Time to buy in to buyouts?

Could staged buyouts be the missing link in the pensions endgame, asks Alan Collins, head of employer advisory services at Spence & Partners

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The landscape of private sector pension provision has changed forever. The experiment with defined benefit pension schemes has failed and those schemes that are still open are heading for almost inevitable closure.

Once a scheme is closed, an employer can no longer derive any benefit from the scheme in terms of staff recruitment and retention. The scheme is simply a millstone round its neck – all risk and no reward. The longer a closed scheme is left to fester, the bigger a frustration it becomes. The level of attachment between the scheme and current staff decreases, but the expenses and time required to manage the scheme remain significant.

The number one aim of the employer is therefore to extinguish its liability to the scheme as soon as possible. Experience shows that year after year, more and more money seems to be poured into the scheme to try and achieve this aim. But yet, the funding level has a nasty habit of reverting to square one.

Legislation rightly forces employers to face up to their obligations. So, how does an employer rid itself of its pension scheme?

The process of addressing the exposure of sponsoring employers to the risks of pension scheme liabilities has evolved greatly over the last 10 years, with the increased prevalence of scheme closures, liability driven investments and liability management exercises. These developments have one common flaw – they reduce the risk, they don’t remove it.

For almost all closed defined benefit pension schemes, the only realistic method of fully extinguishing the employer’s liability to the scheme is to secure members’ benefits with an insurance company and wind up the scheme. This solution is seen as costly and most schemes do not have sufficient assets to secure benefits at this time. Indeed, even schemes which have targeted full buyout in the past have had their hopes dashed by market movements and changing insurance prices – while it is admirable and sensible to set a flight-path to buyout, it becomes very difficult if someone else keeps moving the airport.

So is there no immediate solution? For once, there seems to be light at the end of the tunnel and it’s not a train coming in the opposite direction. The solution is staged buyout, and I firmly believe this will be the single biggest development in pension scheme de-risking over the coming years.

For once, there seems to be light at the end of the tunnel and it’s not a train coming in the opposite direction

The premise of staged buyouts is that the full premium to secure the benefits is not required up front. However, the financial terms are fixed immediately. The full buyout is then achieved over a number of years.

By extending the period of the buyout, the employer is able to reach agreement with the insurer over the payment of the outstanding premium.

his agreement is effectively analogous to the scheme’s schedule of contributions, the exception being that, if the payments are made, the flight-path is complete – no-one can move the airport. The risk to the sponsor is fully transferred to the insurer. It is worth noting here that other insurance arrangements such as “buy-ins” would fall back on the sponsor if the insurer defaults.

Staged buyouts also offer the flexibility for the employer to operate liability management exercises such as incentivised transfer exercises or pension increase swap exercises and benefit from the resulting cost savings. This option is not currently available in the traditional buyout market, where at present the insurer would benefit from members transferring after the policy terms are agreed.

The longer time horizon also allows the trustees and employers to retain a risk seeking element to their investment portfolio. If the scheme is able to achieve investment out-performance over the staging period, then the ultimate cost of buyout will be further reduced. This would only be a realistic strategy where the employer was strong enough to stand behind any additional costs if the investments performed less well.

The idea behind staged buyout is not just a theory. In September 2010, timber merchant Arnold Laver addressed its £43m pension scheme liabilities by undertaking a staged buyout with Pension Insurance Corporation. Other insurers are developing similar products.

I believe that all scheme stakeholders – trustees, advisers and sponsors – should be seriously considering staged buyout. It must be a viable option for well funded schemes or for those with a very strong sponsor. And for those who believe full buyout is a pipe-dream, staged buyout may not be.