The buyout finishing line has probably never been within reach for such a large group of defined benefit schemes. For a corporate sponsor, the time may therefore be ripe to get a buyout transaction on the agenda, but it’s also worth thinking early on about the parameters of the transaction being proposed.
Defined benefit pension schemes have resided for decades within the highly evolved and regulated world of trust-based occupational buyout pension schemes. Schemes dating back to the forties and fifties are not that rare. If you want to put that in context, watch High Society, Top Hat or Harvey. These wonderful films are products of a very different world, not least one without the IT infrastructure that underwrites so much of pension scheme administration.
When you buy out, the legal, administrative, actuarial and governance history of that scheme is not directly inherited by the insurer. The bulk annuity provider will, instead, refer to the information recorded in a benefit specification and data set which are appended to the contract. There is, therefore, a lot of information and history to be distilled into a single contract, and if the body of scheme documentation differs in any material respect to the terms of the contract, the insurer may well not be liable for the difference.
Bulk purchase annuity policies are not therefore a panacea, and it should not be a surprise to anyone that insurers writing billions of pounds of DB pensions risk transfer business per year are extremely careful about those risks they take on, and those they do not. There are, of course, so called ‘all risks’, ‘data risks’ or ‘residual risks’ transactions, which go further than the standard transaction in pushing risks on to the insurer. Such transactions involve an additional premium and, sometimes, material additional work in relation to the due diligence which must be undertaken. In any event such contracts are rarely, if ever, truly ‘all’ risks, and careful consideration for each insurer’s terms will be needed.
You cannot expect an insurer to take on risk without having carried out due diligence. For example, if you want an insurer to accept the risks associated with any undiscovered differences between the schemes’ documentary history and the member benefits described in the policy, the insurer will not be likely to accept that risk without first looking at those documents. Such an exercise has implications in terms of costs and timing, but could also bring to light issues which, on analysis, the insurer is simply not prepared to take on. What is more, having identified an issue, the trustee and scheme sponsor may come under an obligation to resolve that issue, which may itself be a very material exercise.
For sponsors, it is important to consider what happens to the risks that are not taken on by the insurer and, in particular, what package of protections the pension scheme trustees might need to see before they will agree to proceed with a transaction.
For those unaccustomed to bulk annuity contracts, it is often a surprise to learn that the multi-million-pound transaction premium paid to put the annuity in place is often not the final price. This is because insurers typically transact on the basis that they will spend around 12 months working with the scheme administrators to check the data supplied to them – for example, dates of birth, spousal information, pension amounts. If they identify errors, a price adjustment will be calculated. This could leave the scheme sponsor with a request for a top-up contribution, many months after the transaction was thought to be concluded.
This data cleanse period and true up may well be one of the reasons so may buy-ins are able to transact: it allows both parties to commit significant resources to a systematic checking of scheme data without execution risk. However, for sponsors looking for more pricing certainty, it may be worth exploring a residual risks model which can, if structured correctly, avoid the need for the pricing adjustment, by front end loading the due diligence process.
We are in the middle of a boom in bulk annuity transactions, but it remains the case that a successful transaction is not one where all risks pass to an insurer. In practice, the most important and material risks will pass, but the transfer of all risks is never achieved and should not be the aspiration. A successful transaction is one where the trustee and sponsor have understood what risks the insurer means to take-on and properly mitigate those risks that they will not.