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The Actuary The magazine of the Institute & Faculty of Actuaries

Affordable buyouts

Abuyout is the transfer of the liability
from a private defined benefit
pension fund to an insurance
company. The liability is to pay
each member a defined pension from the date
of retirement to the date of death. The insurance
company is taking on an unlimited liability,
the main risks underlying which are:
°ª the members and/or dependants live longer
than expected;
°ª inflation is higher than expected;
°ª the assets backing the liabilities underperform;
°ª assets cannot be reinvested at assumed
The same risks are borne by the pension
fund. But whereas insurers have to have sufficient
capital to meet their liabilities even in
extreme scenarios, the funding requirements
for pension schemes are not nearly so strict.
Importantly, this capital has to be in the
insurance company on day one. Unlike
pension funds the insurer cannot rely on the
parent company making this capital available
in the future. Figure 1 illustrates what this
means in practice. For simplicity, it looks only
at pensions in payment and assumes that the
individual capital assessment (ie Pillar II) bites
for the insurer. Deferred pensions are more
The example demonstrates the highly secure
nature of a traditional buyout and the unlimited
cover that it provides. £643m of capital is
being held against a £500m FRS17 estimate.
This is the reason a buyout appears expensive.
Many have been sceptical of the price
charged for a full traditional buyout. There has
been limited competition and this has led to
claims that insurers are loading in an excessive
profit margin and this is the main explanation
for the perceived high cost of a buyout. The
several recent entrants to the market will mean
that a competitive market will be created and
a ‘market price’ for buyouts will be established.
No doubt prices may fall a little but not significantly
the economics of a buyout do not
allow this. Instead, the pension fund industry
will have greater confidence that the buyout
prices reflect the fair market price for the risk
being transferred and therefore the true value
of a fully secured pension promise. Even if a
full buyout is unaffordable, a market price for
one establishes a benchmark against which to
judge alternative ‘cheaper’ solutions.
While different insurers may charge slightly
different amounts for the same cover, the
important question that a pension fund should
ask is whether it is buying too much ‘cover’.
The value of a member’s pension benefits is
made up of two components:
°ª the amount of the benefits promised;
°ª the likelihood that these benefits will be
paid in full.
A traditional buyout does not change (a) but
it often significantly increases (b) especially if
the size of the pension fund is large relative to
the size of the company itself. Through a buyout,
trustees are providing increased certainty
for their members and this is expensive.
Cheaper alternatives?
Pension funds can disaggregate the risk within
the fund and take a view as to which slice of
risk they wish to insure and which slice they
are prepared to retain. Insurers, equally, will
start to offer more innovative solutions which
are tailored to the circumstances of the pension
fund and the risk appetite of its
trustees, members and sponsoring
For example, let us assume that
trustees take the view that the sponsoring
employer will not be able to
meet its obligations to the fund in the
event that life expectancy exceeds a
certain limit or that assets underperform
beyond a certain level. Members
will have the protection of the
Pension Protection Fund (PPF) but
benefits will be restricted. There may
be buyout solutions that guarantee full
benefits except in agreed adverse scenarios
under which some risks pass
back to the employer, the fund or the
The example in figure 1 illustrates
how this might work. The permutations
are endless but the concept is simple.
Different stakeholders in pension
schemes will have different appetites
for the various risks borne by the fund.
For example, trustees may take the
view that in the event that mortality
improvements exceed long cohort levels
and corporate bond defaults exceed
extreme expectations, the pension
fund is likely to face serious financial
distress and the sponsoring employer
is unlikely to be able to bridge the
increasing gap. The trustees may therefore
take the view that it is better to
insure or buy out the full benefits of the
scheme up to agreed affordable limits
rather than retain all the risk.
Many hurdles will need to be overcome
to implement these new structures
the legal mechanisms, the
nature of the insurance contract, the
interaction with the PPF, the rights of
members, etc. But in an environment
where so many companies are looking
for affordable bespoke buyout solutions
for their legacy pension funds
innovation will flourish.