1 Bulk Insured Pensions A Good Practice Guide September 2011
3 ABI GOOD PRACTICE GUIDE 3 Foreword Pension fund trustees are faced with an ever increasing number of major challenges around scheme funding. Increased scheme longevity coupled with the turbulent investment environment mean that professional advisers continue to flag the issue of long term pension risk and the various options available to mitigate that risk. The spectrum of risk is broad and trustees, along with advisers and corporate sponsors, must decide where their DB scheme fits and its future direction of travel. As a contribution to the DB de-risking debate the NAPF welcomes this Good Practice Guide. It is important that trustees as fiduciaries acting in the best interests of all scheme members should fully understand the key aspects of the bulk insurance solutions available to them as a de-risking tool. While there is no substitute for actuarial, legal and risk management advice from qualified professionals, this Guide can be a helpful source of reference with which to navigate this one aspect of the complex de-risking process. Although scheme specific and external factors will impact upon the pace of de-risking, trustees need to keep under review the options open to them. A clear presentation of the buy out/buy-in debate is useful in setting out the options and can provide reassurance that any action taken has been properly thought through. The NAPF is the leading voice of workplace pension provision in the UK and represents 1,200 pension funds drawn from all parts of the economy which hold assets of 800 billion. Darren Philp Director of Policy National Association of Pension Funds (NAPF)
4 Contents Executive Summary 5 Introduction 6 Acknowledgements 7 Part I: Buy-in/Buyout Process 8 1. Preparation for Buy-in/buyout 9 2. Approach Request for proposal Final quotation Pre-implementation Implementation On-going administration 37 Part II: Other Important Considerations Impact of the Pension Protection Fund Trustee liability and protection GMP equalisation Data risk transfer Longevity insurance Liability Management Treating Customers Fairly 62 Glossary of Terms 63
5 ABI GOOD PRACTICE GUIDE 5 Executive Summary Welcome to this guide to good practice on the subject matter of bulk insured pension funds and de-risking. This guide will give you an overview of some of the options that are available, focusing on the process of pension scheme Buy-in/Buyout. provide you with some essential preparation objectives of a Buy-in or Buyout, to facilitate a smooth, speedy and focused process. help you to consider the essential steps necessary for successful completion of a potentially complicated undertaking. point you towards some of the legal requirements in key areas such as: discretionary benefits; partial Buy-ins; and the role of the Pension Protection Fund (PPF). The guide also contains a glossary of terms to help you understand the language used in Buy-in/Buyout transactions. Whilst it will not answer all questions that you might have, nor spare you the cost of collaborating with external advisors etc. We hope this guide will simplify the decision-making process for you and, in areas where you may have uncertainty, point you in at least the right direction. The guide was written by a group of like-minded insurers, employee benefits consultants, and lawyers, led by Margaret Snowdon of Lucida. On Page 8 you will find the list of contributors who freely gave their time to produce this document. We are also grateful for the support of the NAPF, the Pensions Regulator and the PPF. We hope you enjoy reading this guide, and are always keen to hear your feedback and any particular views you may have. Hugh Savill Director, Prudential Regulation and Taxation Association of British Insurers Darren Philp Director of Policy National Association of Pension Funds (NAPF)
6 6 ABI GOOD PRACTICE GUIDE Introduction The Buyout market is not new, but it has changed over the last few years and not a week goes by without Buyout being mentioned in the press. In the aftermath of the financial crisis, Buyout activity has been buoyant with various options and product offerings available. On the other hand, trustees have probably never been as confused as they are now and despite all the press coverage there seems to be little literature available to explain the how s and why s, what Buyout actually means and most importantly whether or not and by whom it should be considered as a valuable option. But where should one start? This guide aims to help trustees and any other interested parties understand the world of Buyout, explain it in laymen s terms and set out best practice. Page 9 contains a visual representation of the entire buyout process. Buyout is a broad term used to cover situations where the assets and liabilities of a Defined Benefit (DB) pension scheme are taken over by an insurance company. It is no longer simply the solution of last resort but in many cases has become the preferred way to transfer risks from a DB pension scheme. Buyout is considered as the end step in a phased de-risking solution, including liability management exercises (enhanced transfer values (ETV), pensions increase exchanges (PIE) and enhanced early retirement) designed to provide members with more choice and improve the funding situation for remaining members. Buyout can be a very powerful tool in a company s and trustees armoury to facilitate a corporate transaction, but it is important to understand what one is (or is not) buying. Choosing the right insurer to help you on this journey, whether it is a long term de-risking plan or a short term solution to an acute commercial problem, is therefore pivotal. Several corporate deals have failed because of the uncertain and volatile liabilities in a DB pension scheme: the well-publicised J Sainsbury case illustrates the critical nature of the pension plan in corporate activity. Insurance companies can provide tailored and innovative solutions to suit your circumstances and budget, but independent professional advice will always be needed. This could be from your existing scheme advisers, for example actuary, consultant, lawyer, etc. but often external experts are sought for their specialist knowledge of de-risking solutions and the players in the market. Therefore, trustees and companies must select their advisers with care to ensure they get the right advice and the right outcome as well as the right value to the scheme. As expert advice and a clear understanding of all available options is very important it should also be in the interests of the trustees to be well informed and not have to rely on their advisors recommendations blindly.
7 ABI GOOD PRACTICE GUIDE 7 Acknowledgements We are extremely grateful to the following organisations for giving their time freely to prepare this guide: CMS Cameron McKenna Hymans Robertson Lane Clark & Peacock Law Debenture Legal & General Lucida MetLife Pension Insurance Corporation Prudential Tax Incentivised Savings Association (TISA)
8 8 ABI GOOD PRACTICE GUIDE Part I: The Buy-in/Buyout process Preparation Stake holder engagement Understanding scheme and aims The importance of accurate data Investment strategy review Legal Considerations Feasibility employer advisers trustees risks faced objectives funding level availability of extra funding aims of de-risking exercise constraints carry out audit of scheme data assess potential impact on availability/ pricing of de-risking solutions potential impact of scheme s portfolio on pricing of solutions review of scheme rules to check trustee powers codify the exact benefits involved and the extent of trustee discretions possible solutions available assess affordability decision in principle to proceed with Buyout Quotation Process Approach consider approach to exercise (full market/auction/bespoke) Request for proposal use summary data to obtain high level estimated quote complex benefit structures could be simplified at this point typically invite three to five providers to quote Final quotation (up to eight weeks) provide sufficient scheme information and data to allow providers to produce accurate quotations record and circulate all updates and agreed assumptions to ensure consistency of quotations derive shortlist based on all relevant factors engage formally into a mutual exclusivity agreement Implementation Pre-Implementation Implementation Ongoing administration and services (if appropriate) contract negotiation asset transition/disinvestment arrangements preparing for the transaction data cleansing/verification data migration final premium payment shadow administration in buy-in policy administration in buyout policy holder options valuations monitoring and reporting member communication
9 ABI GOOD PRACTICE GUIDE 9 1. Preparation for Buy-in/Buyout The key to a successful transfer is to engage all the relevant parties from the very early stages, ensuring everyone is on the same level with regard to data preparation, the review of investment strategies and the consideration of legal aspects. Transferring pension risks can be complex and involve many stakeholders. The key to success is the right preparation. This chapter highlights the main actions and issues that need to be considered. Engagement of all stakeholders from the outset is essential. A working group consisting of the key stakeholders will help the process run smoothly and efficiently. One of the first steps is to understand your scheme in terms of the risks faced and their concentrations, the objectives of the different stakeholders, the level of funding of the scheme and what, if any, extra funding is available. Once this is understood it should be possible to outline the aims of the derisking in the context of any financial and other constraints, to ensure that the de-risking will deliver the outcome sought. Accurate scheme data is essential to pricing of de-risking solutions. As part of the preparation prior to approaching the market for quotations, an audit of the scheme data could be performed and cleansing considered where data is found to be inaccurate. These steps will improve the speed of response and comparability of quote from solution providers but will need to be balanced against the potential costs of delaying a de-risking. Another factor to consider is the investment strategy of the scheme, as the right strategy put in place before de-risking can reduce the net cost. The trustees must be legally able to complete a de-risking and not prevented in any way by the Trust Deed, the scheme rules or legislation. The exact benefits provided under the scheme must be defined. Where there are discretionary benefits, decisions need to be made on whether, and how, these are to be converted into entitlements as insurers will not normally take on discretionary powers. A feasibility study at the outset provides the opportunity to design and test a solution while ensuring that valuable time and resources are not wasted. This will ensure the support of all stakeholders is obtained before a decision to proceed (in principle) is reached and greater expense incurred. Pension risk transfer, through an insured solution such as a Buy-in or Buyout, is likely to be a new and potentially one-off experience for many trustees and employers. It typically involves a complex set of tasks and considerations requiring interaction between the employer, trustees, their respective advisers, and at a later stage, the insurer of choice. The key to a successful transfer is to engage all the relevant parties from the very early stages, ensuring everyone is on the same level with regard to data preparation, the review of investment strategies and the consideration of legal aspects. The following section will outline these considerations in further detail.
10 10 ABI GOOD PRACTICE GUIDE 1.1. Stakeholder engagement One of the greatest challenges in a Buy-in or Buyout process is to ensure agreement between the various stakeholders involved. These can range from external service providers, such as investment managers and administrators, to internal parties, such as trustees and employers. Each of the key stakeholders involved plays an important role in the process as outlined below: Trustees The trustees are the key stakeholder in the risk transfer process as they are the party who will decide whether to go ahead with the Buy-in or Buyout and will, therefore, select the insurer with whom the pension benefits are to be secured. Employer The employer is often required to contribute towards the Buyout or Buy-in premium or other de-risking costs and thus is an important stakeholder in de-risking. Insurers may be less willing to engage in de-risking discussions where an employer has not been involved in the overall process. Advisers External stakeholders are also critical to the success of the transition. They are best involved from an early stage. Asset structure is a key part of any bulk annuity transaction so investment consultants can play an important role in assisting trustees in this area. Third party administrators can also be heavily involved, from providing the data extract on which the insurer will provide their quotation to liaising with the insurer through data cleansing and on-going administration. One method of achieving consensus efficiently is to establish a de-risking working group or subcommittee, which includes representation from the key stakeholders. It would be advisable to put in place a delegated structure that avoids the need to consult the full Trustee Board at every stage. Ideally, the committee would have an agreed terms of reference in place under which they can act, with appropriate delegated authority. This subcommittee would often ask for a feasibility study to consider the various issues and assess the overall suitability of an insured solution for pension risk transfer. A specialist benefit consultant is often well placed to help trustees with this work, which can save considerable time and energy in the long run Understanding the scheme and aims Once a subcommittee has been established, with the explicit task of investigating de-risking options for the pension scheme, one of its first tasks will be to understand all the various risks faced by the scheme and any risk concentration that specifically needs to be addressed. Additional factors that will need to be considered are the risk management, financial and business objectives of the trustees and the employer, funding levels of the scheme and any potential additional funding requirement.
11 ABI GOOD PRACTICE GUIDE 11 To get an accurate view of the scheme s funding position, the trustees should review the assumptions used in the valuation of the scheme s liabilities, particularly if the mortality assumptions have not been reviewed for some time. An understanding of the scheme s main risks as well as an accurate valuation of the scheme s assets and liabilities should be sufficient for the trustees to make an informed decision whether to consider a Buy-in or Buyout. Larger pension schemes especially may also wish to consider insuring a subset of liabilities in order to de-risk in stages, either through a quota share approach (for example a percentage of each member s liability) or by segmenting the population by age, category etc. Following a valuation of the scheme s assets and liabilities, it is then important for the trustees and employer to outline their aims vs. any constraints with regard to the de-risking exercise. This will have an impact on the structure of the overall exercise, for example, whether or not full Buyout will become a short or medium term aim and whether there are any restrictions on funding available from the employer which might limit the extent of the exercise. Similarly, the employer may have specific aims which have an impact on timing, i.e. completing the exercise before the financial year-end. Trustees should discuss these aims and constraints with their benefit consultant at the start of the process to ensure that the exercise will deliver what is required The importance of accurate data As trustees are well aware, especially given the focus of the Pensions Regulator, good data is crucial throughout the life of a pension scheme. See also the Pensions Regulator s Guidance on Record Keeping: Poor record keeping can lead to significant additional costs in a number of areas including administration, inaccurate actuarial valuations and even claims from disgruntled members. For many schemes, the full extent of poor record keeping is only realised after a major event in the scheme s lifecycle (for example, when a scheme derisks or a wind-up is triggered). However, data cleansing at that point is often too late. In preparation of a Buy-in or Buyout, trustees should carry out a thorough audit of scheme data to ensure member records are accurate and up-to-date. Where issues exist, data cleansing should be considered prior to approaching the market for quotations. This is because poor data can have a number of effects on the quote process. Inaccurate data can increase the time it takes for trustees to receive quotations from insurers. It can also affect the ability of an insurer to issue a formal quotation if, for example, some data items such as postcodes are incomplete.
12 12 ABI GOOD PRACTICE GUIDE When reviewing investment strategy the scheme needs to balance the long term investment strategy vs. potential shorter term transactional requirements. Moreover, if lack of data requires insurers to make assumptions on data and/ or benefits, which may differ across providers, comparing quotations can be a near impossible task. An insurer may also add a risk premium to the quotation to account for the potential additional costs resulting from poor data. Data cleansing is, therefore, crucial to ensure that trustees can run a competitive quotation process. However, the benefits of data cleansing should be weighed against the cost of delaying de-risking activities Investment strategy review In a phased approach to de-risking, an investment strategy review is typically one of the first steps taken by pension schemes. When reviewing investment strategy the scheme needs to balance the long term investment strategy vs. potential shorter term transactional requirements. For instance, obtaining advice on portfolio structures that can more easily be transferred to an insurer prior to a Buy-in or Buyout may be valuable. Investment consultants can assist schemes to put in place an investment strategy that helps to ensure that scheme assets are structured to closely mirror Buyout pricing, for example by moving to less risky investments. This way of de-risking would stabilise the funding level and also assist with an in-specie asset transfer as part of a partial or full payment of the agreed premium for risk transfer. This can potentially reduce the net cost of Buy-in or Buyout Legal considerations A trustee s role is to act prudently and responsibly whilst operating the scheme in accordance with the scheme rules. Trustees must at all times ensure they look after the best interests of their members. While there are many areas of consideration, ultimately the role comes down to protecting the benefit promises made to the scheme beneficiaries. That is why it is important that the trustees are knowledgeable about all the features outlined in their scheme s documents. Before Buy-in or Buyout, the trustees should be able to demonstrate that they have the power to complete the transaction and take legal advice on any restrictions under the Trust Deed and rules of the scheme or under pension legislation. The trustees should also review the specific benefits that are to be secured. Where the benefit structure is complex, for example with different rates of annual pension increases due to changes over time, the trustees should determine if this contractual arrangement needs to be replicated or whether there are alternative solutions that could be considered.
13 ABI GOOD PRACTICE GUIDE 13 Trustees should note that the current uncertainty surrounding the Government s change in policy on the inflation measure from RPI to CPI will have some impact on investment strategy and de-risking. While RPI hedging is commonplace, there is no market yet in CPI linked instruments. In the meantime, trustees may wish to ensure that Buy-in contracts entered into have the flexibility to be restructured for CPI in future and any cost savings returned to the policyholder. The DWP issued a Consultation document on the change from RPI to CPI in December 2010, so there is less uncertainty now than there was, but still trustees will have to await final legislation before definitive answers can be given. It is particularly important to consider benefit features which are specifically at the trustees discretion. The insurer will not usually take on any discretionary powers so a decision is needed as to whether to secure the discretionary benefits as an entitlement (for example paid for in the premium) or to stop the discretionary benefit entirely. Ideally, the approach to discretionary decisions should be determined at the start of the Buy-in/Buyout process with details of these features to be agreed as early as possible during the set-up phase and then accurately implemented in a timely fashion. The trustees will also need to consider whether there are any aspects of their pension scheme or de-risking activity that would necessitate special requirements. For instance, in the case of a Buy-in, although insurers are required by regulation to hold prudent reserves and additional capital to back their guarantees, the scheme may desire additional security where significant liabilities are secured under a standalone insurance policy. (See section 4.3 for further discussion of collateralisation.) Where a Buyout relates to only one particular subset of the scheme (partial Buyout), trustees will need to consider the impact this may have on remaining members who will not transfer to the insurer. Two main points should be considered here: Protection offered by the insurer will usually provide more security vs. protection offered by the residual assets left in the trust. Cost of securing the insurance may outstrip the relevant member s fair share of the assets of the scheme. One way to address this perceived inequity is to establish that there is a sufficiently strong employer to back the remaining pension promise, as well as asking the employer to pay part of the premium so that only a fair share of the scheme s assets are used. In the event of a weak employer covenant, it is important to ensure that non-insured members do not lose out.
14 14 ABI GOOD PRACTICE GUIDE Feasibility provides the opportunity to design and test a solution and ensure the support of all stakeholders before incurring significant expense Feasibility Buyout exercises can be derailed because of failure to set out a process and lack of understanding. A feasibility study at the outset helps to ensure that valuable time and resources are not wasted. Establishing that buyout is the right solution and understanding how the process will run leads to no surprises and gives greater confidence in the decision to proceed. Trustees will usually engage an adviser with the necessary skills and experience to help with feasibility. Having completed a feasibility study, trustees will find insurers more willing to be involved in the quotation process. It is important that the trustees consider the pros and cons of the de-risking options available so that the decision to buy out is right for the scheme and, once made, focus can be on getting the right deal at the right time. There are several variations of buyout solution and trustees should work with their adviser to explore options to fit objectives and budget. Feasibility provides the opportunity to design and test a solution and ensure the support of all stakeholders before incurring significant expense. Finally, a feasibility study allows trustees to consider their budget for the Buyout exercise, including adviser costs and management time, as well as the potential premium for the policy. This means trustees can fairly accurately assess the affordability of buyout and structure the exercise to suit the size and financial circumstances of the scheme and will be in a position to make a decision in principle to proceed with Buyout.
15 ABI GOOD PRACTICE GUIDE Approach Once the decision in principle is made to proceed with buyout, the trustees should agree the approach they will take. Trustees should also set out the objective criteria on which they will base their decision on the preferred provider. Trustees should take advice on the current state of the market and the providers, and consider which insurers are likely to have the capacity and expertise to deliver the best solution when needed. A budget for the exercise should be set out and monitored. This should include the time expected of trustees and scheme advisers as well as the likely overall time to conclude a deal. Roles and responsibilities should also be set out including, for example, who can make decisions and how the final decision on preferred provider will be made. Once affordability has been determined and a decision in principle is made to proceed with buyout, the trustees should agree the approach they will take. This will include whether a full market review will be needed or if a more focused exercise is appropriate to the circumstances. For example, will there be an auction approach based on an initial level playing field for all providers or will trustees seek a bespoke solution to fit their needs? In the latter, a smaller number of providers will be involved and perhaps only one for an innovative solution. Trustees should also set out the criteria on which they will base their decision on preferred provider, as this ensures the exercise remains focused on factors important to the stakeholders and the exercise will be more efficient and robust. It is important than these factors are adequately considered in advance to ensure that the questions asked of providers are appropriate from the outset. It is also helpful to ensure providers are aware of the important factors in the selection and that the criteria do not change as the exercise proceeds. The most common criteria for selection are: Price Structure of offer Ability and flexibility to deal with scheme benefits Financial security of provider Flexibility and efficiency in asset transfer Execution and transition capability Service to members Administration capability and track record Contract/policy conditions
16 16 ABI GOOD PRACTICE GUIDE Some criteria may be more important than others, for example, price may be by far the most important and trustees may wish to weight factors accordingly. In this planning stage, the trustees should take advice on the current state of the market and the providers, and consider which insurers are likely to have the capacity and expertise to deliver the best solution when needed. The likely timescales should be set out, especially where timing will impact on asset valuations, annuity pricing and resource availability. It is important that the subcommittee is able to demonstrate to insurers that a structured timetable is in place for the process. This allows insurers to plan resource appropriately and shows that the trustees are seriously considering de-risking. Wherever possible, timing should be set to take account of major scheme exercises like a valuation or change of advisers or suppliers. The buyout adviser can help with project planning and management, unless one of the trustees has particular expertise. As it is very easy to spend a lot of valuable scheme monies on large exercises, a realistic budget for the exercise should be set, agreed by all and monitored by the trustees. This should include the time expected of trustees and scheme advisers as well as the likely overall time to conclude a deal. Roles and responsibilities should also be set out, for example, who can make decisions and how will the final decision on preferred provider be made? If a full trustee meeting will be needed, it should be arranged well in advance.
17 ABI GOOD PRACTICE GUIDE Request for Proposal Once the approach has been decided, the next step is to prepare a request for a bespoke proposal. Typically you might approach 3 to 5 insurers at this stage for an initial quote. Details of the data needed by the insurers can be found at Pensions_and_Insurance_Data_Requirements_a83.aspx Quotations will be more easily comparable if the data provided is as complete as possible and all insurers are asked to use the same key dates and assumptions in their calculations. Complex benefit requirements can be simplified at this stage, though you would want to check that each insurer could cater for the more complex benefit structure if they were successful. Typically the timescale for an initial quotation is 3-4 weeks, with a more accurate quotation taking up to 8 weeks. The next step is to commence work to prepare a request for a proposal or quotation. It would be typical to approach 3 to 5 insurers at the initial quote stage. The insurer will require information and scheme data in order to produce the quotation as, even at this stage, the quotation is bespoke to the scheme. These requirements can be lengthy and complex and are comprehensively covered in the ABI Defined Benefit Pensions and Insurance: Data Requirements document: and_insurance_data_requirements_a83.aspx If information provided is incomplete or unclear, insurers may make their own assumptions and quotations may, therefore, not be consistent between insurers. A good way of minimising the risk of each insurer making different assumptions is to record and circulate to every insurer any updates or amendments to the original information/specification provided. This should ensure that each insurer has a consistent set of information to use. Trustees should ensure that Data Protection Act 1998 requirements are covered when using identifiable member data for quotations. To help compare like for like, all insurers being asked to quote should be asked to use the same key dates in their calculations (e.g. market conditions date, premium payment date, risk transfer date). It is also good practice to specify any key assumptions you want them to make on missing data elements.