There are two different regulatory regimes pre and post buyout. Ongoing schemes fall under the ambit of the Pensions Regulator and the sponsor covenant applies, with eligibility for the fully funded Pension Protection Fund compensation if the sponsor fails.
If the trustees have done a bulk annuity transaction, it is the insurer’s covenant that matters, which is overseen by the Prudential Regulation Authority. In the event of insurer failure, the unfunded Financial Services Compensation Scheme is the members’ lifeboat.
How leaky a boat the FSCS is a matter of conjecture. The scheme promises that if a pension provider fails, it will provide 100 per cent compensation with no upper limit.
I accept they are heavily regulated, but to me that’s a lot of eggs in only a few baskets. Everyone hopes the PRA are doing their job as they do and the ball doesn’t get dropped
However, it is financed by an annual levy and is set to receive £833m in 2021-22, a minuscule amount when compared with the trillions of pension liabilities in the UK.
Additionally, it has never been tested for annuity business, although it paid out on the failures of retail banks such as Bradford & Bingley.
Duncan Buchanan, partner at Hogan Lovells, explains that he and his colleagues work “on the basis that the PRA has a very strict and prudent approach to solvency levels, which is great news and gives trustees a lot of comfort when they are entering into a buy-in”.
“When I advise pension trustees because of the PRA’s strict solvency requirements, coupled with the existence of the FSCS, trustees of occupational schemes consider that they are moving to a more secure environment,” he says.
However, despite considering that the “PRA regulation is tougher than the TPR regime”, Buchanan questions whether the FSCS would be able to cope with the default of a buy-in/buyout provider.
“The FSCS is funded by an annual levy, which may well not be sufficient to meet a major claim,” he says.
“In the past, for very large transactions we used to see early termination rights or collateral set aside as security. Such arrangements are not common today and are only really an option for the very largest transactions.”
A ‘lot of eggs in only a few baskets’
Buchanan notes, however, that this is “a macroeconomic issue rather than a legal issue, but we are seeing this significant shift of occupational schemes to a relatively small number of insurers”.
“I accept they are heavily regulated, but to me that’s a lot of eggs in only a few baskets. Everyone hopes the PRA are doing their job as they do and the ball doesn’t get dropped,” he says.
The Bank of England and the PRA declined to comment on this matter. However, Pensions Expert understands that insurance buyouts of pension liabilities benefit from a very high degree of policyholder protection.
UK insurers are subject to robust, risk-based prudential regulation with a capital buffer able to absorb losses with confidence of 99.5 per cent over one year.
This is in addition to having not just enough assets to meet the expected cost of pension liabilities, but enough to cover also an estimate of the price an insurer would have to pay to get another insurer to take on those pension liabilities, which includes a risk premium on top of the expected cost.
In relation to the FSCS, a spokesperson at the lifeboat says that it is “prepared to step in and protect consumers if a large insurance company goes into default”.
“We forecast claims volumes by monitoring trends in the industry and using data from a variety of sources, including the Financial Conduct Authority, the PRA and the Financial Ombudsman Service,” the spokesperson explains.
“The assumptions are reviewed monthly and, as such, may change across the year when, for instance, a large failure or unforeseen event occurs. In 2020-21, for example, we saw significant changes following the original budget with higher-than-expected London Capital & Finance claims.
“While the year ahead is highly unpredictable, we continue to monitor closely our claims forecasts and provide regular updates to the industry.”
Despite the notorious collapse of Equitable Life, which closed to new business in 2000, Tiziana Perrella, professional trustee at Dalriada Trustees, notes that “no individuals with benefits backed by a (non-profit) individual or bulk annuity issued by a UK insurer have ever seen their benefits reduced or stopped”.
She says: “This is against quite volatile and adverse conditions over the past 15 years. Of course, nobody can predict the future, but I think this is good evidence that the prudential regulatory regime insurers operate under is fit for purpose and can generally be relied on.”
Concerns over offshore reinsurers
Other specialists, however, have concerns over the increasing numbers of transactions, which leaves consumers’ pensions ultimately reinsured in offshore territories such as Bermuda.
Steven McEwan, partner at Hogan Lovells, explains that these “are supported by carefully negotiated security arrangements that protect the UK insurer against the insolvency risk of the reinsurer”.
“Moreover, the UK insurer remains fully responsible for paying benefits, irrespective of any default by the reinsurer. Therefore, so long as the insurer’s overall reliance on reinsurance remains at prudent levels, this will not represent an inappropriate risk for UK pension schemes,” he says.
Yet Rosie Fantom, partner and bulk annuity consultant at Barnett Waddingham, believes that “there are certain aspects of detail within the insurance regulatory environment that are widely acknowledged as being ripe for adjustment to better drive appropriate behaviours from providers”.
For example, Sam Woods, deputy governor for prudential regulation of the Bank of England and chief executive of the PRA, commented in March that “the risk margin is not correctly calibrated, resulting in levels of offshore reinsurance of longevity risk in the provision of UK retirement income that will become increasingly uncomfortable over time if we take no action”.
For John Reeve, director at Cosan Consulting, reinsurance around the world is not a problem.
“It is a form of diversification, which improves security of benefits. However, as we have seen with a number of high-profile cases, it is the incestuous nature of some insurance markets that are the issue,” he says.
Over the next 10 to 15 years, the focus of pension risk policy will be how far innovative investment arrangements will be developed.
Half of all DB liabilities paid out or insured by 2030
Fully half of all UK defined benefit liabilities will either have been paid out to members or insured by the end of the decade, according to analysis by Mercer, as buy-in and buyout values topped £30bn in 2020.
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McEwan points out: “The more flexibility insurers and reinsurers are given for their investment arrangements, the lower will be the price for pension risk protection for pension schemes, resulting in higher members’ benefits.
“This will bring other social advantages because it will mean that long-term capital is deployed more widely, including supporting infrastructure development.”
He adds: “That brings with it some risk of losses that have not traditionally been of concern to the pensions and insurance industry, and against which insurers may currently not be as well placed to protect themselves as other financial markets participants.”
Yet Adam Davis, managing director of K3 Advisory, stresses that “doing a buyout with a UK-regulated insurer remains the ‘gold-plated’ security choice”.
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