Bulk annuities are insurance contracts which replicate the future liabilities of a Final Salary pension scheme to help ensure there is no material difference to individual members. Annuities are investment vehicles which can replicate the cash flows to match a Final Salary Pension Scheme's benefits for active, contingent, and deferred members. Bulk annuities can be structured to pay benefits at the levels contained within the Scheme rules, regardless of what happens to interest rates, price inflation (RPI and CPI), investment returns, future reinvestment rates, and longevity. The ability of bulk annuities to mirror the ceding Final Salary pension scheme allows the trustees to take all reasonable actions available to it to maximise the likelihood that the right plan benefits are paid to the correct individuals, on time and usually for life.
The application of bulk annuities provides a recognised route, supported by UK legislation, for trustees and sponsoring employers to transfer responsibility for payment of the plan's benefits to the insurer issuing the annuity. All links between the members and sponsor and trustees are replaced with an insurance policy and the product providers issuing bulk annuities are required to hold capital to support the insurance policy.
Bulk annuities facilitate the application of Defined Contribution (DC) solutions to Defined Benefit (DB) schemes by annuitisation and this increases the choices of the structure of the benefits payable to members, giving them more options and flexibility in how to structure their pension payments. This straddling of DB and DC worlds has seen an application of innovative advances made in the DC world to Bulk Buy Ins. Of particular note is the rise of medically enhanced solutions, which bears a direct correlation to the growth of impaired life annuities in terms of the increased range of qualifying conditions and the improved generosity in offered rates. Specialist providers of impaired life annuities, such as Just Retirement and Partnership Assurance are active within the Bulk Buy in and out markets and offer to medically underwrite members of DB schemes. Given the recent decline in sales of Compulsory Purchase Annuities, this frees up capacity for impaired life annuity writers to offer Bulk Annuities.
The bulk annuity market consists of two very different ways of using annuities to transfer risk and insure pensioners' income streams throughout their retirement: "buy-ins" and "buy-outs".
Bulk Buy out
A "buy-out", as the name suggests, involves an employer securing members' accrued benefits through the purchase of a bulk annuity contract. The insurer takes on the liabilities of the pension scheme from the trustees and has direct responsibility for ensuring that members' benefits get paid. This transaction safeguards the benefits of the member, while removing the liability of providing those benefits from the employer.
Members of schemes which have used a bulk annuity buy out are provided with individual annuity contracts and these remove the scheme's liability to pay pensions. Deferred annuity policies can be issued for those members who have yet to reach retirement age.
Bulk Buy in
Bulk annuity "buy in's" are similar to "buy-outs", where an insurance company takes on the financial responsibility of meeting the costs of providing the scheme's pension promise as it hedges pensioners' income streams in relation to interest rates, inflation and longevity risks. The buy in contract is held as an asset of the scheme and entitlements such as income and spouses' benefits already written into the scheme rules remain unchanged. The pensioners remain a member of the pension scheme and the connection between corporate sponsor, trustee and member remains.
Often bulk buy-ins are performed piecemeal where phases of de-risking are undertaken in a series of transactions involving targeted cohorts of pensioners, rather than the entire pensioner section. This phasing of on-going de-risking has meant bulk buy-in's are often a precursor in the transition to a full bulk buy-out and may be one strategy of a raft of de-risking solutions.
Longevity swaps are contracts with a counterparty where fixed cashflows based on projected scheme mortality rates are swapped for cashflows based on realised mortality rates based on either other named schemes or a wider sample, removing or reducing longevity risk. This replication of cashflow enables schemes to hedge the risk of longevity without the capital required for a bulk buy-out or bulk buy in. Longevity swaps tend to be placed with the larger re-insurers such as Munich Re, Swiss Re and SCOR Global.
Advantages and Disadvantages of Bulk Annuities
- Other investment products and strategies can offer good approximations, but only annuities match a plan's exact benefit payments as and when they are due and for the life of the insured individuals, regardless of when or how they take their benefits.
- The strength of the statutory reserves which have to be held by the issuers of bulk annuities offer policyholders a financial covenant which is often more solvent than the covenant underpinning many Final Salary pension schemes. This is because the solvency rules for insurers are much more rigorous than for Final Salary Pension Schemes which are allowed to continue to hold deficits.
- Using bulk annuities provides an employer with a "clean break" from its Defined Benefits Scheme obligations. The purchase price includes all future member administration services allowing for the complete de-coupling of a company with its Final Salary Pension liabilities.
- Sponsoring employers can minimise the risk of unexpected calls for additional contributions to their Defined Benefits Scheme and so minimise the risk of generating an adverse accounting impact.
- Bulk annuities can be prohibitively expensive, costing more than the market value of a Final Salary pension scheme's existing assets. To some extent we can help mitigate these costs by identifying "trigger points" when a bulk annuity may represent good value if crystallised when both equities and medium dated gilt yields resent value.
- The market for bulk annuities is smaller than for open market annuities, available for individuals. Presently there are six or seven providers but this number is likely to grow as suppliers of individual annuity contracts look for new markets in light of legislative changes which are freeing up capacity for bulk annuities.
- A legal contract must be written and agreed prior to proceeding. This can delay the process and adds an additional layer of complexity and cost.
Protection for members
After a bulk annuity purchase, the security of the income is dependent on the solvency of the annuity provider but is guaranteed by the Government. Often this represents improved protection from a DB member of a scheme in deficit, particularly where the covenant strength of the employer is weak. Sharing covenant risk with an insurer through a de-risking exercise can often put members in a better position than relying on the solvency of the corporate sponsor.
Additional protection is offered to annuity holders who have had their benefits bought in or out through a bulk annuity in the form of statutory protection from the Financial Services Compensation Scheme which guarantees benefits at 90% if the insurer's financial solvency falls below strict minimum standards. This 90% guarantee is without limits and includes the value of annuity options added, such as the level of spouse's benefits, indexation and guaranteed periods. Before the Financial Services Compensation Scheme protection is applied, should an annuity provider fall below prescribed solvency margins, the book of business can be transferred to another insurer so that policyholders continue to be paid in full. We saw an example of this with the transfer of the Equitable Life's non With Profits Annuity book being transferred to the Prudential.