Why winding-up schemes should not buy bulk annuities
by Dr. Ros Altmann
(All material on this page is subject to copyright and must not be reproduced without the author’s permission.)
When a pension scheme winds up, the only way trustees can secure pensions for the members is to buy annuities from an insurance company. However, the law requires that all the assets of the scheme are used to buy annuities first for those scheme members already getting a pension and, for schemes which started winding up before September 2004, the trustees have to buy annuities with full index-linking for all the pensioners first. The law says that all other members, however long they contributed and however old they are, cannot get any pension until indexed annuities have been bought for others first. The problem is that annuities have become so expensive that most schemes are using up all the assets to buy the annuities for the pensioners and then there is nothing left for the other members. This seems a waste of assets. For example, one scheme bought annuities a few weeks ago, it had originally £27m of assets, but buying annuities means there is now only £1m or so left. This means that all the non-pensioners will need to be compensated from scratch, whereas, if the assets were just used to pay out pensions on an ongoing basis, there would be less cost to the taxpayer.
There is a strong case for asking trustees not to purchase annuities for schemes in wind-up, while the Government looks into the details of FAS. The purchase of annuities will mean that there will be less assets left to fund ongoing pensions over time. The PPF is based on the idea that it is more efficient to run the schemes on an ongoing basis, rather than purchase annuities and it seems difficult to understand why this principle should be different for current wind-ups, which will be eligible for assistance from the Government’s ‘Assistance Fund’. Since we do not yet know which schemes will be eligible, surely all schemes should put annuity purchases on hold, until the situation becomes clearer.
The reasons to stop buying annuities include:
1. Annuities entail increased costs, due to insurance company profit margins:
It is more costly to buy annuities, than to run the schemes on, because insurance companies make a profit on annuity business (otherwise they would not offer them!) and this profit margin entails a reduction in scheme assets.
2. Bulk annuity market is not functioning well – only two providers (and often only one) willing to offer bulk annuities:
Only Legal and General and the Prudential offer bulk annuities for winding up schemes and recently only Legal & General have been left, as the insurance companies do not always have the reserve backing available to offer bulk annuity business. This is not a well-functioning market, and the trustees do not have any buying power to shop around for good quotes, because there are not enough providers to shop around with!
3. Annuity purchase exacerbates the unfairness of the priority order:
The result of buying annuities is that the scheme assets will be even more unfairly divided up than is required by the windup priority order. Those already retired will be taking a larger share of the assets, due to the costs of annuity purchase, and this leaves less assets for the non-retireds, meaning they will eventually get smaller pensions.
4. Costs of Government assistance should be lower and can be spread over many years, if annuities have not been purchased:
If Government is to offer an assistance scheme, it will be cheaper to run on an ongoing basis, just paying out pensions over time. But once the winding ups schemes have bought annuities, the costs of any top up assistance rise and the taxpayer will need to pay more than would be the case if the annuities were not purchased.
5. Annuity purchase usually includes members who are not traced, wasting valuable resources:
When trustees buy annuities for a scheme in wind up, they usually purchase pensions for members they have not been able to trace, in case these members subsequently come to light and want to claim their entitlements. This means that the schemes are buying annuities for people who may not even exist, and therefore some of assets will be wasted (and the insurance company will pocket the extra money). This money would be better deployed on giving more to other members. If an assistance scheme is run on an ongoing basis, pensions will only be paid to members who lodge claims and no assets will need to be set aside for people who may not exist!
6. Purchase of index linked and deferred annuities is particularly expensive:
The purchase of index-linked annuities is particularly poor value at the moment, because of the lack of backing assets. Purchasing such annuities is sapping far too much from pension schemes, leaving far too little to divide among other members. If the trust fund is run on an ongoing basis, the profit margin for the insurance companies would be available instead to the scheme members.
Questions and Answers:
1. Surely buying annuities now will at least offer a ‘guaranteed’ outcome for one group of members.
The cost of this ‘guarantee’ is not justified. There could be some guarantee for some members, but the purchase of annuities will mean that this guarantee of income for pensioners is bought at the expense of those members who are not yet retired. If the scheme buys annuities for all members, then even more of the assets will be lost to insurance company profit margins and risk margins. Both level and index-linked annuities are poor value – especially deferred annuities – and this means that too much of the assets will be used to secure an income for the group which gets the fullest entitlement (pensioners), to the detriment of other members. If the trustees are supposed to look after all members’ interests and given that we know an assistance scheme is a possibility, it would make sense to wait before buying the annuities, to see who will be helped and how. It will be cheaper in the long run if pensions are paid out over time, it will be more cost-efficient for the taxpayer if assistance is needed on an ongoing basis, rather than an amount of money to pay out the replacement ‘assistance’ pensions from day one.
2. Annuity rates may worsen, so schemes should buy now.
Interest rates are rising, longevity forecasts have already been revised upwards and annuity rates could improve or worsen – it is not a one-way bet. Insurance companies will be pricing in expected future demographics and will have been widening their risk margins in the last couple of years. Since there are only two providers – and sometimes only one provider – it is impossible to argue that this market is functioning to offer good value to the consumer. It may be, but equally, it may not be and trustees cannot be sure that they will be better off buying now. Of course, the insurance companies will tell them that rates will worsen, to encourage purchase, but this may turn out to be wrong.
3. At least buying out level pensions will secure something.
The problem is that buying out level pensions will still mean that more of the assets are used for this one group than might be necessary if the funds are run on an ongoing basis. Until we know more about how the assistance fund will work, which schemes and members will be entitled and so on, the trustees are at risk of favouring one group unfairly over another. Also, it would perhaps be better for the Government itself to write the annuities and pass on any profit margin to the taxpayer, rather than to the Prudential or Legal and General shareholders.
4. Annuities offer good value and a guaranteed income.
If annuities are such good value, why is the PPF not planning to buy them? First of all, there are only two providers for bulk annuities, secondly index linked and deferred annuities have become extremely expensive, thirdly the providers will be building in a profit margin, fourthly the trustees will be buying annuities for some people they have not traced and who may never come to light, so this money will simply sit with the insurance companies and be wasted, when it could be used to pay higher pensions to deferred and active members.
5. What about the GMP?
This is one area where it would really help if the DWP would agree to take over all the GMP and contracted out rights responsibility from existing trustees. Putting all members back into the state scheme automatically would save enormous amounts of time and money for trustees and release significant extra assets to be used for members’ pensions. Buying annuities for the GMP is a very complicated and expensive exercise and hugely wasteful in pension fund resources. The small amounts, different indexation requirements and complexity of this exercise suggest to me that purchasing annuities to match this liability is a dreadful waste of money. Annuities purchased for this purpose are very hard to justify.