UK annuity liberalisation: Challenge or opportunity?
Tiziana Perrella assesses the impact of annuity liberalisation on UK DB pension funds
It will take time before the impact on UK defined benefit (DB) pension schemes of the changes announced in the March 2014 budget becomes apparent. Much will depend on scheme members’ behaviour and preferences, which are hard to anticipate. However, the idea seems to have spread that freedom and choice – to a much greater extent than in the past – are desirable features in all types of pension arrangements.
This presents a challenge for DB schemes as trustees will have to make decisions on how their plan is run in the future.
It also presents an opportunity. In many ways, DB schemes are ‘one size fits all’ arrangements, with limited opportunity for members to exploit individual circumstances, such as the possibility of receiving a higher benefit in the absence of a spouse, or individual beliefs such as concern about future inflation. Members could of course opt to transfer to a different arrangement, such as a personal pension, to increase control over their benefits, although the terms on offer have made this unattractive. Increasing flexibility in the payout phase could mean that benefits fit better with circumstances and as such offer greater value, meaning funds would make a saving against the cost of a buyout.
This increased flexibility could result in a ‘win-win’ scenario for both members and trustees following a de-risking process such as an enhanced transfer value (ETV) exercise or a pension increase exchange (PIE), with schemes able to afford a bulk annuity purchase when previously they would not. Of course, there is a material risk that bulk annuity terms could deteriorate over the extended period during which a de-risking exercise such as an ETV can be run, so that any profit may be lost. Where possible, it makes sense to tie one or more de-risking exercises with a bulk annuity purchase. A number of high profile deals have been completed on this basis in 2014 and we believe that this model will become popular in the new regulatory environment.
Is de-risking possible?
Although 2014 saw considerable bulk annuity business in value terms with previous records smashed – as well as the largest ever buy-in, buyout and longevity swap contracts – insurers’ appetite for bulk annuity business remains strong. This is linked to the decline in individual annuity business, where insurance companies have seen a reduction of 50-75%. While individual annuities are expected to rebound as more individuals with DC-only provision reach retirement age, this is likely to be on more competitive terms than previously, with bulk annuities remaining attractive for many insurers and for new entrants.
As insurers have had experience of a large number of deals with bespoke features, they have become comfortable offering these features as standard. They have been willing to meet with trustees and advisers to seek ways to innovate. The full range of de-risking alternatives – ETVs, PIEs, trivial commutations and flexibility at retirement options, where members are given the option to retire or retire early either from the scheme or by securing an immediately vesting policy funded with a cash equivalent – can be offered to members in conjunction with a bulk annuity policy. The terms available take into account expected take-up rates for each exercise and the consequent impact on the finances of the scheme.
The principles for pricing this type of contract are simple. The insurer can cost the bulk annuity policy based on an estimate of the end position for the scheme after the exercises have been run. Any discrepancies can be reconciled in terms set out in the contract and agreed at outset, so that the risk for both parties is reduced. The real difficulties are around the practical aspects of running the exercises. Here are some of the fundamental issues:
•Have the exercises been properly planned, including the order in which they will be run and agreement on the calculation basis underlying the various options being offered?
•What are the timescales, and how can it be ensured that these will be adhered to?
•What is the scope of any individual financial advice to be provided to the members?
•Has a financial planning firm been appointed and briefed on the fuller implications of the exercise? An exercise for a multi-billion pound pension scheme could wipe out the capacity of a large firm for an extended period.
•Have all the costs been taken into account when assessing the viability of the exercise?
It is essential that there is an experienced team in place to control each aspect and a manager to pull the exercise together. Close links with the chosen insurer are important.
An alternative way to achieve the same would be to carry out the de-risking activities separately from the bulk annuity purchase, working with a pre-selected insurer to monitor price movements and potentially also implementing tranched transactions when conditions allow. However, this model would only be efficient for large schemes.
Trustees and sponsors
We recommend that trustees discuss the implications of the regulatory changes and make appropriate decisions. It is likely that the pensions industry will be stretched after the changes come into effect, for both administration and advisory services, which may have an impact on the timescales for implementation.
As the bulk of DB schemes are legacy arrangements, UK sponsors remain keen to reduce their risks, both relating to the level of contributions and their volatility. De-risking exercises curtail liabilities once and for all, which mean that pension contributions used to fund these exercises are more efficiently used than ‘normal’ recovery payments. The same applies to a bulk annuity purchase. While an immediate full scheme buyout may be out of the question, strategies can be put in place to target this within a reasonable timescale on terms assessed to be affordable. The growing popularity of member options, together with the availability of flexible bulk annuity contracts, can help with these.
Tiziana Perrella is a principal at JLT Employee Benefits