Articles - Most small DB pension schemes overestimate longevity

 By Steve Groves, FIA, CEO at Partnership
 At some point in time the principle of longevity risk will have been the bane of most readers’ lives; it will therefore possibly come as a surprise that thousands of small defined benefit pension schemes representing tens of thousands of members are ignoring ways to better understand longevity.
 Quite simply, thousands of schemes are paying significantly more than they need to because they are ignoring the scheme specific mortality risks of their members, with the knock on effect that members may be making contributions that don’t reflect the scheme profile.
 To place the issue into context, the Purple Book indicates that schemes of fewer than 1,000 members have assets worth ‘just’ £83bn, whereas those of over 1,000 have assets worth over £754bn. It is therefore of little surprise that much more effort goes into monitoring and managing the longevity calculations of larger schemes and their smaller peers rarely get the personal modelling that they deserve.
 However, whilst the assets of small schemes may be considered trivial by some, the size of the issue is far from inconsequential. In the UK there are 6,897 DB schemes of which 2,468 have between 5-99 members, 3,132 have between 100-999 members, 884 have between 1,000 and 4,999, 191 have between 5,000 and 9,999 members and 222 have over 10,000 members. So, while the bulk of the assets sit in larger schemes, the rump of the ‘need’ resides with smaller schemes.
 It is also worth noting that, while this article looks at the issues for DB schemes, many of the issues also apply to DC schemes, especially those that are adopting a Master Trust arrangement, whereby many of the governance benefits of a DB scheme are replicated in a DC environment.
 Furthermore, even in a member DIY approach, such as the forthcoming NEST, the benefits of personalised underwriting must be considered. For some members with impaired lives, their pension can increase by over 20% a sum that may be more than the employer originally contributed to the pension.
 Given that not trying to understand member mortality more accurately for smaller schemes has been the norm, the question that has to be asked is ‘why bother now?’ The most compelling reason for many schemes is their deficits.
 At the end of 2011, according to actuaries at Xafinity, which measures deficits across the whole of the Purple Book, DB pensions had deficits of circa £450bn. Common sense dictates that the larger schemes will have the largest deficits. However, it is also true that many of the employers with the smaller schemes will have the greater need, as often they are the ones facing the most challenging business environment. For these, survival of the business ranks higher than the schemes defaulting to the PPF, which at the end of 2010/11 was responsible for supporting 335 schemes with assets of £9.2 billion and liabilities of £10.5 billion.
 On the DC side The Pensions Regulator (TPR) has already taken the proverbial bull by the horns and stressed to trustees and employers that, if they fail to offer appropriate guidance to members and employees on how to secure better retirement income, then they will be failing in their duty of care. But, while the argument for many DB schemes is equally compelling, few do anything about it.
 Accepting the fact that, going forward, DB schemes are, for all but a small minority of private workers, a thing of the past, their continued performance still impacts around 12 million current members. Therefore, the scheme sponsor and trustees’ priority remains de-risking and securing the best possible protection and income for their members.
 De-risking strategies are well established for larger companies, but smaller firms, with up to 300 pensioners, have traditionally been advised that their options are fewer and more costly.
 The “buy-out” option, where liabilities are moved to an insurance company, is attractive, but daunting, as the full buy-out cost of the annuities has to be met by the scheme or employer. This can be 25% more expensive than what is currently put aside.
 The “buy-in” option involves purchase of a bulk standard annuity policy as an asset of the scheme. The sponsor retains responsibility for paying benefits but has an asset to provide a matching income stream. Crucially, the option also allows for changing mortality expectations. Another approach is for the scheme to buy an annuity policy when a deferred member reaches retirement.
 For smaller companies with less than £50m in liabilities the buy-out and buy-in options are unlikely to be viable financially, and this is likely to be further worsened after 31 October 2012, when insurance firms in the EU will have to be Solvency II-compliant, a move expected to require the holding of higher capital requirements for insurers and thus increase the costs.
 For smaller schemes, there is possibly one viable solution which is more traditionally associated with individual DC pensions: enhanced annuities which are gaining ground as a de-risking mechanism. These can be thought of as ‘individual member buy-outs/in.”
 The primary benefit to a smaller DB scheme is cost savings, which can be realised for up to half of retired members on a typical scheme, depending on its socio-demographic profile.
 A typical discount could be the following (based on a male life at age 65):
    Condition     Typical Discount      
    Smoker     14 -18%      
    Smoker with high BMI and high blood pressure     20 - 30%      
    Type 2 diabetes treated by insulin     18 - 20%      
    Secondary Cancer     14 - 27%      
    Stoke     16 - 20%      
    Cardiac arrest     13 - 20%      
 Introducing enhanced annuities can reduce the cost of buy-out or buy-in by making allowance for those with serious medical conditions or with life shortening lifestyle factors, such as obesity and smoking. Using them instead of a standard annuity – which uses generic mortality rates – enables pensioner liabilities to be insured on an individual instead of a bulk basis. This approach uses member-specific lifestyle and health information to secure the most competitive terms from annuity providers. It allows access to buy-in for schemes that cannot afford standard policies.
 In essence, gaining the lifestyle/medical information about members means the understanding of longevity can be improved and hence the associated risk is lower and can therefore be cheaper.
 This type of policy guarantees existing pension benefits, but it can be bought at a potentially significantly lower cost because a more accurate forecast is made of longevity risk across a scheme’s membership.
 Even so, establishing the health status of retired members can be a challenge. Some trustees are wary of the potential for invasive and complex underwriting. The way to deal with that is to cut the process to a minimum. Our research with scheme members has shown that they will return enough personal information if presented with a short one page questionnaire requiring yes or no answers. Current rates of return for this personalised information are typically 80-90% and we have found that in excess of 50% of a scheme’s pensioner population qualify for enhanced annuities. This simplified underwriting approach can secure a buy-in or buy-out quote within 48 hours of completion of the questionnaire.
 Enhanced de-risking is particularly suited to schemes in industries or with occupations that are typically associated with health problems or shortened life expectancy, such as manufacturing, construction, brewing, printing and any industry with a high degree of manual labour. In addition, schemes where retired members carry a disproportionate percentage of the overall longevity risk can achieve substantial savings if these members qualify for enhanced annuities.
 A recent example was where a scheme with 21 pensioners secured a traditional bulk buy-out quote for £7.26m. Simplified individual underwriting was then carried out on all members and 15 of them qualified as an enhanced/impaired life. The best standard rate quotes were obtained from the whole market for the remaining six members. Using this method, the combined cost was reduced by £1.02m or 14% on the original bulk buy-out quote.
 One of the traditional arguments against individually underwriting was the invasive nature of the health-related questioning. But, from an actuarial and underwriting perspective, we believe that sufficient information can be gathered from 10 simple ‘yes or no’ questions.
 An example of the simplified questions used include:
 • What is your weight and height?
 • Have you been diagnosed with high blood pressure, requiring ongoing medication?
 • Have you suffered a heart attack requiring hospital admission?
 From the Scheme’s perspective the process of establishing whether there are benefits from individual member lifestyle/medical underwriting is simple.
 Whilst this option won’t work for all schemes, the following schemes in particular should look at the potential benefits of individually underwriting members.
 • Schemes with fewer than 300 members (typically up to around £50m in funds);
 • Schemes unable to afford a full Buy-in or Buy-out, but that wish to remove certain risks;
 • Schemes with a small number of members who carry a disproportionate liability;
 • Schemes whose socio-economic profile may differ from average assumptions;
 • PPF cases that are overfunded on Section 143 basis;
 • DB schemes with attaching DC benefits for members over the age of 55.
 The other area that DB schemes are starting to show a lot of interest in is that of Early Retirement, or IVPP, offers. An exercise like this can be carried out for example by utilising a pre-existing Enhanced Transfer Value (ETV) exercise, but instead of excluding older members, those deferred members aged 55+ can now be included.
 Through the offer of a Transfer Value to buy an immediate annuity from an insurance company (and the offer to facilitate the process), the Trustees can help the pensioner procure an annuity that better suits their circumstances whilst removing a liability from the scheme.
 A major success factor in this approach will be down to how many of the deferred scheme members can be qualified for an enhanced annuity and will therefore see a tangible benefit in taking up the offer. Typically, this can be 40% of members and over 50% if the spouse is included.

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