Small does not have to be expensive when it comes to longevity risk suggests Nigel Barlow, Partnership
The principle of longevity risk will, at some point, have been the bane of most readers’ lives; yet thousands of small defined benefit (DB) pension schemes, representing tens of thousands of members are unaware of ways to understand longevity better.
Many schemes are paying more because they are simply ignoring the scheme specific mortality risks of their members, resulting in higher costs for the scheme and, possibly, difficulties when de-risking the scheme.
The Purple Book indicates that schemes of fewer than 1,000 members have assets worth “just” £83bn, whereas those of over 1,000 have assets worth over £754bn.
Unsurprisingly, much more effort goes into monitoring and managing the longevity calculations of larger schemes than their smaller peers.
However, the size of the issue is far from inconsequential. In the UK there are 6,897 DB schemes of which 2,468 have 5–99 members, 3,132 have 100–999 members, 884 have between 1,000–4,999, 191 have 5,000–9,999 members and 222 have over 10,000 members. So, while the bulk of the assets sit in larger schemes, the rump of the “need” resides with smaller schemes.
As not understanding member mortality accurately for smaller schemes has been the norm, the question that has to be asked is “Why bother now?” For many schemes, it is their deficits.
According to actuaries at Xafinity, who measured deficits across the whole of the Purple Book, DB pensions had deficits of circa £450bn at the end of 2011. Although larger schemes will have the largest deficits, many employers with smaller schemes will have the greater need because they often face the most challenging business environment. For these, survival of the business ranks higher than the schemes defaulting to the Pension Protection Fund, which at the end of 2010/11 was responsible for supporting 335 schemes with assets of £9.2bn and liabilities of £10.5bn.
On the defined contribution (DC) side, the Pensions Regulator (TPR) has already stressed to trustees/employers that, by not offering appropriate guidance to members/employees regarding securing better retirement income, they are failing in their duty of care. But, while the argument for many DB schemes is equally compelling, few do anything about it.
Accepting that DB schemes are now a thing of the past, their continued performance still impacts around 12m current members. So the scheme sponsor and trustees’ priority remains de-risking and securing the best possible protection and income for their members.
De-risking strategies are well established for larger companies, but for smaller firms, with up to 300 pensioners, their options are fewer and more costly.
The buyout option, where liabilities are moved to an insurance company, is attractive, but daunting, as the scheme/employer has to meet the full buyout cost of the annuities, which can be considerably more expensive.
The buyin option involves purchase of a bulk standard annuity policy as an asset of the scheme. The sponsor retains responsibility for paying benefits, but has an asset to provide a matching income stream. Crucially, the option also allows for changing mortality expectations. Alternatively, the scheme could buy an annuity policy when a deferred member reaches retirement.
For smaller companies with less than £20m in liabilities the buyout and buyin options are unlikely to be viable financially, which is likely to be further worsened after 31 October 2012, when insurance firms in the EU will have to be Solvency II-compliant.
For smaller schemes, there is possibly one viable solution which is more traditionally associated with individual DC pensions: enhanced annuities – or “individual member buyouts/in.
The primary benefit to a smaller DB scheme is cost savings, which can be realised for up to half of retired members on a typical scheme, depending on its socio-demographic profile (see Box).
Introducing enhanced annuities can reduce the cost of buyout or buyin by making allowance for those with serious medical conditions or life shortening lifestyle factors, such as obesity and smoking. Using them instead of a standard annuity enables pensioner liabilities to be insured on an individual instead of a bulk basis, using member specific lifestyle and health information to secure the most competitive terms from annuity providers. It allows access to buyin for schemes that cannot afford standard policies.
In essence, gaining the lifestyle/medical information about members means the understanding of longevity can be improved and hence the associated risk is lower and can be cheaper.
This type of policy can guarantee existing pension benefits, but can be bought at a significantly lower cost for some members because a more accurate forecast is made of longevity risk across a scheme’s membership.
Even so, establishing the health status of retired members can be a challenge. Some are wary of the potential for invasive and complex underwriting. Our research with scheme members has shown that the way to deal with that is to cut the process to a minimum, using a short one page questionnaire requiring yes or no answers. Typically 80–90% of the questionnaires are returned with results indicating that over 50% of a scheme’s pensioner population qualify for enhanced annuities.
Enhanced de-risking is suited to schemes in industries/occupations typically associated with health problems or shortened life expectancy, such as some manufacturing, construction, brewing, printing, etc. Schemes where retired members form a disproportionate percentage of the overall liabilities can achieve substantial savings if these members qualify for enhanced annuities.
For instance, a recent scheme with 21 pensioners secured a traditional bulk buyout quote for £7.26m. Simplified individual underwriting was carried out on all members and 15 of them qualified as an enhanced/impaired life. The best standard rate quotes were obtained from the whole market for the remaining six members. Using this method, the combined cost was reduced by £1.02m or 14% on the original bulk buyout quote.
One of the traditional arguments against individual underwriting was the invasive nature of the health related questioning. But, from an actuarial and underwriting perspective, we believe that sufficient information can be gathered from ten simple questions, such as:
The other area that DB schemes are starting to show a lot of interest in is that of early retirement, or immediate vesting pension offers. An exercise like this can be carried out, for example, by utilising a pre-existing enhanced transfer value exercise but, instead of excluding older members, those deferred members aged 55+ can now be included.
Through the offer of a transfer value to buy an immediate annuity from an insurance company, the trustees can help pensioners procure an annuity that better suits their circumstances while removing a liability from the scheme.
A major success factor will be down to how many of the deferred scheme members can be qualified for an enhanced annuity and will therefore see a tangible benefit in taking up the offer. Typically, this can be 40% of members and over 50% if the spouse is included.
Advice is crucial to ensure members fully understand the alternatives on offer, but the issue of investment pre-retirement, a major cause of uncertainty, is removed in these cases, enabling a much clearer comparison.
Author: Nigel BarlowNigel Barlow is director of product development and marketing at Partnership; firstname.lastname@example.org