To answer questions on UK pension schemes, we've turned to our expert, Kevin Wesbroom, Hewitt's Global Risk Services Leader for the United Kingdom. If you'd like to ask a question on pension investment or risk management, or any other pressing HR challenges you might be facing, e-mail us, and we'll share responses to selected questions on a regular basis.

Bad news on financial positions of schemes has created an incentive to focus on risks. This has led to a much greater focus on the risks being run by pension schemes and the potential to manage those risks more effectively. The increased focus on pension risk has resulted in an increase of solutions in the market. To make the most of the opportunities that exist, trustees and sponsors should have a clearly defined and appropriate risk strategy.

For some schemes, reducing or removing risk will be a focus. For others, retaining or even raising their level of risk will be appropriate. Before deciding upon a course of action, it's important to be clear on both your short- and long-term objectives and constraints. Where risk is taken, the focus should be on taking the right types of risks — the ones for which you're suitably rewarded.

Question: What's the difference between a buy-out and a buy-in, and which one is right for me?

Answer: Both buy-ins and buy-outs involve insuring the liabilities of a pension scheme. A buy-out involves either the partial or full liquidation of a scheme, and hence scheme members will become policyholders of an insurer and cease to be members of the scheme. Individual policies are purchased on each transferring member's behalf.

In contrast, a buy-in involves a scheme purchasing an insurance policy. Membership of the scheme is not affected by the transaction. The scheme buys the policy as an investment to match its liabilities more closely.

In the past, most purchases of insurance policies by pension schemes occurred during wind-up (i.e., these were buy-outs). Buy-ins are a relatively new phenomenon for larger solvent schemes. While buy-outs offer a scheme finality, typically they're more difficult to execute. Full wind-ups can take anywhere up to five years to complete.

Partial liquidations are quicker to implement, but they're more difficult than buy-ins for a number of reasons:

• Trustees need to consider the implications for remaining members relative to those transferring to the insurer. The protection offered by the insurer may be better than that offered by the residual scheme assets and employer covenant. Trustees may find it difficult to favor one class of member over another.
  
• Trustees need to weigh up the relative merits of the Pension Protection Fund and the Financial Services Compensation Scheme (the scheme set up by the Financial Services Authority to compensate policyholders of insolvent insurers) for individuals being insured.
  
• Dealing with contracted-out benefits is tricky when you buy out. This is not an issue for a buy-in.
  
• The partial liquidation rules of a scheme are often more prescriptive than the investment powers (which are used to effect a buy-in).
  
• Data quality needs to be better for a buy-out than for a buy-in, although insurers are often willing to quote an additional premium should data not be acceptable for a buy-out.
  
• Some benefits are uninsurable, such as discretionary pension increases. For a buy-out, this presents a problem, and benefits will need to be changed. However, trustees can buy in most of the benefits and self-insure the rest.
  
• Members may not wish to transfer to the insurer selected by the trustees.
  
• Communication with stakeholders regarding a buy-out is more involved and is governed by legislation.

For these reasons, many schemes that historically would not consider a buy-out are now considering a buy in.

Question: There's talk about a market in longevity swaps as an alternative to buy-out. What are they — and is this just talk?

Answer: There's now a market in investment products that allow schemes to hedge out longevity risk in isolation. The basic premise in a pension scheme is to structure a longevity swap. No deals have been completed in a pension scheme context yet, although the concept of longevity risk management is well developed in the reinsurance world.

A number of players are willing to act as counterparties (both insurers and capital markets players), and we're currently working with a number of clients who are seriously considering purchasing a longevity swap.

The diagram below shows how longevity swaps work:

Question: I keep on hearing about enhanced transfer value exercises — isn't this a pensions mis-selling scandal waiting to happen?

Answer: Enhanced transfer value exercises have certainly attracted some negative publicity in the past. With an enhanced transfer value exercise, deferred pensioners are exchanging defined benefit pension promises (that, subject to the employer being able to support the scheme should be "guaranteed"), for an enhanced transfer value that will usually be invested to buy a pension on a defined contribution basis.

Unlike with a defined benefit pension scheme, in a defined contribution arrangement the member, rather than the employer, is exposed to financial and longevity risk. There has been concern that members may not understand the value of their existing defined benefit promises, and may be making inappropriate decisions. There is further concern that where a cash sum is offered instead of an enhancement to the standard transfer value, members may be squandering their existing pension provision.

All of these are valid concerns, and something that employers need to manage when undertaking such an exercise. However, providing best practice guidelines are followed such exercises can be beneficial for both employers and scheme members. We recommend that:

1. Employers provide access to members receiving such an offer with independent financial advice to ensure that appropriate decisions are made (with the cost of advice paid for by the employer).
2. Enhancements are large enough to then enable an Independent Financial Adviser to be able to positively support the transfer.
3. Member communications are made clear and understandable. Members also need to be given sufficient time to make their decisions.

With these three components in place, employers can mitigate potential risks of mis-selling claims from members in future.

A well run exercise that has each of these components in place can also help to improve member take-up rates, and potentially create a win-win between the employer and the member. The employer can remove liabilities at a price less than the cost of buying-out the benefits with an insurance company and the member may prefer to transfer their benefits elsewhere in the expectation that they will receive higher benefits than in the defined benefit scheme.

About Our Expert
Kevin Wesbroom is Hewitt's Global Risk Services Leader for the United Kingdom and part of our UK investment leadership team. Kevin has authored several pension, investment, and risk articles and is often asked to speak at conferences. He earned a degree in mathematics from Oxford University. Kevin is a longtime Hewitt employee having joined what was then Bacon & Woodrow in 1975.