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April 2016
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Welcome to the April 2016 edition of InTouch.
In this issue... ▪▪ Budget 2016 ▪▪ Bulk annuity market update ▪▪ Pension scams update ▪▪ Emerging area: Medicallyunderwritten mortality studies
Budget 2016
March’s Budget didn’t include the dramatic changes to pension taxation that just one month previously looked likely: Pensions ISAs were not introduced; salary sacrifice wasn’t abolished; and neither did the Chancellor move to a “flat rate” system of tax relief on pension contributions. Those changes that were made to pensions were relatively minor and constituted more of a “tidying up” exercise than anything else: ▪▪ changing serious ill-health lump sums so that they can be paid from uncrystallised rights even if the member has already drawn benefits from the arrangement; ▪▪ making serious ill-health lump sums taxable at an individual’s marginal rate when paid in respect of individuals aged 75 or more, instead of a freestanding 45% tax charge; ▪▪ permitting a child of a deceased member to continue to drawdown income after attaining age 23 without giving rise to unauthorised tax charges (thereby providing consistency with the tax treatment of nominees’ income withdrawal); ▪▪ permitting small DC pensions already in payment to be paid as a trivial commutation lump sum; ▪▪ providing that employer top-ups to “cash balance” money-purchase arrangements to fund dependents’ lump sum death benefits are authorised payments; and ▪▪ removing unnecessary legislation relating to charity lump sum death benefits. Perhaps of more significance is the introduction of a new Lifetime ISA or “LISA”. With effect from April 2017, those under age 40 will be able to open such a product into which they can contribute up to £4,000 per year. For each £1 an individual contributes, up to age 50, the Government will provide a top-up contribution of £0.25 (in effect basic rate relief will be provided on contributions). The funds built up can either be withdrawn from age 60, or used to purchase a first property. The introduction of this Lifetime ISA, and the prominence given to it in the Chancellor’s speech, suggests that the Chancellor may ultimately like to move to a Pensions ISA system for everyone. The introduction of LISA could be a relatively easy way for the Chancellor to test reaction and build support for such a move. One of the most interesting aspects of the Lifetime ISA is how it will interact with traditional forms of retirement saving for those under 40. Whilst individuals with sufficient disposable income to save into both a pension and a LISA may well do so, what about those individuals who have less disposable income? Some of them will no doubt stop saving into a pension in order to save into a LISA. This seems almost certain to increase Auto-Enrolment opt-out rates, and may in the longer term undermine the concept of pensions for those under 40. Perhaps if this does occur it will be easier for the Government to make more sweeping changes to the pensions system in future
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Bulk annuity market update In August 2015’s edition of InTouch we provided an update on the bulk annuity market (i.e. the market for buy-in and buy-out policies for DB pension schemes). Some of the latest developments in this market are summarised below.
a) Merger of Just Retirement and Partnership
Members less healthy than expected
Premium
The merger of Just Retirement and Partnership has just taken place. As a result of this merger we think it likely that there will be lower levels of competition in the medically-underwritten bulk annuity market going forwards (unless a new provider enters this part of the market – we note that LV= has announced that it will not be entering the market in the near future). This brings into focus the question of whether medical underwriting will be of value in the current bulk annuity market.
Members healthier than expected
One of the key drivers for considering medical underwriting has been a view that it could help reduce premiums, particularly for small schemes or where there is a concentration of risk in a small group of members. One of the supporting arguments is that in these situations insurers may set higher margins for prudence where they do not have detailed information on the members’ health and lifestyle, and underwriting would help reduce these margins. Added to this is the high level of competition we have observed in the medically-underwritten market, particularly from Just Retirement and Partnership. The combination of these factors has led to very attractive pricing often being available on medically-underwritten transactions, and we have helped a number of our clients to take advantage of this opportunity. However with the merger of Just Retirement and Partnership levels of competition in this part of the bulk annuity market may diminish, which means pricing opportunities going forwards may not be as attractive as they have been over the last couple of years. Whilst it may continue to make sense in some situations we encourage trustees to think carefully before embarking on a medically-underwritten process in today’s market.
b) Solvency II
for PIC
Solvency II is?
Question Can you explain what
From 1 January 2016, insurers have needed to comply with Solvency II. This has significant implications for insurers, and therefore for those pension schemes that are planning to purchase a bulk annuity policy. We asked leading bulk annuity provider Pension Insurance Corporation for their comments on what Solvency II means.
“Solvency II is the new solvency framework for insurance companies, developed by the European Union. Long in gestation, it was first approved (in its initial form) in 2009 and evolved through a number of consultations and updates before being formally implemented across the whole of Europe on 1 January 2016. The new framework’s aim is to standardise the approach across Europe to the ‘three pillars’ of running an insurance company: (1) minimum capital requirements, (2) supervisory review by regulators of insurance companies assessment of risk, and (3) enhanced disclosure requirements. There are a number of similarities to the previous regulatory regime operated by the UK’s Prudential Regulatory Authority and so it is fair to say that UK firms have been better placed than their European counterparts to implement Solvency II. It is equally fair to say that it has still required a massive amount of effort over the years and 2015 in particular was a very busy one behind the scenes as UK insurers raced to change their models, processes and systems in fundamental ways!”
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for PIC
Question What is the impact of
Solvency II on pricing of de-risking products?
for PIC
Question What are the key
differences caused by Solvency II?
April 2016
“In terms of the impact on the pricing and security offered by bulk annuity products (whether pensioner-only buy-ins or full buyouts of entire schemes) there are three fundamental implications of Solvency II: 1. Solvency II generally increases the levels of minimum capital required by insurance companies to protect pension liabilities as compared to the minimum requirements of the previous Solvency I regime (although UK firms and regulators were generally operating in excess of these minimums as a norm anyway). 2. The principle of cashflow matching is more rigorously enforced – assets and liabilities in an insurer’s portfolio now have to be matched to a very close tolerance (and for that tolerance to not materially change even in stressed market conditions). If this isn’t the case then the insurer would not be eligible for the ‘Matching Adjustment’ which is the addition to risk-free rates that insurers can use in discounting their projected cashflows to calculate their liabilities by virtue of those liabilities being closely matched by assets already held by the insurer. Not being able to reflect the Matching Adjustment would substantially increase the insurer’s reserving requirements. A natural extension of this is that insurers are required to ‘buy and hold’ their matching assets. Any investments purchased at outset to match new liabilities are expected to be held to maturity rather than traded so that it can be demonstrated that Matching Adjustment eligibility can be preserved. Therefore pricing for new transactions will be directly influenced by what bonds are available to buy in the market at the time of execution and the spreads available on the bonds across the duration profile of the liabilities. 3. A new concept called the Risk Margin has been introduced. Previously insurers were expected to hold sufficient reserves such that if they suffered a stress event (e.g. at a 1-in-200 year level) then they would ‘burn through’ a risk capital margin but still have, at a minimum, sufficient assets to pay out all future pensions even if that meant operating the insurer in run-off mode. The Risk Margin is a new additional capital requirement that ensures that after a stress event insurers will have sufficient assets to transfer their business to another, ongoing insurance company if required (e.g. if deemed to be necessary by the Regulator). This extra layer of capital can be thought of as the funds required to compensate another insurer for their cost of capital and profit requirements in running off a competitor’s back-book.” “Where more capital is required under Solvency II to underwrite risks the cost of this additional capital to insurers is likely to be passed on to customers. However, the impact is not uniform and insurers’ business models will innovate to manage the risks and returns optimally at the same time as the regulatory regime is refined to make the system more efficient. In particular pricing for transactions that comprise in-payment pensioners only is likely to be broadly similar to 2015 levels (other than naturally reflecting changing market conditions) and may actually reduce in some instances, based on insurers being able to benefit from closely matching asset and liability cash-flows and reflecting the Matching Adjustment in their calculations. However the introduction of the Risk Margin requires insurers to carry a second layer of capital in respect of unhedged risks and the cost of holding that additional capital will likely be reflected in pricing. For transactions which are wholly or predominantly in respect of pensioners in payment this additional burden is relatively modest as insurers can reliably hedge demographic risks for these members via longevity reinsurance (although for smaller schemes the insurer may have to hold the risk for a period until it can be packaged with other transactions for the reinsurer to accept and the cost of a higher capital requirement for this period may be reflected in pricing).”
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for PIC
I should know about?
Question Is there anything else
There is currently not a fully established reinsurance market for deferred pensioners and as a result any transaction which has a material component of non-pensioner liabilities may be more costly than last year as a result of Solvency II. However, this reinsurance market is developing, for example in 2015 PIC reinsured an unprecedented level of non-retired lives of the Philips Pension Fund following the pension insurance buyout. Finally we would note that, on-balance, there has been an increase in the level of competition in the pension de-risking sector over the last year with more insurance companies either actively bidding on transactions (at least on a case-by-case basis) or entering the market. This should help Trustees and scheme sponsors to have confidence that they are getting best value in a transaction. And a number of insurance deals have already completed in the first quarter of 2016 so despite the various challenges and new considerations introduced by Solvency II it clearly hasn’t quite killed the market! “
“Alongside the pricing implications considered above there are a number of additional points of relevance arising from the introduction of Solvency II. The first point to note is that this framework is still very new and although it was widely anticipated, the proof of the regulation pudding is very much in the eating and insurers are still getting to grips with the real-world application. The timetable for producing quotations is likely to be longer, particularly in the short term, and this should be allowed for when planning price investigation processes. It also may appear that insurers are less willing to be flexible on areas which were previously common grounds for discussion and negotiation. Eligibility for Matching Adjustment trumps all other considerations and insurers will be keen to follow the letter of the regulations which imposes restrictions on structures like paying part of the premium on a deferred basis or preagreeing terms for extending the insurance to cover additional liabilities in future. This also extends to member option factors for transfers, commutation lump sum calculation and early or late retirement. Insurers may now have less leeway to vary their standard terms for these options and so it might be advantageous to establish what these are at an early stage in a price investigation process. Away from insurer-focused considerations readers should be aware that in late 2015 the Financial Services Compensation Scheme (FSCS), the guarantor of policyholder benefits in the unlikely event of insurance company insolvency, changed its terms of reference for bulk annuities. The FSCS is now covering 100% of bulk annuity insured pension benefits. This means that, combined with the increase in security brought about by Solvency II, bulk annuities can be considered an even more secure product than before.” If you would like to discuss any of these points in more detail, a member of our specialist pensions insurance team would be delighted to speak to you.
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Pension scams – an update In a ruling given in February, the High Court overruled a Pension Ombudsman’s decision concerning a person’s statutory right to transfer benefits to an occupational pension scheme. This has potentially significant implications for Trustees.
Background Where a member of an occupational or personal pension scheme has a statutory right of transfer, section 95 of the Pension Schemes Act 1993 covers the ways of taking the transfer value. This includes acquiring “transfer credits” allowed under the rules of another occupational pension scheme. The term “transfer credits” is defined as meaning rights allowed to an earner under the rules of an occupational pension scheme.
The crux of the issue considered by the Court This concerned the meaning of the term “earner”. The Pensions Ombudsman had previously determined that this meant that the person must be an earner in relation to a participating employer under the receiving scheme. The High Court has overturned this. The High Court Judge ruled that in order to be an “earner”, the person must simply have earnings from one or more sources, and this does not have to be
from an employer participating in the target occupational scheme.
Comments •
If a member is looking to exercise a statutory right to transfer benefits to an occupational pension scheme, the person must have earnings from somewhere. This is an issue for the transferring scheme. • As a result of the High Court ruling, it will now be far easier for individuals to move their money from legitimate schemes, ultimately leading to a potential influx of monies into suspicious schemes. It will be especially important, therefore, for the transferring scheme to continue to check that the proposed receiving arrangement is a bona fide occupational pension scheme (or QROPS). Given the above, it is worth remembering that pension scams continue to be perpetrated in significant numbers. We continue to uncover cases where members have decided to transfer DB benefits as a result of receiving “cold calls” from third parties who sell members overseas investment opportunities promising high guaranteed levels of return; opportunities that are, in all likelihood, too good to be true.
Emerging area: Medically-underwritten mortality studies A relatively recent idea for Defined Benefit pension schemes is known as “Medically-Underwritten Mortality Studies” or “MUMS”. The idea behind MUMS is that by asking pension scheme members some questions about their health and lifestyle, pension scheme trustees (and companies) can have more confidence in the likely longevity of pension scheme members. This might be of use at the time of a funding valuation, a corporate transaction or for determining pension liabilities from an accounting perspective. In particular, undertaking a MUMS may enable schemes to reduce the value of their liabilities through removing some of the prudence that might otherwise be built into this key assumption. To consider this concept it is helpful to recap how a longevity assumption is constructed. A mortality assumption can be thought of as a combination of: (1) estimated current longevity together with (2) an assumption about how mortality rates will evolve in the future: 1. Various pieces of information and evidence are used to determine an appropriate assumption for current mortality. The starting point will be a table
of national statistics, and that can be tailored for more mature and larger schemes through postcode research and other scheme-specific information. Depending on the nature of the scheme, this part of the assumption can often be determined with relatively high confidence. 2. The assumption for future changes in mortality is typically based on industry-standard projections. This part of the assumption is particularly uncertain given the long time horizon of the projections. Because of these limitations, in some situations it can be difficult to determine an appropriate assumption, which might lead to additional prudence being built into the assumption. This approach to determining a mortality assumption has several potential limitations: ▪▪ Analysis of rating factors is limited by data collected ▪▪ Population underlying standard tables may not reflect scheme membership e.g. lifestyle factors ▪▪ Ability of schemes to apply rating factors is limited by scheme data held
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Medically-underwritten mortality studies continued... ▪▪
Lack of available industry experience data for high earners ▪▪ Small schemes may not have sufficient members for credible analysis ▪▪ General limitations of the models used - for example, future mortality improvements over the longer term By gathering information about members’ health and lifestyle through a MUMS, you would have one more piece of information that may be useful when determining current mortality rates, but this information is of limited relevance to the question of future improvements. Given the other risks facing pension scheme finances, it would be unusual to find a situation where attempting greater precision on current mortality rates in, say, a funding valuation would add value. Having said this, it
is conceivable that there will be circumstances where undertaking MUMS could be justified: ▪▪ An employer may need to provide evidence to support a particular view for the company’s balance sheet disclosure. ▪▪ While the majority of trustees and employers are aligned on funding strategy, there will inevitably be cases where there are firmly held opposing views. The same could also easily be said where the pension scheme is an important element in a corporate transaction. In these circumstances, it may be helpful to have an objective, third party view on the mortality rate. Where the costs of a undertaking a MUMS could be justified, it is worth considering the downsides of gathering medical information for this purpose:
Uncertain impact on mortality assumption - could lead to an increase or decrease in liability Provides limited information to inform future mortality improvement assumption Requires reliance to be placed on Morgan Ash’s method for converting medical data into life expectancy Provides a potential solution where the limitations of the traditional approach are most prevalent
Output only deemed ‘valid’ for six months to three years so refreshes may be needed
Provides additional input into mortality assumption setting process reflecting an additional rating factor
Could lead to issues in a future bulk annuity transaction as it is not possible to ‘un-know’ the information
Potential pros
Potential cons
While we believe that in practice MUMS will be of only limited appeal, when faced with headlines about some pension schemes shaving millions of pounds off of their liabilities in this way we think it is something that companies in particular will want to at least consider. Xafinity is a market leading actuarial, pensions and employee benefit consultancy providing a full range of consulting and administration services to over 500 clients. We combine expertise, insight and technology to address the needs of both trustees and companies, specialising in pension de-risking solutions. We are committed providing a professional and proportionate service, tailored to our clients’ needs and delivered cost effectively. Xafinity Consulting Limited. Registered Office: Phoenix House, 1 Station Hill, Reading, RG1 1NB. Registered in England and Wales under Company No. 2459442. Xafinity Consulting Limited is authorised and regulated by the Financial Conduct Authority. A member of The Society of Pension Professionals.
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