PP asks three lawyers about how the key legal issues schemes facing schemes conducting or considering risk reduction exercises
Coyne is a partner in the pensions practice at CMS. He has wide experience in dealing with all kinds of pension issues, with a particular interest in risk transfer, where he has experience in advising on benefit restructurings, buy-ins and buyouts, longevity swaps and transactions.
He is a member of the Association of Pension Lawyers' main committee and is also an adviser for The Pensions Advisory Service.
Longfellow advises trustees and employers on all aspects of pension law, with a particular focus on risk transfer - and was part of the team that advised the trustee of a multi-billion pound pension plan in relation to the biggest single buy-out transaction in the UK.
He also acts for insurers of defined benefit pension plans, providing advice in relation to everything from complex all-risks buyouts through to the more straightforward buy-in transactions.
ARC Pensions Law
Rogers has spent her entire career advising clients who operate or sponsor occupational pension schemes, with a particular expertise in defined benefit schemes.
Prior to co-founding ARC Pensions Law in 2015, Rogers was a pension partner at Mayer Brown. She is a fellow and former council member of the Pensions Management Institute and was chairwoman of the Association of Pension Lawyers from 2013 to 2015.
What are the key legal issues facing schemes conducting and considering buy-ins or buyouts at the current time?
Pete Coyne: There is no doubt that the bulk annuity market is currently a very competitive place (with new entrants and re-entrants). Pricing is keen and insurers are working hard to make themselves attractive to trustees. The most obvious way in which this is playing itself out is in the contract terms available to schemes. There is no doubt that terms are softening and trustees are seeing improvements in, for example, the termination rights which they are able to negotiate.
The other legal issue which schemes are continuing to grapple with is the thorny question of collateral. Is it worth having and what size deal do you need to justify the undoubted extra time and expense of having it in place? A marked development we have seen in the market in recent months is a raising of the bar in terms of the size of deal where collateral is seriously considered. Below £500m it is now not being considered in our experience. In fact, some large schemes are tranching the liabilities they bring to the market - to take advantage of umbrella contracts and the ability to transact more quickly and easily once you have the umbrella in place, and also to spread risk among different insurers in a way which makes collateral less attractive or necessary in the first place.
Stephen Longfellow: The pensions risk transfer market has been transformed by a prolonged period of innovation. Solvency II restricted some options, but there's still a wide range of solutions available. Trustee must therefore have clarity about what they want to buy, and then buy it, rather than being distracted by the latest shiny new product, only to find they wanted an apple but they bought an orange.
The latest shiny product might well be the consolidator. Trustees should be under no illusions in my view. Consolidators might be a solution, but they're not the same solution as insurance, not least because of the absence of a robust regulatory capital regime.
At a granular level, the key legal challenges don't change. Most trustees want to insure a cashflow that's a perfect match for the scheme's liabilities or a subset of those liabilities. Trustees must therefore ensure that they understand those liabilities. Trustees often bring a trade to market only to discover midway through that the scheme's benefit structure isn't quite what they thought it was. Mid-trade changes aren't fatal, but they're inefficient and undermine execution certainty. Trustees must do their homework pre-trade: insurers are most enthusiastic about ‘clean' trades where there's clear evidence of preparation by trustees and their advisers.
Anna Rogers: To my mind the main risk is future-proofing. That can take all kinds of forms. One issue is that benefits may need to change in future, especially for schemes which have an ability to change the index used for their pension increases from RPI to CPI or something else. Bulk annuity contracts have had flexibility built in for years but it's important to consider how it might actually work in practice and the interaction with scheme rules. For example, it's a commonplace observation that it's a lottery whether the lawyer drafting the rules in past decades phrased the definition of ‘index' widely enough to allow for change, or whether such change was hard coded, or banned, or allowed at the trustees' option. An issue that is coming to light now is the trustee might want to change to ‘RPI minus a margin', or ‘CPI plus a margin' and that may work for insurers too but those formulations, firstly, might not be allowed within the definition of Index because the replacement is not an index and, secondly, ‘RPI minus' does not serve to displace the statutory requirement for CPI, so it would introduce a CPI underpin, which could cost more but, worse, could be problematic from an insurer's point of view. At some point schemes with bulk annuity contracts are going to want to move to buyout and it is crucial that the trustees and sponsor are in the driving seat at that stage. If scheme benefits change in ways that can't be insured then trustees won't be able to get the clean break they want. There will be no competitive tension about the pricing of changes in benefits if they have not been pre-priced and committed to at the outset. And if the insurer can't or won't provide the desired benefit, that could present a real obstacle to a successful move to buyout.
The other issue that I'm not sure is being debated enough is, are these buy-ins reducing risk or actually increasing it? They are locking in deficits at current pricing. They transfer risk for the least risky liabilities of the scheme. I'm not qualified to advise on the financial issues but one thing I know after 33 years in pensions is that things change. No scheme could ever have a winding up deficit; inflation could never be below 3%; life expectancy can go on increasing forever. The certainties of our era may not hold good forever.
How are your schemes preparing for any future risk reduction exercise? What are the key areas you are working with clients on currently?
Pete Coyne: For those schemes approaching the bulk annuity market, advisers have become adept at anticipating what providers will require and trying to get to the top of insurers' in-trays. So carrying out due diligence on the scheme - is the data clean, what is the mortality experience etc. and getting a benefit specification into a form that can be easily shared with insurers before you approach them is time well spent and ensures you get the right price first time.
On the wider risk reduction front pension increase exchange (PIE) and retirement transfer options continue to be popular. Of growing interest are split transfers which more and more schemes are starting to think about (often led by member demand). There are some issues that need careful thought and consideration, though, particularly around contracted-out benefits and how much member optionality schemes want to offer.
Stephen Longfellow: Many schemes are now on a journey plan. Some journeys are longer than others: there are longer lead times than was the case five years ago.
Good preparation reflects the themes above. Trustees should ensure at an early stage that they understand their liabilities, they are paying the correct benefits and their data is accurate.
Choice of journey plan is key. Some trustees and sponsors target a single trade to transfer all a scheme's liabilities: nothing wrong with that. Others are becoming ‘trade ready' at an early stage and adopting an opportunistic strategy, insuring specific tranches of liabilities when pricing is favourable. Either approach can be effective, but trustees need to ensure they pick the best solution for them. Once they have a plan, trustees should consider starting a dialogue with insurers with a strong track record in the type of trade they're targeting. This isn't always easy for trustees. Some trustees - too few in my view - run a tender process and retain a specialist risk transfer consultant. These transactions are amongst the most significant events in the life of a pension scheme: trustees should work with someone who can maximise the prospects of a favourable outcome.
More than ever before, trustees must come to market with an attractive proposition, with absolute clarity as to their requirements and evidence of preparation so as to deliver high execution certainty. 2018/19 will likely be the year of the ‘mega deal'. Insurers and consultants are talking about pipelines with more billion-pound trades than ever before. Trustees and their advisers need to work hard to make their potential trade stand out from others.
Anna Rogers: We have a number of clients who are front loading the work in specifying the legal entitlements under the rules. This involves identifying the different sets of rules that now apply to the whole pensioner and deferred populations (as well as actives if any) and putting together working copies of the historic rules, with the amendments marked up on them. It's obvious enough, but many schemes don't have a set of documents like that to hand. The challenges tend to be that later amendments, for a PIE exercise for example, have only been made to the latest rules. Most current pensioners may in fact be governed by other sets of rules, which haven't been amended. PIEs involve paying more now in return for a reduction over the longer term and if the legal documentation isn't right for the long term, there is going to be extra cost. Other issues include discovering what pension increases and survivor pensions are actually discretionary.
To what extent has there been an increase in the use of liability reduction exercises among your schemes? What are the key considerations in this area?
Pete Coyne: It's a mixed picture. Schemes and sponsors have a huge amount on their plates at the moment - GDPR compliance, a potentially tougher funding environment and ever-difficult investment markets. The recent pensions white paper also points to a tougher regulatory regime coming our way and no clear prospect of some of the sponsor hoped-for flexibilities around benefit reductions and indexation overrides. Once GDPR compliance is out of the way we are expecting more schemes to look again later in the year at risk reduction and liability management.
Stephen Longfellow: DC freedoms and higher transfer values (TVs) have resulted in more transfer exercises and increased take up rates. A challenge in relation to liability management exercises (LMEs) is whether they can be bundled into an effective insurance solution. Recent debate included comment that insurers could quote a risk transfer premium based on an assumed outcome of LMEs to be implemented post-inception, effectively underwriting the take up rate. The most experienced provider of bespoke insurance solutions has done this previously, but it's not common.
It's attractive from a trustee perspective. It delivers certainty. But there are some knotty issues to work through. Who would implement the exercise: if the insurer is underwriting the outcome, is it appropriate / fair for the trustees and their advisers to implement it? Wouldn't it be fairer for the insurer to be involved given its cheque book is on the line, but would other stakeholders cry conflict? If the outcome is a higher take-up than assumed for premium pricing, would trustees feel compelled to ‘re-trade' the insurer?
It's positive that key players are pushing the boundaries on insured solutions. But I expect that extending the insurer's role to underwrite the outcome of LMEs has too many associated issues to resolve to make it viable in the short term, given that insurers and consultants are (rightly) currently focussed on converting a strong pipeline into transactions.
Anna Rogers: Most schemes are considering liability reduction exercises as business as usual now. Small lump sums, early retirement and transfers to access pensions freedoms are becoming standard features often by way of initial one-off exercises which are then built in to scheme admin going forward. The key considerations are good communications and processes. Informed consent is the antidote to legal risk.
What do you believe will be the key risk reduction trends among the schemes you work with over the coming 18-24 months?
Pete Coyne: All indications are that the bulk annuity market will continue to be a competitive place which trustees will instinctively look to in order to achieve full risk reduction and member benefit security and we expect innovation and product development to continue. One interesting idea is a transaction that looks at the whole of a scheme's pensioner population and under which some members are covered by a bulk annuity and some by a longevity swap, with a clear and defined flightpath to convert longevity swap liabilities into bulk annuities over time.
An important development in the pensions white paper is the government's stated intention to encourage the consolidation of defined benefit schemes and the role which ‘commercial consolidators' will have. Much of the detail is still to be developed - but the key questions are likely to be: how will the commercial consolidation offerings interact with the Pension Protection Fund and will they represent a threat to the bulk annuity market or be a way in which pension liabilities can be neatly packaged up in a way which makes them more insurable?
Finally, no consideration of the future can ignore Brexit. Until the smoke clears, it's difficult to predict the impact it might have. One very practical issue for anything that hangs on the Pensions White Paper will be whether there is sufficient parliamentary time over the next couple of years to develop and then legislate for what has been promised. The government is already managing expectations on that and suggesting that the 2019/20 parliamentary session (at the earliest) is when we might expect final legislation.
Anna Rogers: Providing transfer value statements at retirement with paid-for advice, and reminding members or their options from 55 will become standard practice. If robo-advice becomes more widely available that will increase the trend. Trustees and sponsors are aware that members find it hard to make these financial decisions and a full fact find through traditional channels is a time consuming business. If the quality of advice could be standardised and delivered for a cheaper cost it would make a significant contribution to reducing the risk of yet another future mis-selling scandal.
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