Defined benefit (DB) liability management has grown considerably in the last decade. Enhanced transfer values have stolen most of the headlines – mainly regarding whether DB transfers are in the interest of members. Meanwhile, more and more DB schemes have been quietly undertaking pension increase exchange (PIE) exercises. The popularity of PIEs is unlikely to change, especially as DB schemes look to bolt a PIE onto GMP conversion as part of their GMP equalisation. As such, DB sponsors, trustees and members should be very careful when considering the different aspects of a PIE exercise.
A PIE is an offer to increase a member’s pension – by up to 80 per cent in some cases, in return for giving up part or all of the future increases to their pension. Members tend to like PIEs as the revised payments better suit spending requirements. They regard more money sooner as a good thing while they are more active and enjoy higher living costs. We typically observe take-up rates of 35 per cent of members exchanging benefits.
But PIEs should be an even more popular option to members. We can consider the increase in pension from the PIE option as a loan to the member from the DB scheme, in which members receive an annuity of reducing extra income in the early years that they pay back if they live long enough. The interest rate on these loans is far better than those available in the lending markets, not to mention the advantages of selection.
Our research shows that for a member aged 65 based on typical terms for a PIE, including full value being offered by recycling all forgone future pension increases into the immediate increase in pension and current market conditions, the PIE offer is free until age 90 – in fact it has a negative interest rate meaning the DB scheme (or more specifically the remaining DB members) are effectively paying the members who take the PIE.
The rate of interest doesn’t reach 7 per cent p.a., a typical rate on loans in the open market for pensioners, until age 107.
You may think this is due to the low interest rate environment – you would be wrong. Even if long term interest rates increase by around 3 per cent, the implied PIE interest rate is still very attractive, only reaching 7 per cent at age 97.
If we focus on a life expectancy of age 95, the picture is even starker. Our analysis estimates implied interest rates of between 3 per cent and just over 4 per cent p.a. for members above age 55 – a 55 year old will effectively pay 3 per cent p.a. for a 40 year loan.
However, more typically, DB sponsors that lead PIE exercises tend to offer less than full value as it is a member option after all and there is selection risk in favour of the member.
IFAs advising members don’t consider the exchange from the loan perspective. As part of their advice, they compare break-even ages – that is, the age at which the accumulated income received under the PIE falls below the accumulated income received if the member rejects the offer – to average life expectancies. That allows DB sponsors to offer as low as 70 per cent of full value and still achieve a successful take-up rate.
If we look at a typical offer of 85 per cent of full value, our analysis shows that all members under age 98 can take a PIE and enjoy an interest rate of less than 7 per cent p.a.
So what does this all mean? There are three important conclusions that follow. Firstly, have companies been offering members too much of full value within their PIE projects? From a loan perspective, members who take a PIE are getting a very good deal to the detriment of the remaining members and the scheme’s financial position – the balance doesn’t seem fair.
Secondly, trustees of DB schemes have a role within all PIE projects, not least as they act in the interests of members and protect the security of their benefits. Are trustees comfortable with the potentially significant cross subsidy between those who take the PIE offer and those who don’t?
Finally, have those DB members that did not take up a PIE offer in the past acted in their own best interests? Certainly, a 35 per cent take-up seems too low based on our analysis.
With lots of new DB members potentially being in line for a PIE offer, not least as part of GMP equalisation, I think DB sponsors, trustees and members need to be very careful around the areas of offer design, member understanding of the offer and whether members are making decisions in their best interest.