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Home > Insurance Markets Best Practice > The Origins and Current State of the Buyout Market for Pension Funds

Insurance Markets Best Practice

The Origins and Current State of the Buyout Market for Pension Funds

by Steven Haasz

Executive Summary

The article looks at the way the market for annuities buyout activity has developed over the last decade and at the stresses that market is experiencing as a result of the global downturn through 2008/2009. The following topics are covered:

  • The origins of the buyout market as a “rescue” for distressed companies, now taken over by the Pensions Protection Fund

  • The risks facing annuities providers, that the assets will be insufficient to meet the liabilities, and the longevity risk

  • The pressures in the market pushing companies towards pensions buyout, despite the high relative cost of this solution

  • Different types of providers in the market

  • The dynamics of buyout pricing

  • The trend for larger and larger schemes to adopt a buyout solution


The buyout market for final salary pension or defined benefit (DB) schemes began more than a decade ago in the UK, with Legal & General as the sole provider. At the time, the focus was on distressed companies going into insolvency or administration. A buyout enabled the liquidator to separate off the company’s pension scheme, with its statutory obligations to pay benefits to members, from the company. Instead, the buyout provider would take over responsibility for the scheme and the liquidator would be free to sell on the viable parts of the company, unencumbered by the liability constituted by its pension scheme.

In this context, it is important to remember that, from the company’s perspective, while a DB pension scheme might be a very important part of its overall reward package for employees, the pension fund is, ultimately, just another debt on the company’s books.

For taking over the scheme, the provider would charge the company a fee, and the fee would cover any shortfall between the company pension-scheme’s assets (which would be transferred to the provider) and its liabilities. The liabilities are the totality of the benefits that the scheme is obligated to pay to members for the life of the scheme (i.e. until the last scheme member dies). Often, though, the company was unable to pay the fee because of insolvency, and so the member benefits would be reduced. This line of business from insolvent companies is effectively closed now, as a result of the introduction of the Pension Protection Fund (PPF). The main lines of business are with solvent companies looking to de-risk their liabilities.

Risks Facing Providers

There are two major classes of risk involved in a provider taking over the liabilities and assets of a pension scheme. The first involves the risk that the future returns on the assets of the scheme will not be sufficient to meet the expected payments when they fall due, and the second is the longevity risk.

This is the risk that members in the scheme will live longer than expected. When calculating whether a scheme is fully funded or is in deficit, actuaries have reference to the average or expected lifespans of all the members of the scheme, in order to calculate the benefits the scheme is going to have to pay out over its lifespan.

As providers are in business, ultimately, to add value for their shareholders, Legal & General, and then Prudential, which was the second player to enter this market in 1997, took—and still take—a very prudent view of these risks. The returns risk was managed by investing in low-to-negligible-risk securities, such as government bonds, with some investment-grade corporate bonds.

The second risk is something of a movable feast, as longevity at present is on the increase, and no one knows where that process will end. That risk was, and is, managed by charging a premium which allows for longevity to improve in the future. For many companies, however, the combination of low-yielding assets and the buyout premium made the buyout just too expensive to contemplate.

Pressures in the Market Pushing for DB Scheme Buyouts

However, several things have happened which, combined together, have predisposed many financial directors and CEOS of companies with final salary schemes to be much more energized about finding ways to close their final salary schemes—something that they can only do in law by effecting a buyout (or a buy-in) with a provider. Without retelling the whole saga of the decline of the final salary scheme market in the UK, which is a fairly well known and well documented story, it is fair to say that a combination of accounting changes, which look to reflect scheme deficits much more prominently on a company’s balance sheet, and legislative changes, which have considerably added to the burden final salary schemes impose on companies, have effectively sounded the death knell for the vast majority of UK final salary schemes.

Other countries have tended to go much more towards defined contribution schemes. Again, in brief, the difference between the two types of scheme—a final salary scheme and a defined contribution (DC) scheme—is that in the former, the employer makes a promise that they will pay x proportion of an employee’s final salary, and then takes on the responsibility for funding that promise. In a DC scheme, on the other hand, the employee builds up his or her own “pension pot”, and it is the employee who takes the risk that that pot will not be big enough to provide a decent pension for them on retirement. As no “promise” has been made about the level of benefit that will result, there are no funding issues, and a DC scheme cannot be in deficit in the same way that a final salary scheme (DB scheme) can. Nor does it import any market volatility into a company’s balance sheet—all market volatility resides with the member.

The total final salary scheme liability on the books of UK companies is estimated at around £800 billion. A figure on that scale, once it became clear that companies would increasingly be exploring the buyout of their scheme as an option, is sufficiently large to attract new players into the buyout market. This is exactly what we have seen over the course of the last few years.

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