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Why and how small DB pension schemes should insure

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Bulk annuity insurance might seem like an obvious objective for a small pension scheme but what are the specific factors behind that? Let’s consider a couple.

Longevity concentration risk
The larger the number of members in a scheme, the more predictable its mortality experience becomes and the lower the chance of an extreme adverse event occurs (adverse in a financial sense only, as this means members living longer than expected).

In a pension scheme, each member does not contribute the same longevity risk. It is very common for a small minority of members to make up most of the liabilities. This means a scheme’s mortality experience can effectively depend on the life expectancy of a very small group of members and the probability of a ‘bad’ outcome is significantly higher than you might expect.

Unpredictable mortality also leads to a series of other secondary risks. For example, a scheme might hedge its interest rate and inflation exposure based on an estimate of its liabilities. The more unpredictable those liabilities are due to mortality, the more uncertainty there is over how well hedged the financial risks really are.

Insurance companies have tens of thousands of policyholders and so their mortality experience is much more predictable than for any single pension scheme. Adding a small scheme to its book of business has a negligible impact on an insurer’s longevity risk. This means a small scheme gets the same pricing for this risk as a large scheme and insurance can provide better value for smaller schemes.

Economies of scale
2014 research by The Pensions Regulator showed that the mean per member cost of running a DB scheme in the UK was £1,054 for small schemes, compared with £505 and £281 for medium and large schemes respectively.
K3’s modelling suggests that ongoing expenses translate to additional liabilities of roughly 15% for small schemes, compared with 7% and 4% for medium and large schemes respectively.

Despite the significant headwinds small schemes face because of increased regulation, industry solutions have developed to help them benefit from economies of scale. These include bundled administration, investment and actuarial services and more sophisticated pooled investment funds.
However, advisory costs are not usually scaled with size, i.e. there is not 90% less work for a £10m scheme than for a £100m scheme.
Therefore, one obvious attraction of insurance is that it removes all future costs of running a scheme. The key question is whether small schemes pay more or less for expenses in an insurance premium than they would in ongoing running costs?

Insurers also need to charge for ongoing running costs but again, small schemes can benefit from those costs being spread across a huge number of policyholders and assets under management.
The table below illustrates the difference between average ongoing expense costs for schemes and the cost paid as part of an insurance premium. (Source: K3 analysis)

How to approach the insurance market
With the annual volume of pension liabilities transferred to insurers being in the £25bn to £40bn range since 2018 (Source: K3 analysis), small schemes must work harder than larger schemes to stand out. Being well-prepared in the following areas is critical to maximise insurer interest.

Data: Collect postcodes, marital statuses and spouses’ dates of birth. Ensure pensioner existence checks are recent. Calculate contingent spouses’ pensions. Focus on the members that matter most, i.e. those with the highest liabilities.

Benefits: The scheme administrators should accurately document how they administer the scheme. Then the scheme’s legal advisor should review that against the scheme rules. Deal with any differences upfront, not at the point of trying to transact. Consider ways to change any benefits that are expensive to insure (e.g. underpins).

GMP equalisation: While not essential to resolve before insuring, schemes should plan what they are going to do.

Affordability: Take specialist advice on what insurance is likely to cost and what impact it will have on key metrics (e.g. funding, accounting, investment strategy).

Assets: If assets backing an insurance transaction move differently to the way insurer pricing moves, this poses a major risk to the transaction.

Governance: Do the trustees have experience of insurance transactions? Can they meet at short notice and make decisions when needed? Detailed project planning is valuable.

Addressing each of these areas will allow a scheme to approach the insurance market with confidence that more insurers will be interested and, ultimately, get a better outcome for its members.

Thomas Crawshaw, Senior Actuarial Consultant, at K3 Advisory