Longevity: A healthier way to de-risk
Trustees could secure big savings by de-risking through medically-underwritten bulk purchase annuities, argues Debbie Harrison. That could mean the difference between affordability and unaffordability
Trustees of defined benefit pension schemes could secure savings of 10% or more relative to conventional pricing when they de-risk their pensioner sections through medically-underwritten bulk purchase annuities (BPAs).
The ‘enhanced BPA’, which develops buy-in morbidity and mortality-pricing techniques, was the subject of ‘A Healthier Way to De-risk: The Introduction of Medical Underwriting to the Defined Benefit De-risking Market’, published in February by the Pensions Institute at Cass Business School. The report coincided with the announcement of the first completed enhanced BPA deals transacted with Partnership.
Under a buy-in, the trustees purchase a bulk annuity policy from an insurance company as an asset of the scheme. The policy delivers an income stream that aims to match the pensioners’ liabilities and provides a hedge against a range of risks, including those relating to interest rates, inflation, investment, and longevity.
Enhanced or individual underwriting takes into account the health and lifestyle of the individual pensioners, which means that the cost of insuring liabilities can be lower due to the shorter life expectancy of certain members. The reduction in cost, relative to conventional pricing techniques, will vary depending on pensioners’ health, but typically could be about 10% – much more where retired executives and directors in ill-health account for a disproportionate proportion of total liabilities.
Importantly, as the first completed cases evaluated in the report demonstrate, individual underwriting makes possible de-risking transactions that employers and trustees previously had found unaffordable, taking schemes closer to a fully funded position and to a final buyout.
Members could also benefit from these transactions, which can reduce the risk of scheme transfer to the Pension Protection Fund (PPF). This is particularly relevant where the scheme has a weak covenant. In this case it benefits from the security of the insurer’s covenant, which is supported by the regulation of solvency and capital adequacy and is backed by a compensation system.
The de-risking market, which started in 2006, is seen as an urgently-needed response to scheme funding problems that appear to be getting worse rather than better. The 2012 Purple Book, published by the Pensions Regulator (TPR) and the PPF, found that the aggregate full buyout funding position of DB schemes had risen from 60% in 2011 to 67% in 2012, with the result that DB deficits continue to stall corporate activities and threaten to force otherwise viable companies into liquidation.
Initially the enhanced BPA service from new players such as Partnership and Just
Retirement will be targeted at smaller DB schemes with up to 400 pensioner members.
The focus on smaller pensioner sections is due to the trade-off between a range of factors including feasibility, trustee knowledge of the retired membership, ‘random variation risk’ (deaths are much more difficult to predict in smaller schemes), covenant risk-hedging, and economies of scale. Based on data in the Purple Book, the initial market represents more than 5,000 schemes with about 350,000 pensioners in aggregate and assets under management (AUM) of about £40bn (€47bn) – that is, just over 10% of AUM of pensioner sections in the total market. If the enhanced bulk buy-in can be developed to cater for all sizes of pensioner sections, the market would represent AUM of about £380bn.
However, the report warns that in any complex market such as DB de-risking, there are risks that must be addressed, especially since local and regional advisers to smaller DB schemes might not have the necessary expertise in corporate finance, insurance company covenant evaluation and reinsurance strategies.
A bulk buy-in is an essential process in the transition to a bulk buyout. It is likely to be the biggest investment decision trustees will make before arranging bulk buyouts for the pensioner section and then for the remaining sections of the scheme, leading to scheme windup. Unlike other investments, the bulk buy-in – whether transacted on a standard or enhanced basis – is generally irreversible, so the counterparty risk must be considered very carefully. Moreover, the deal will shape the final bulk buyout package, when annuities held as assets of the scheme are transferred to individual members. Accuracy of income-matching and pricing at the buy-in stage, therefore, is essential to the longer-term goals of trustees and corporate sponsors.
Given these concerns, the report recommends that regulators and stakeholders work together to establish a clear regulatory framework and a code of practice to enable the market to reach its full potential and to develop in an orderly manner. The recommendations include a call for:
• Consistent regulation of the BPA market on the part of The Pensions Regulator (TPR) and the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA), which replaced the Financial Services Authority (FSA) in April 2013. The FSA and TPR memorandum of understanding on pensions issues was last updated in 2007 and does not address de-risking.
• Consistent and reliable data for the de-risking market as a whole and the development of consistent data in the enhanced buy-in market. To achieve the latter objective would require enhanced insurers to share their qualitative and quantitative experience.
• Insurers to develop flexibility in the way they can collect data on members’ health, so that schemes can benefit from whole-of-market bidding processes and avoid having to pre-select the insurer with the most appropriate methodology, as might be the case at present.
• Insurers and reinsurers to work with schemes and their advisers to develop a comprehensive disclosure process, so that all material medical underwriting facts are made available during the bidding process. This would eliminate anti-selection concerns on the part of conventional underwriters.
• Employers and trustees to seek expert advice about the impact of the insurer’s covenant on the scheme’s financial position. They should also ensure that their trustee liability insurance extends to cover their liability in relation to de-risking exercises, including enhanced buy-ins.
• Stakeholders and regulators to produce clear guidance for advisers, employees and trustees to ensure best practice is extended to the smaller schemes, which constitute the market initially identified by medical underwriters as suitable for enhanced buy-ins.
The de-risking market as a whole remains small, relative to aggregate scheme liabilities: to date, de-risking transactions account for about 3% of total liabilities (£40bn out of £1,340.5bn) and just short of 10% of pensioner liabilities (£380bn). Without innovation in pricing, it seems unlikely that the market would be able to match the potential appetite of trustees and employers.
The combination of new players from the DC enhanced-annuity market, together with the existing stalwarts of the DB BPA market, brought the line-up of enhanced underwriters to four at the beginning of 2013. It is possible that in 2013-14 some of the conventional insurers will develop their own medical underwriting services or strike deals with specialists in order to remain competitive. This would represent a radical new trend in DB scheme de-risking, whereby the pricing of risk is much better quantified using sophisticated medical underwriting techniques.
Trustees and scheme sponsors depend on securing affordable buy-ins in order to reach their ultimate goal, which is to transfer all liabilities to insurance companies. The introduction of medically-underwritten buy-ins should help them to reach this goal more quickly – but the potential risks must not be overlooked in a complex market already destabilised by the frequent entry and withdrawal of new players.
Debbie Harrison is a senior visiting fellow at the Pensions Institute, Cass Business School