The current economic climate, together with the decrease in mortality, makes 2014 an attractive year to consider pension buy-outs.1 This gives rise to a number of issues for trustees of such plans.
The term ‘pension buy-out’ is used to cover situations where the assets and liabilities of a defined benefit pension scheme are taken over by an insurance company. The objective is that the trustees of defined benefit pension plans and employers who sponsor the plan will be discharged from their obligation to pay members’ benefits. A number of global companies, such as Clorox, are exploring pension buy-outs during 2014.
Defined benefit pension payments are calculated by reference to factors which include the length of the relevant employee’s service, retirement age and final salary. The risk that the plan’s fund may be insufficient to meet employee’s entitlements remains with the employer and the trustee.
The costs of providing defined benefit plans have progressively increased and become more uncertain because of factors including increasing life expectancy, increased stock market volatility, periods of low interest rates on medium- and long-term bonds.2
Trustee considerations
Plan trustees need to consider:
- whether the plan’s rules permit them to enter into a buy-out and, if so, whether member consent is required;
- the extent that the particular buy-out transaction is a proper exercise of its powers; and
- the extent they may be discharged from liability upon completion.
Trustees may wish to consider amending the plan rules to permit entry into the buy-out. Care needs to be taken as plan rules may contain restrictions on the amendment power to ensure members’ entitlements are not compromised.3
When exercising a discretion whether to or not to enter the buy-out, trustees are required to:
- consider all relevant considerations;
- ignore all irrelevant considerations; and
- exercise their discretion in a manner consistent with the purpose of the scheme taking into account the best interests of the beneficiaries as whole.4
This does not mean the trustees should disregard the interests of the employer.5 However, the fair treatment of members is of paramount importance.
In addition, relevant considerations include the:
- reputation of the insurer and its ability to meet obligations to members;
- likelihood that the insurer will provide a reasonable administration service to members;
- impact on the benefits of different classes of members;
- amount or premium proposed to be charged for the buy-out; and
- the nature of the benefits the insurer proposes to provide to members.6 Trustees would be expected to explore the offerings of a reasonable number of suitable insurers.
In some instances, insurers, due to the nature of their business and relationships may be able to provide benefits which trustees and employers may have difficulty providing cost-effectively.
The costs of premiums and impact of the buy-out on different classes of members is particularly noteworthy in a partial buy-out. For example, members who have not had their entitlements bought out may consider the premium paid for a buy-out excessive and that this has a material adverse impact on the trustee’s ability to pay their entitlements.7
Employers ordinarily perform feasibility studies assessing various options to manage its risks associated with plan funding. The trustees can benefit from this information. However, ultimately it is the trustees’ decision whether to proceed with a buy-out. The trustees may wish to obtain their own independent review of the investigation and advice as the employer may be primarily focused on the viability of the arrangements from its financial perspective.
Can the trustees be discharged from liability?
Trustees may seek to rely on exoneration provisions in the trust deed to protect them against liability to members in connection with the buy-out.
Exoneration provisions generally survive the termination of the plan but, subject to the wording of such clauses and the governing law, may not cover the trustees for loss arising from their gross negligence. Such clauses are strictly construed.
Trustees of plans subject to the law of England and Wales may seek to rely upon statutory discharges such as that under s74 of the Pension Act 1995. Section 74 provides trustees a discharge from liability in connection with a full buy-out upon the winding up of the plan if certain conditions are fulfilled.8
One of those conditions includes issuing a detailed notice to the members impacted and obtaining their consent.8 The statutory discharge provided by s74 may not protect the trustee in a partial buy-out or where the trustees fail to properly identify all members to insurers or otherwise make negligent misrepresentations in connection with the transaction.9
Trustees may consider arranging for a data cleansing exercise in order to minimise exposure resulting from omissions in records. In addition, trustees may consider negotiating indemnities and security from the employer sponsor and its related entities, or obtaining insurance, as protection against such claims.
Conclusion
The interests of different classes of beneficiaries, the circumstances of the employer and the on-going viability of the plan are among the key issues for trustees to consider when faced with a buy-out proposition. With buy-out activity likely to increase in 2014, trustees of a number of defined benefit plans may have some complex decisions ahead.
- 1Sean Brennan, Mercer Pension Buy-out Index, www.mercer.us/articles/US-pension-buyout-index, 1 April 2014
- 2John A. Turner, Gerard Hughes, Large declines in defined benefit plans are not inevitable – The experience of Canada, the United Kingdom and the United States, Discussion paper prepared for the Ontario Pension Board, 2008. Consequently, in recent years, many employers have been exploring arrangements, including buy-outs, to manage these issues.
During 2013:
- Philips Pension Fund secured a GBP484 million buy-in with Rothesay Life, Prudential agreed a GBP120 million buy-in with Jardine Lloyd Thompson and NCR Pension Plan entered a buy-in transaction with Pension Insurance Corporation covering GBP670 million of liabilities.
- Insurer Pension Insurance Corporation completed two full buy-outs a GBP21 million buy-out deal with Imation UK Pension Scheme and a GBP40 million buy-out deal with Lloyds Superannuation Fund.
‘Buy-ins’ and ‘partial buy-outs’
Full pension buy-outs can be distinguished from:
- ‘partial buy-outs’ where an insurer only takes over the trustee’s obligations to certain plan members; and
- ‘buy-ins’ where the trustee acquires insurance policies (annuities) and the insurer makes payments to the trustees who apply the sums received to pay members’ benefits.
Captives
Employer sponsors of a number of large defined benefit pension plans, including Coca-Cola and General Motors, have utilised captive insurers as part of their pension buy-out arrangements.
A captive insurer is an insurance or re-insurance company established to finance risks associated with a particular group of companies’ operations. Unlike institutional insurers, captives are often formed primarily with the view of minimising costs rather than generating profit.
An employer may enter into a buy-out arrangement with an independent insurer with the captive agreeing to re-insure all or part of the independent insurer’s risk. Utilising a captive in this way may facilitate the employer to:
- minimise costs of the buy-out;
- access surplus funds which are not required to meet pensions; and
- determine the level of risk which it transfers to the independent insurer and that retained by the captive.
Bermuda and Cayman Islands have the largest captive insurance industries in the world. General Motors utilised its captive in Bermuda to secure many of the abovementioned benefits as part of its buy-out.
The buy-out involved USD26 billion of pension plan liabilities and 44,000 members - 3IMG Pension Plan HR Trustees v German [2009] EWHC 2785 (Ch) and Re Courage Group’s Pension Schemes [1987] 1 All 528
- 4Edge v Pensions Ombudsman (Court of Appeal) [1999] PLR 2/5
- 5 Edge v Pensions Ombudsman
- 6 Lee v Verizon Communications Inc. (3:12-CV-4834-D) which was an unsuccessful class action where the members alleged that: the sponsor breached its fiduciary obligations to employees by arranging for the pension plan to be amended to permit a buy-out arrangement; the pension plan trustees and sponsor paid an excessive amount to the insurer for the buy-out; and the buy-out discriminated against those members whose pensions were bought out when other members were allowed to remain in the pension plan. See also Edge v Pensions Ombudsman Op Cit
- 7Lee v Verizon Communications Inc. (3:12-CV-4834-D)
- 8 a b Ibid
- 9Bermuda is ranked number one in the world based on number of captive licenses. In 2012 over 850 Bermuda captive insurers recorded premiums in excess of USD20 billion. Bermuda Monetary Authority Press Release 27 March 2013, www.bma.bm/BMANEWS/Bermuda%20Insurance%20Sector%20Achieves%20Strong%20Results%20in%20Tough%20Market%20Conditions.pdf