David Barker reviews deferred premium buyouts, a development in the insurance market that allows employers to spread the cost of a buyout

A commonly accepted goal of many defined benefit pension plans is to fully insure the
plan benefits and then wind up, transferring responsibility for future benefit payments to an insurer. Why then is the UK market for such products around only £5bn (€5.8bn) each year when defined benefit liabilities are significantly in excess of £1,500bn (€1,744bn)?

The numbers transacting with insurers paints a similar picture– around 150 insured bulk annuity transactions complete each year, which is enough to create a decent market but small when compared with the 6,500 registered defined benefit plans in the UK.

Not surprisingly, a key barrier is price – and hence the size of the capital injection needed from the plan sponsor to support a transaction. There is, of course, no magic bullet. The plan’s deficit on a buyout basis needs to be funded one way or another if buyout and wind-up are to be achieved.

But there is a decent gun-sight that can help funds target a robust and sensible solution.
Innovative developments in the bulk annuity market mean that many UK defined benefit pension plans no longer need to be fully funded on a buyout basis to insure full plan benefits. To an extent, this has always been true, but the extent and scale of the offering from insurers has developed significantly recently. Recent transactions, such as the transaction between the Kenwood pension scheme and Legal & General, demonstrate that this approach can work and has real merit.

Some insurers are willing to insure full plan benefits from the outset but spread part of the premium, over as much as 10 years, by means of a deferred premium buyout. Many trustees and sponsoring employers will find this to be a useful development, not least as it could mean fully insuring the plan is possible years earlier than anticipated.

This means that it is possible to lock down the pension fund’s key risks much sooner than might have been thought – and simultaneously transform the funding strategy into a one-off defined schedule of cash contributions over an agreed period. Once the contributions have been paid, the plan is fully insured and can be wound up.

This might seem too good to be true. But for many trustees and sponsoring employers, this strategy could represent a robust route to buyout and wind-up in a defined period. The strategy leads to the only recovery plan on which the sponsor can actually rely, given essentially that all plan risks are insured at the outset with future contributions known.

The pension fund remains in operation while the deferred element of the premium is being paid. Once paid, the insurance contract can be converted, at no extra cost, to a buyout and the plan can be wound up.

Importantly, if the sponsor is unable to pay the full amount of the deferred premium, the insurer will scale back the insurance to reflect the premium actually paid and the plan continues to cover the uninsured benefits directly. In practice, the insurer is likely to want to partner with the sponsor to help ensure that the full balance can be paid as this is likely to be the ultimate objective in any event. This provides substantial flexibility and protection for all parties and differentiates the strategy from, for example, the sponsor taking out a loan from a third party to fund the plan deficit. Also, the insurer’s charge for interest on the unpaid balance may be lower than commercial rates.

For an example of how this works in practice, imagine a plan with pensioner and deferred members that is 75% funded on a buyout basis. Assume that the current recovery plan is to fund to 100% of the buyout level over five years and that the plan actuary has estimated that this could be achieved with annual contributions of £600,000. The actual funding level at the end of the five years will be higher or lower than 100% due to the actual experience of the plan being different to the assumptions made.

If, on the other hand, the trustee and sponsor had investigated and purchased a deferred premium insurance product, then the funding level after five years would very likely be exactly on target, that is 100% in our example. The insurer would provide cover from the outset for 100% of the plan benefits in exchange for the initial premium – likely to be the majority of the existing plan assets and possibly an initial contribution from the sponsor – and agreement to future premium payments being, say, £700,000 annually over eight years. While this amount is higher and the period is longer, the trustee and sponsor have the assurance that all benefit cashflows will be met by the insurer and that there would be nothing further to pay at the end of the period.

Why not just wait until the fund has sufficient invested assets to afford a full buyout? This might be a sensible strategy – but buying now and spreading payment of the premium over several years could be beneficial for a number of reasons:

Locking into insured buyout terms now creates a robust path to buyout and wind-up, supported, importantly, from the outset by a regulated life insurer and without the usual uncertainty associated with funding the plan.

The strategy gives confidence that contributions will directly reduce the remaining buyout deficit and not be swallowed by adverse investment performance, long-term interest rates, inflation, or longevity – all of which are fully insured from the outset.

It allows you to report now to members, sponsor shareholders, and other stakeholders that you have put in place a robust arrangement for reaching buyout and wind-up in a defined timescale, with contractual protections.

Not all plan assets have to transfer to the insurer at the outset, so any existing illiquid assets held by the plan can be sold on in a timescale that reduces financial penalties. The strategy could also reduce PPF levy payments from the outset.

Deferred premium buyouts are a way to reach buyout and wind-up in a robust and structured way and the product applied to all types of plans, with existing assets ranging in value from a few million pounds sterling to several hundred million.

But the structure will not necessarily suit all plans. The main disadvantage compared with a traditional funding approach is that a deferred premium buyout locks in the current deficit, meaning that the only way out is through contributions rather than through a combination of contributions and investment returns. And there is also no upside for the trustee or plan sponsor in that the insurer takes all profits resulting from any better-than-expected experience during the premium deferral period.

Overall, this is another strategy to consider – but one that gets to the very heart of pension plan funding.

David Barker is a benefits consultant at Mercer