London:

Deep within the balance sheets of some of the UK’s largest companies lingers a trillion-pound headache. These are companies, many of them household names, with traditional “final salary” pension plans, where the employer is on the hook to pay the retirement income of its members for life.

 

As longevity has increased, so the pain has intensified for employers, who have had to dig deeper into their pockets to make good their pension promises. Money that could have been used for investment or returned to shareholders is instead being used to honour promises made to employees years, or even decades, ago.

 

Against this backdrop, insurers, banks and investment experts have stepped forward with complex deals aimed at easing the burden of UK pension liabilities, which collectively amount to more than £1tn.

 

These de-risking deals, known as “buy-ins” and “buyouts”, give employers an opportunity to shed some or all of their liabilities — for a price. Since the early days of the market in 2006, when about £1bn of de-risking deals were struck, the “bulk annuity” business has grown rapidly, driven by favourable market conditions and the entrance of new players. About £9bn of deals, covering 200 employers, were struck last year, with an estimated 1m pension members affected. But 2014 is expected to be record-breaking.

 

“Not so long ago a billion-pound deal would have been rare,” says Jay Shah, co-head of business origination, of Pension Insurance Corporation, a leading player in the de-risking market. “But we are seeing these deals get bigger, with more mainstream companies wanting to de-risk.”

 

While buy-ins and buyouts help employers cope with pension headaches, there are growing concerns that members’ interests are not being adequately safeguarded.

 

Your benefits in their hands

 

In the UK, pension de-risking is supported by regulators, who say the arrangements can help employers manage risks and improve member security.

 

De-risking deals fall broadly into two camps: buy-ins and buyouts.

 

Under a buy-in, or “longevity swap”, responsibility for continuing to pay a member’s pension if they live longer than expected falls to an insurer or a bank, not the employer. Under these deals, members remain part of the company pension scheme but do not see any practical change to how their income is paid. The employer is effectively buying insurance against employees living longer than expected.

 

“Buyouts” are more complicated arrangements negotiated between employers and insurance companies, and have the most impact on members. Under these deals, the employer severs its links with the scheme and farms it out to an insurer.

 

“The argument for de-risking pension plans, for both sponsors and employees, is to improve the stability of the scheme,” explains Martin Bird, head of risk settlement with Aon Hewitt, the consultants.

 

“As people have continued to live longer, pension costs have increased and getting rid of longevity risk is one way of making the scheme more stable.”

 

Scheme trustees act as a safeguard for members in the de-risking process, but many lack the expertise and knowledge fully to understand the deals put before them. Trustees can also come under pressure to focus on the employer’s drive to get the best, often lowest cost, deal.

 

“It can be a challenge for trustees to understand what’s happening as these deals are incredibly complicated,” said David Cule, partner with Punter Southall, which provides actuarial and investment advice to trustees. “Some trustees will be experienced in this, but they are few.”

 

Safety first

 

Employers will often hire professionals to help trustees. But even with professional guidance, trustees face pressures which can act against them securing the best possible outcome for members.

 

A critical role for trustees is to ensure that members’ benefits, such as income or spouse’s benefits, are properly transferred to the insurer. The better these data are matched, the less chance of problems later. However, this is not always given priority.

 

“Data checking is time-consuming and should be the among the first things done in a de-risking exercise,” says Emma Watkins, partner at Lane Clark & Peacock, the consultants. “But in some situations this is left until later in the process, largely as it is an upfront cost to the employer. In our view it should be done as early as possible to minimise the risk of future mismatches.”

 

One other area of potential tension for trustees is the consideration given to the financial strength of the business taking on responsibility for members’ benefits, in whole or part.

 

Complex strategies

 

The rapid growth of de-risking worries consumer groups, who are concerned it is evolving without adequate member protections and joined-up regulatory oversight.

 

In a 2013 report, academics at The Pensions Institute, part of the Cass Business School, expressed concerns about how well-equipped trustees were, particularly in smaller schemes, to act for members.

 

“The overarching impression I have is that banks and insurers are increasingly keen to sell complex de-risking strategies to smaller and medium-sized schemes,” says Debbie Harrison, visiting professor at the Pensions Institute. “These are still uncharted waters for many trustees. The regulator has previously raised concerns in its reports about the capabilities of trustees of these schemes.” Regulators are also urged to pay closer scrutiny to insurers who have moved into the bulk annuity business since personal pension reforms were announced in the Budget.

 

“There are concerns that some insurers are now pushing bulk purchase annuities because they have to make up for the massive losses suffered on retail annuities sales post-Budget,” adds Ms Harrison.

 

“The FCA, the Pensions Regulator and the actuarial profession should consider the risks in existing bulk annuity buy-ins and buyouts, where an insurance company’s covenant has been weakened by the loss of business in the retail market and a fall in the company’s share price. A company’s financial strength is crucial for members.”

 

While the PRA requires companies doing these de-risking deals to have appropriate capital and solvency to write their business, there have been casualties. In 2010, Paternoster, a specialist buyout company, was put up for sale, with tens of thousands of members under its charge, after closing its doors to new business. Buyout specialists Lucida and Synesis were also bought out after withdrawing from the market.

 

The Pensions Institute is now calling for a code of practice to be drawn up to ensure the market develops safely and efficiently with consistent regulation from both the FCA and PRA.

 

The Pensions Regulator, which oversees workplace schemes and has previously underlined the importance of trustees exercising caution with regards to new or complex products, says it is “continuing to monitor the de-risking sphere”.

 

“The regulator supports de-risking products that offer value for money, assist in managing risks and improve member security,” said Stephen Soper, interim chief executive of TPR. “We need trustees to act as a safeguard in the de-risking process, so it is essential that they work closely with their advisers to understand details — including the extent to which risk is being managed, shifted into the future, or exchanged for risk of another sort.”