Aon Hewitt has said that while the cost of hedging inflation linked pension increases could make a bulk annuity prohibitively expensive for many pension schemes, other options are available to take them to their ideal destination.
John Baines, a principal consultant in Aon Hewitt's Risk Settlement Group, said:
"When entering into a standard bulk annuity contract, a scheme automatically enters into a hedge on its inflation-linked pension increases – and for many schemes this is a key reason for making a bulk annuity unaffordable.
"The cost of hedging pension increases could be at least 5% greater than might currently be allowed for in the scheme's funding valuation or in the company's accounts. And if a scheme's benefits are linked to the Consumer Prices Index, the difference could be a staggering 15%. The main reasons behind these cost differences are the price of inflation floors in the swaps markets, along with the lack of CPI linked investments."
However, trustees and companies are beginning to consider alternate routes for reaching their ultimate goal of purchasing a bulk annuity. These involve reshaping their benefits in order that they can avoid the commitment to buy inflation linked pension increases.
Ben Roe, head of Aon Hewitt's Liability Management team, said:
"Offering members the option to convert inflation-linked pension increases into a higher initial pension with fixed increases is a well-established method of managing pension cost and risk. Now, trustees and sponsors are increasingly considering whether this change can be made across the whole membership for some of their pension increases - and on terms that do not penalise members - while still making settlement more achievable.
"It is, of course, vital that members are genuinely provided with fair value for their benefits, but if this is achieved, the sponsor and trustees have far greater certainty over the outcome compared with giving each individual member the option to consider a change to their pension. For some schemes, the financial implications of this could be the difference between being able to secure members' benefits through a buy-in, or not. We expect more and more trustees and sponsors will be looking at taking this approach as they consider bulk annuity projects and the benefits they bring."
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