Environmental, social and governance factors are becoming an important consideration for trustees running a pension scheme, but what issues does sustainability raise when trustees are looking to conduct a risk transfer?
Risk transfer momentum is on the rise, according to research published by Legal & General. The bulk annuity market in the UK reached £30bn in 2021, with £22bn accumulated in the second half of the year alone — a market record.
L&G expects the market to continue to grow in 2022, as defined benefit schemes look to offload their risk to other parties.
Sustainability is now a core issue facing trustees, and it is worth considering the extent to which it is a factor when assessing risk transfer opportunities.
Not all insurers are equal when it comes to sustainable investments
Wayne Phelan, Punter Southall Governance Services
Consider the cost
“If trustees decided upon a [sustainability] strategy that works for them, but not for those taking the risk from them, then the strategy becomes part of the problem,” says Henry Tapper, chair of AgeWage and Pension Playpen.
Tapper says some sustainability strategies may need to be “unwound” when risk is transferred, which could be expensive to the scheme or its members, depending on who is paying for the risk transfer.
“The key to mitigating risks is to offer funded solutions that can be adapted by both parties to the risk transfer,” he continues.
“Generally, we ought to be more interested in ensuring that sustainability is not an ‘impediment to’ but a ‘means of’ reducing risk.”
Cost is one of the major considerations when it comes to a risk transfer. Wayne Phelan, chief executive of Punter Southall Governance Services, says trustees need to be sure sustainable investments will not add costs or reduce returns, which would push out the date by which a buy-in or buyout could be secured.
“At present, trustees’ principal legal duties are blind to ESG/sustainability, so any decision to push back any risk transfer solution needs to be well considered,” he says.
“Even if [trustees] pick sustainable assets, they need to make sure these remain liquid, relatively inexpensive to trade, or in the form an insurer can accept them, otherwise this may lengthen the buy-in/buyout journey further.”
Finding the right insurer
One strategy open to trustees could be to leave sustainable investing to the insurers.
“A number of insurance companies may well have the buying power and resources to implement sustainable investments more quickly — some trustees may need to hold their noses for a short while and pass on the sustainable investment challenge to [them],” Phelan continues.
“The challenge is finding the right insurer and at the right price. Not all insurers are equal when it comes to sustainable investments.”
Nick Mellor, senior investment consultant at Broadstone, says there are circumstances in which there is no way to reverse the decision if the members are unhappy with where they end up, which is why picking the right insurer is so important.
“Any members transferred to an insurer under a buyout will have a contract with the insurer and will also have to accept the sustainability practices of the insurer,” he says.
“There is currently no market practice to transfer an annuity policy — either in payment or deferred — to another insurer. Trustees should therefore consider the sustainability policies of a prospective insurer when selecting an insurer to purchase a bulk annuity contract with.”
More specifically, Alexandra Westley, associate director at 20-20 Trustees, says considering whether an insurer’s net zero ambitions align with a pension scheme should be a factor when selecting an entity to take on the scheme’s liabilities.
“[This is] because trustees acknowledge that climate change poses risks that need to be mitigated, and because trustees have set targets with a view to protecting the world members will retire into,” she explains.
“Trustees should assess whether they believe providers are appropriately considering climate risk in the assets they are holding to support risk transfers, and also whether this aligns with the well-below 2C target required to protect our world as much as possible.”
Impact of employer’s sustainability
Lorant Porkolab, director at LawDeb Pension Trustees, says another sustainability-related area trustees should not be blind to when thinking about a risk transfer is the sustainability of the employer itself and its ability to support the pension scheme and meet obligations to members.
“The sustainability of the employer poses an obvious risk to schemes until they fully transfer all liabilities to a third party,” he says.
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“Following the risk transfer, the sustainability of the entity taking on the obligations to members becomes relevant, including its ability to pay members’ benefits in full as they fall due over a very long period — potentially 20-30 years or even longer, hence the relevance of the sustainability of the underlying business.”
Porkolab says these factors may affect the trustees’ risk transfer strategy and plan, as if the employer is high risk in terms of longer-term sustainability, but still operating as normal at present, the trustee may consider accelerating their risk transfer plan and ask for more cash in the short term to secure a buyout sooner.
