How to determine the value to your scheme of a buy-in/buyout contract

In return for payment of an agreed premium, the insurer guarantees to pay pensions to specified members on a predetermined basis.

Bulk annuity contracts are usually written in two ways:

• Buy-in where the contract is between the scheme trustees and the insurance company, with the affected individuals remaining as scheme members

• Buyout where the contract is between each individual and the insurer, the individuals ceasing to be members

For both types of contract, how does the plan know whether the premium that has been quoted represents good value? This question should be answered from two perspectives – financial and risk reduction.

These questions cannot be answered until actual quotations have been obtained from selected insurance companies.

To prepare the quotations, the insurance companies will require member data about the chosen segment. It is very important for this information to be as accurate as possible so the quotations are meaningful.

Assessing against required provisions

The quotations will be extremely sensitive to the actual market conditions on the day on which the calculations are prepared. It is normally possible to specify the actual calculation date that the insurer should use to prepare their quotations so that a like-for-like comparison can be made.

Both the trustees and the company director will want to know how the quoted value compares with the technical provisions established using the scheme’s own funding basis. From this, they can readily assess if it is a transaction that would be sensible for all parties.

It is useful to compare the quotations with both the solvency assessment used at the last valuation and the best-estimate long-term cost. The directors will also want to see how the company’s balance sheet may be affected if the contract proceeds.

An estimate of the quotation based on the prevailing gilt yields on the calculation date should also be making (ie self-sufficiency with no investment risk) so that the relative values are known.

As the insurance company will usually choose to match these types of liabilities with gilt-type investments correlation between the two values would be expected.

The trustees and directors should also take account of the actual investments the scheme currently holds and how closely these are matched to the liabilities. Gilts are typically held to match some or all of the scheme’s pensioner liabilities.

Risk reduction – removing uncertainty

An advantage of completing a buy-in or buyout – once the business is placed – is that the pension scheme is no longer subject to the negative external financial conditions caused by falling gilt yields and inflationary pressures in the market.

Conversely, the scheme will not gain from the positive effects of such changes. However, the guarantee itself and the removal of uncertainty has an unspecified value.

If a bulk annuity contract is transacted, the longevity risk that a pension scheme is currently covering would be transferred, as the insurance company would be responsible for making all pension payments to the scheme members for the remainder of their lives.

Each pension scheme will regard the longevity risk in a different way depending on the actual health and lifestyle of their membership.

While the majority of these transactions are completed without conducting any medical underwriting, enhanced annuities are now being used more frequently.

The insurance company will complete some form of medical underwriting for the specified members and will then produce a quotation taking these factors into account.

This route can be advantageous for schemes where certain members, particularly those with large liabilities, are known to have certain medical conditions. At present, this option is available from a smaller number of insurance companies in this market, but it can lead to a more favourable outcome regarding the final price of guaranteeing the benefits.

Claire Plackett is an actuary at Premier