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The Actuary The magazine of the Institute & Faculty of Actuaries

Markets, pensions, and afternoon tea

Over the past few years, members of the profes-
sion have thought deeply about how to
value a member’s defined benefit pension rights for the purpose of taking transfer values into or out of a scheme. Recent discussion has focused more on ‘mark to market’ approaches and requires that we determine a proxy for the market worth of a pension benefit.
But suppose instead that it were possible to buy and sell occupational pension rights in the same way that traders buy and sell commodities such as, say, tea. Instead of actuaries telling members the market worth of their pension, each member could find out the market price in the same way that they find out the market value of their other assets by putting them up for sale. In principle this should be possible. Even if it proves impossible to establish an actual market in pensions, it may be instructive to consider how it would operate and how pension rights would be priced.
That is what this article is about. Please don’t write to me to tell me how unworkable the proposed framework is it is set out to provoke thought and to illustrate principles, not as a fully developed and workable solution to the transfer problem!

An example
Consider another circumstance where the role of actuaries in determining prices has been circumvented by the development of a traded market: the market for second-hand or traded endowment policies. If I don’t like the surrender value quoted by my insurer for my endowment policy, then I can put the policy up for auction. Although the market is limited, it can and does add value for policyholders. And policyholders have the satisfaction of knowing that the price they get for their endowment is a fair market price.

Trading pensions and trading tea
Could such a market exist for pensions? The obstacles are not trivial. Whereas I can sell my endowment policy or my shipment of tea for cash, such a transaction would be illegal for a pension benefit current Inland Revenue rules prevent me from assigning pension rights to a third party. The only way I can exchange those pension rights for cash is to keep that cash in another pension vehicle by transfer out from my scheme to another (defined contribution) scheme.
If there were to be a traded market in pension rights then it might require three steps, as follows.

– Step 1 Make some TEA
Currently a pension must be paid for the life of the pensioner. Suppose the law were changed so that any scheme could, on request from a member, convert this actual benefit into an equivalent deferred annuity payable, say, from 1 January in the year he or she reaches age 65. The annuity would be either level or RPI-linked, but payments would decline each year in a predetermined way at rate representing qx for the appropriate age as determined on a standard year of birth-type table. The point is that the benefit is then (a) standard and (b) independent of the members’ circumstances or life expectancy. Let us call this benefit the traded equivalent annuity (TEA). For example, instead of a level annuity of £1,000 per annum payable until the member’s own death, the TEA benefit would be an annuity of £1,000 falling to £994 after one year, to £945 after five years, to £847 after 10 years, and so on down to £1 at age 107.
We could hypothesise also that the payout from all TEAs from all schemes would be subject to the same simple and standardised payment rules. Schemes could do a calculation to determine the equivalent value of the TEA based on the scheme rules and the member’s status. But this part of the conversion would not be particularly sensitive to the financial assumptions made for example interest rates or inflation (although there would still be a material decision to be made as to life expectancy). So the profession could mandate assumptions to achieve this conversion without anyone being too upset about it.
Since there is no link to that member’s circumstances, there is no moral hazard if the TEA then became payable to someone other than the member (ie no other party to the transaction has a financial interest in whether he or she lives or dies). Since all TEAs would have the same payout structure, there would be a reasonably homogeneous set of TEAs to trade in any market (TEAs would trade in tranches according to the year in which they started or will start to be in payment). These are necessary but not sufficient steps to getting to a market in pensions benefits. The next required step would be to set up a structure so that the parties could

– Step 2 Buy and sell some TEA in
Suppose also that such schemes could, at the member’s request, pay the payout from the TEA to someone other than the member himself. The law would require that member was responsible for finding someone (the buyer) to become the recipient of TEA payout. If the member could not find someone to do so, the TEA would stay in the scheme and, after say 12 months or on his or her prior death, be converted back into exactly the same benefit as before the conversion. If the member could find a buyer, he or she would also need to nominate a scheme to accept the payment from the buyer call it the member’s new scheme.
If the member found a buyer, then there would be four parties to this transaction: scheme, buyer, member, and member’s new scheme. Their roles in the transaction would be as follows:
– The member and the buyer agree the price of the TEA. The scheme has no say in this because it does not affect the scheme.
– The scheme becomes liable to pay the TEA proceeds to the buyer, not to the member (ie it still has the TEA liabilities on its books, just with a different payee).
– The buyer pays the price it has agreed with the member in cash to the member’s new scheme (or maybe to the scheme for onward transmission to the member’s new scheme the principle is the same either way).
– The member’s new scheme agrees with the member what benefits it will offer in return for the cash (probably based on the market price of its own TEA).
So, members get cash in their new scheme in exchange for giving up their rights in the scheme. From the member’s perspective this is just like a transfer, but at a market price. The scheme, meanwhile, has still got pretty much the same long-dated liabilities as it always had, albeit that it has avoided the member-specific longevity risk. If it wished to discharge that liability it would need to

– Step 3 Find a wholesale supplier of TEA
The scheme could of course buy out its liability, by getting someone else (the buy-out institution) to honour its TEA obligations. It might do this in bulk. The group of buy-out institutions enabled to do this would be much wider than the group of insurance companies in the bulk annuity market (since there is now no insurance element to the payout from the TEA) so it could include commercial banks, for example. It would be for the scheme to find a buy-out institution to take on its liability and agree with the buyer that the buy-out institution was of equivalent credit standing to the scheme itself.

What is the price of TEA?
What would any potential buyer bid for such a TEA? It would depend on the underlying payouts from the TEA and also the security attaching to them. So the bidder would put a value on the components of the underlying payout. The bidder may decide that the part (if any) of the TEA which is protected by the Pension Protection Fund (PPF) should be AAA-rated and could value the rest as, say, BBB, or plain junk. But that would be a decision for the bidder. My assessment of PPF security, for example, might be a lot less than AAA! And my assessment of the security attaching to non-PPF benefits might well vary according to things other than the asset backing for the promise (ie the funding level) for example investment strategy and the detailed scheme rules on contribution rates.
Who would buy all this TEA?
Some organisations might find TEA to be very useful. An institution such as a life insurer could accumulate TEAs from a variety of schemes to give them a diversified asset-backed investment. This might be an attractive asset to hold when taking on, say, deferred annuity business. The asset would have credit risk attaching to it, but so do the corporate bonds they often already hold to back their annuity liabilities.
Retail TEA funds might also be established in the same way that there are retail funds of traded endowments. Private individuals could buy them for their SIPPs. So everyone could have a defined benefit pension scheme as long as they were prepared to pay the market price for one!

Would it work?
So the $64,000 question is: could this be made to work? There are obvious and major barriers:
– the fact that members cannot now legally assign their pension rights;
– the interaction with the PPF;
– the relatively small unit size of most pensions; and
– the huge complexity arising from the tax approval rules.
But it is worth thinking about these issues in order to get a better handle on what a market value of a defined pension promise would look like if it could be traded. It’s not as simple as the price of a shipment of tea, but the principles of market pricing are the same.