pass some or all of these risks to an insurance company through the purchase of a bulk annuity policy.

Unless a company can afford a policy that covers all the scheme’s liabilities the contract will usually be structured as a buy-in – a contract between the insurer and the scheme which is effectively a scheme asset that exactly matches the scheme’s liabilities it has been purchased to cover. Therefore, if members live longer than expected then the policy will have to pay out for longer.

There has been demand for these policies with over £6bn transacted in the last two years. However, are these policies affordable at the moment? At first glance, scheme asset values will be depressed as equity markets have struggled. In addition bulk annuity prices have been rising due to falling yields caused predominantly by quantitative easing. This might suggest that a deal will be unaffordable. However, a common strategy adopted by pension schemes is to notionally back the current pensioner liabilities with government gilts. These assets have seen very strong returns over recent months and there may be an opportunity to exchange these assets, which are seen as a reasonable match for the pensioner liabilities, for a buy-in policy which represents an exact match for the pensioner liabilities.

But don’t insurers look to make a profit on these policies? The price charged by insurers will include margins such that they expect to make a profit. However, schemes that hold a reasonable proportion of their assets in gilts are taking no investment risk on those assets. If those assets are used to purchase the bulk annuity policy then a deal may look particularly attractive. An insurance company will be prepared to invest in assets that are expected to give a higher return than government gilts. This additional return, compared to the returns expected by the scheme, will reduce the price of a buy-in policy offsetting the profit margin the insurer looks to make. This can make such a transaction attractive to both parties.

There are no rules about which liabilities will be covered by a buy-in policy. So if a buy-in for all pensioners looks expensive, a buy-in for older pensioners may be achievable without additional contributions being required. Another option is to complete a buy-in for high-liability members who will be responsible for a significant portion of the total risk in the scheme.

If a buy-in does appear affordable and you are keen to remove the risks then it is important to transact quickly. Market conditions can change very quickly and opportunities can be missed. These changes can be for better or worse but, if a deal is affordable, why not use the opportunity to remove the risks now rather than take the risk.

Where a deal would be attractive to the company but the price is not quite good enough then a monitoring process could be established so that the transaction can be completed if prices improve in the future. The affordability of a buy-in is not always obvious as it will depend on the relative movements in a number of areas including equity markets, gilt yields, corporate bond yields and inflation expectations.

Following the recent changes to legislation, many defined benefit pensions will now increase in line with the Consumer Price Index (CPI) rather than the Retail Price Index (RPI). CPI is difficult to insure due to a shortage in assets that linked to CPI increase. However, insurers are finding methods to achieve this so if CPI increases are to be insured, a small saving compared to the cost of RPI should be possible for a reasonable sized transaction.

In many cases a bulk annuity transaction has been initiated by the company rather than the scheme’s trustees but both parties will need to work together so that unexpected snags don’t occur. Opportunities have been missed because the trustees have been unaware of important corporate considerations until very late in the process.

To avoid incurring unnecessary costs we recommend that the first stage is to carry out a feasibility exercise to assess affordability before undertaking a full market review if pricing looks attractive.

For many schemes, a bulk annuity policy will not be an attractive option in the current economic environment. However, for some the current low government gilt yields may present an opportunity to remove significant risks from your pension scheme at an attractive price.

Nick Griggs is a partner and head of corporate consulting at Barnett Waddingham

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