Defined benefit longevity solutions
Common retirement framework
The UK retirement framework is a good example for the common features of retirement plans all over the world and therefore other countries retirement funds and life insurers tend to keep a close eye on developments in the UK retirement market and risk-mitigating products offered there.
Common features are:
- Prevalence of employer-provided retirement funds: historically retirement funds were mainly Defined Benefit funds whereas recent times have seen a significant shift towards Defined Contribution funds;
- Members of Defined Contribution funds can choose between a lump sum and the purchase of an annuity at retirement, with the choice of annuities, essentially, being:
– Guaranteed Annuities
– Income Drawdown/Lump Sums
– With Profit Annuities
Providers of guaranteed and with profit annuities are faced with the uncertainty of the longevity of the pool of lives insured and are thus exposed to the risk of these lives living longer than had been expected. The guaranteed annuity market has seen the development of enhanced/impaired annuities in the UK, where the monthly benefit is adjusted based on a combination of one or more factors such as the annuitant’s health status, smoker status, geographical location and occupation prior to retirement.
Defined Benefit funds
With the widespread switching to Defined Contribution funds, most Defined Benefit funds in the UK are closed to new members, however, there are still enormous liabilities sitting in these funds for current pensioners as well as members who have yet to reach retirement age.
There is significant pressure in the UK on employers to fund Defined Benefit liabilities and the need for employers to either reduce pension fund liabilities or bring more certainty to pension fund liabilities
Over the past 50 years life expectancy has increased by up to 10 years.
Various solutions have been developed in the UK to allow Defined Benefit schemes to transfer all or part of the longevity and investment risk from the Defined Benefit scheme to an insurer.
The need for solutions in the UK has been exacerbated by two trends that have increased the liabilities of Defined Benefit schemes:
1. increasing longevity (longer life expectancy than allowed for) and
2. lower investment yields from bonds and equities
These trends have been placing strain on employers to meet projected liabilities, but more importantly, they also highlight the risk to Defined Benefit schemes of further future mortality improvements and/or reductions in investment yields. Thus the products available to Defined Benefit schemes in the UK to mitigate longevity and investment risk have seen considerable growth. The complete transfer of risk from a Defined Benefit scheme is generally called a pension buy-out. The graph below shows the improvement in life expectancy in the UK for males and females from 1960 to 2010.1
In this transaction an insurer takes over the responsibility for the payment of all pension benefits to the members of the Defined Benefit scheme. All liability is thus transferred to the insurer along with the assets to meet the expected liabilities, plus a margin for the insurer. No liability remains in the Defined Benefit scheme and the scheme can be wound up, with the potential return of any surplus to the employer. The relationship following this transaction is between the insurer and the members of the Defined Benefit scheme and an advantage for members is that the insurer is required to hold defined surplus assets, potentially providing better security than the Defined Benefit scheme. Another similar solution is the pension buy-in.
The main difference is that the Defined Benefit scheme is not wound up; rather the members of the scheme retain their relationship with the scheme. The trustees buy a policy from an insurer that provides the pension benefits promised to members. The value of the liabilities plus a margin is transferred to the insurer, which pays the defined pension benefits to the trustees of the scheme for distribution to the members (unlike a pension buy-out where the insurer pays the defined pension benefits directly to the members). Similarly to a pension buy-out, the security of the benefits is enhanced through the excess assets the insurer is required to keep.
A third option available to Defined Benefit schemes that only want to transfer longevity risk, but not investment yield risk, is the regular premium annuity treaty. This is described in more detail in the next section.
According to the 2018 LCP Pensions Buyout report, nearly GBP 150 billion of pension buy-outs/buy-ins and longevity swaps (including regular premium annuity treaties) have been written since 20072. In 2015 volumes totalled GBP 21.7 billion (down from GBP 35.1 billion in 2014, this year was exceptional due to a GBP 16 billion longevity swap by British Telecom) including a GBP 2.4 billion regular premium annuity treaty concluded by the Philips UK Pension Fund, see case study.
Buy-ins remained the most common solution as schemes that are not fully funded struggle to transfer all liabilities to an insurer in a low yield environment, an environment which serves to increase the size of the scheme’s liabilities. The market nowadays provides a favourable environment for pension schemes wishing to offload this risk and they have a wider choice of longevity solutions at attractive terms. Unsurprisingly, the market in 2017 has seen risk transfer deals of GBP 18 billion, with pension buy-ins and buy-outs remaining the most popular product due to the relative affordability of this solution3.
The outlook for 2018 is quite optimistic, with the view that 2017 volumes can be reached or even excel these numbers. Still sufficient capacity is available in the market to back these deals. All of the above solutions provide Defined Benefit schemes (and the employers who fund them) with more certainty of the cost of the scheme, with the full pension buy-out providing 100% certainty of the cost. The demand from well-funded Defined Benefit schemes for these products is mainly driven by this crystallisation of the cost of the scheme for the employer.
The various risk transfer options available to Defined Benefit schemes have generated significant business volumes.
Imprint Disclaimer Data privacy
If you need further information or would like to send us feedback, please feel free to get in touch.