The Great Debate UK

- Richard Jones is principal at Punter Southall Transaction Services. The opinions expressed are his own. -

A bulk annuity buy-out is an insurance contract which allows a defined benefit pension scheme sponsor and its trustees to absolve themselves of their responsibilities in regard of the accrued liabilities to members.

During 2005 and 2006, the buy-out market saw new mono-line insurance providers challenge the more established and diversified market players such as the Prudential and Legal and General. Despite the attractiveness of certain aspects of this insurance product, the premium required makes buy-out too expensive for many pension schemes.

Successive government statutes establishing stricter regulation, more transparent accounting disclosures and substantial movements in asset markets have made defined benefit pension schemes an increasingly unwieldy and frightening animal for companies to manage on their balance sheet. Buy-out provides a means to remove this risk: reducing the likely volatility of contributions and the exposure to longevity and investment risk.

Further benefits from a company’s perspective are that insurance companies may potentially have more efficient administration systems, and lower investment transaction costs due to large aggregate fund sizes. From the member’s perspective, the credit rating of an insurance company and the stringent oversight by the FSA may provide a better guarantee of benefit promises being met, than had they continued to be sponsored by their employer.

However, the transfer of pensions risk to an insurer is expensive. An insurance company faces the very same risks as a sponsoring employer of a pension scheme, but is encumbered by additional regulatory constraints associated with operating within an insurance regime and the obligation to make a profit. As a result the cost of purchasing annuities has historically been prohibitively expensive to most.

To generate interest in the market some of the new participants priced aggressively. Legal and General continued to compete, whereas some of the other players such as Lucida, Rothesay Life and Prudential appeared to cherry pick deals. This led to deal volumes rising to 2.9 billion pounds in 2007 and 8 billion pounds in 2008.

As the difficult economic climate  subjected insurers to increased reserving costs, companies became more precious with their cash and pension scheme funding positions often weakened significantly, coinciding with the removal of these discounts. The decline of sell and demand side appetite has caused the volume of transactions to fall significantly to 2.1 billion pounds over the year to date.

Prices have reverted closer to their historical average. Taking into account costs associated with insurance reserve and a profit loading, our research would suggest that 84 percent of the time it is not worthwhile for annuity contracts to be purchased.

This is re-enforced by the number of increasingly sophisticated and cost effective mechanisms for controlling the risks of a pension scheme. For instance, instruments can now be purchased to manage inflation and interest rate risk and there is a nascent market in transferring mortality risk, which this year has seen transactions occur with Goldman Sachs and Credit Suisse. Meanwhile a number of measures can be used to reduce the scheme size, such as member choice exercises, as recently offered by ITV.

Whilst each scheme is different and subject to its own specific circumstances, the buy-out market of the future is unlikely to see the activity witnessed in recent years. The most price-aggressive new entrants may well have written business at uneconomic levels, making future rounds of fundraising more difficult. Further, under realistic pricing buy-out remains too expensive when compared with the growing number of more flexible, better value money measures.