2019 was a record year for UK pension scheme bulk buyouts. Total transactions exceeded £40bn.
As employers and trustees continue to work towards the ‘pensions endgame‘ by off-loading their defined benefit schemes to insurance companies, it is useful to take stock of some of the key legal issues facing all parties as they grapple with the ‘ultimate’ in liability management tools.
Traditional fully-insured buyouts
An insured buyout involves the trustees of an occupational pension scheme securing all the scheme’s accrued benefits with an insurance company. This can involve two routes – the trustees: (i) buying individual annuity policies in the members’ names; or (ii) buying a policy in their own name and subsequently transferring the benefit to members. The latter approach is known as a “buy-in” which eventually leads to a buyout.
Buyouts are usually carried out as part of the process of winding up the scheme. Once the annuities are in the names of the members, the trustees can proceed to wind-up and terminate the scheme thereby ending any further obligations to the members. Likewise, for sponsoring employers, this is usually the final step in achieving a ‘clean break’ from any further funding responsibilities towards the scheme. Some schemes will see this as the final destination in a scheme’s funding flightpath or endgame.
In agreeing to take on the employer’s responsibilities for paying out the members’ pensions, the insurance company typically agrees to take a premium (i.e. top-up payment), together with the assets, such as bonds and shares, that back these liabilities. The insurers are essentially betting they will make more in investment returns than they pay out in pensions.
Issues to consider
Members’ interests
Assuming the rules of the scheme in question permit the trustees to buyout members’ benefits (if this is not the case, an amendment to the scheme’s investment power may be necessary), trustees must only consent to a buyout if they believe it to be in the members’ interests. The interests of members will usually be their financial interests. Generally, members whose benefits are being bought out will benefit from increased security – UK insurers are subject to capital solvency requirements and if they become insolvent, policyholders can seek compensation from the Financial Services Compensation Scheme. Before a buyout, members look to the sponsoring employer and in the event of an insolvency, the Pension Protection Fund.
Care should also be taken to identify those discretionary benefits under the scheme which will potentially be lost on buyout. Trustees would therefore be well advised to analyse the frequency with which such benefits are granted – it may mean hard-coding such benefits into the rules of the scheme which can obviously have a knock-on effect on pricing calculations.
Benefit specification
Trustees and their advisers will need to prepare a detailed
benefit specification, setting out the benefits to be insured. This is usually
required at the quotation stage and care must be taken to ensure that the
correct rules are used to determine each member’s benefits. This can be a
particularly onerous task where schemes have a long history and different
versions of rules are used to determine the benefits payable to different
members and their dependants. It is not unusual for the benefit specification
to form part of the negotiated buyout contract.
Data cleanse
The trustees and employer should also make sure that the scheme’s data is as accurate and up to date as possible. Usually, insurers will want representations and warranties from the trustees on the accuracy of the data provided.
Where time, or indeed inadequate scheme records do not allow this, insurers may be willing to accept an additional premium to remove the scheme from the employer’s balance sheet.
Provider due diligence
Selecting an insurance provider is primarily down to the trustees. Given that the insurer is to become the first port of call for members post-buyout, trustees need to be satisfied with (amongst other things):
- the provider’s track record and reputation in the market;
- the provider’s credit rating, geographical location and commitment to the market;
- administration and data protection systems in place;
- methods and quality of member communication;
- financial backing available in the event of a call on capital; and
- the price quoted: as trustees have a duty to consider the interests of the employer as well as the members.
Transfer and assignment
Having undertaken thorough due diligence on their chosen insurer, the trustees will generally be unwilling to allow flexible assignment or transfer provisions in relation to the buyout contract. The level of flexibility to allow the insurer to transfer within the insurer group and the effect of a change of control of the chosen insurer should also be carefully negotiated.
Equalising benefits for the effect of GMPs
The High Court decision in the Lloyds Bank case[1] confirmed that pension schemes containing guaranteed minimum pensions (GMPs) are obliged by law to equalise members’ overall scheme benefits between men and women to take account of unequal GMPs. The decision also gave guidance about the most appropriate method for achieving this.
Before the Lloyds’ decision, insurers had been willing to assume the risk of GMPs being equalised in the future, in return for an additional premium. Whilst the picture is now somewhat clearer following publication of GMP working group guidance, there is still uncertainty over which of the available equalisation methods is most appropriate. Until we have definitive guidance from the Government, this is an area that requires detailed advice albeit given the high levels of buyout activity over the last few years, insurers are obviously willing to assume a degree of risk.
Statutory discharge for trustees
For trustees to be discharged from their obligations to provide benefits once the buyout is complete, certain statutory requirements must be met. These include the statutory requirements regarding the preservation of benefits and protection of accrued contracted-out rights. Trustees will almost certainly be looking to their lawyers to provide comfort that these requirements have been met before the scheme is properly terminated and wound up.
Effecting a buyout is one of the most important milestones in a pension scheme’s lifecycle. Legal, actuarial, investment and project management advice is key to ensuring smooth transition.
Original Publisher: Pensions Today
[1] [2018] EWHC 2839