Greg Wenzerul finds ways to ensure your buy-in contract stands the test of time

In recent years many pension schemes have been able to de-risk tranches of pensioners up to the value of their gilt portfolio without any funding impact against the scheme’s technical provisions. The situation has arisen due to the high value of gilts when compared against the price of annuity buy-ins.

Such buy-ins, in tranches, are often chosen by trustees as part of their journey plan to a full buyout and ultimate goal of winding-up the pension scheme. A key question that can be overlooked is which tranche of members might best be de-risked first, for example the older pensioners or the younger pensioners or perhaps a random selection of all of the pensioners, or indeed a cross-section of all members including deferred members.

This article looks at the merits of choosing each tranche, and how choosing a specific tranche may help in the context of the overall goal of moving to a full buyout of the whole scheme, including deferred members, over a period of say 10 or perhaps 20 years.

Consideration of the scheme’s assets

The size of a tranche is often dictated by the choice of assets the trustees wish to use to fund the buy-in. More recently the size has often been determined by the scheme’s gilt portfolio, but with the recent gains in some equity markets the trustees may consider locking in some equity gains; clearly this is a decision for the trustees to make with their advisers. Once the availability/amount of assets has been decided the specific profile of members can be chosen e.g. youngest pensioners up to say age 70, or oldest pensioners down to say age 75.

The competitiveness of a specific tranche versus the scheme’s technical provisions

Typically a scheme will measure the attractiveness of different tranches by looking at the funding impact of de-risking a specific tranche against the scheme’s technical provisions. This is clearly important as if there is an adverse impact then the trustees may require the agreement from the sponsor for a cash-injection to maintain the funding position of the scheme.

Risk considerations and the journey plan

However, as well as assessing the price of a transaction versus technical provisions, the trustees could also view a specific tranche in the context of the risks being removed. If a specific tranche offers greater risk reduction to the scheme then that fact should not be ignored; and all too often a straight comparison against technical provisions does not readily take differing risk profiles of tranches into account. Some schemes have looked at risk adjusted technical provisions effects to help quantify such differences.

As a general rule, uncertainty increases with time, and so younger pensioners carry more longevity and investment (and re-investment) risks than older pensioners. Potential scientific break-throughs and general health improvements could increase life expectancy significantly beyond the longevity improvements built into the technical provisions basis, and the younger the pensioners the greater this uncertainty. On the investment side, the longer the liabilities the greater the opportunity for an unexpected event to occur (default or downgrade of assets being held) and the greater the reinvestment risk that could de-rail the scheme’s funding position, unless it is very well matched in very secure assets such as gilts.

A natural conclusion could be that a buy-in for deferred pensioners is the best risk reduction choice for trustees, however the market prices for deferred member buy-ins can seem very expensive, especially when comparing against underlying technical provisions which often use a higher discount rate than for pensioners. Younger pensioners would then appear to be the best option, with older pensioners the least attractive.

The journey plan to full buyout

A similar conclusion is seen when looking at the scheme’s de-risked position in say 10 years time or 20 years time; which should be an important consideration in the context of the scheme’s journey plan to buyout. A buy-in of younger pensioners will continue to be valuable in terms of overall de-risking position compared to a buy-in of much older pensioners (where many more of the pensioners would have died in 10 years time) i.e. a buy-in of younger pensioners arguably better stands the test of time. A buy-in for pensioners under age 70 could still be insuring circa 70 per cent of originally secured membership after 20 years, compared to only 25 per cent of the original pensioners for a buy-in of pensioners over age 70.

Summary

There are a number of considerations for trustees when entering into a buy-in outside just the effect on their technical provisions. In particular they should consider their journey plan to wind-up and also evaluate the risks actually being taken off the table.

Greg Wenzerul is head of defined benefit solutions at Prudential

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