Wind-up and buy-out - the cheaper option?

The words "cheap" or "cheaper" are not normally seen in the same sentence as pension scheme wind-up or buy-out.  However, my challenge is whether it is not indeed the cheaper option after taking into account the capitalised costs of running a pension scheme for another 10 or 20 years.

The risk-based Pensions Regulator (TPR) in the U.K. recently completed a survey of the costs of running a defined-benefit (DB) pension scheme.  Average costs were over £1,000 per annum per member for small schemes and only a quarter of that for the largest schemes.  The normal human reaction features words such as "horrendous", "incredible" and "never-ending".  Given the number of ex-employees involved, the typical reaction of the finance director also involves a significant rise in blood pressure.

Take a very modest average (small) scheme cost of £100K per annum for a paid-up scheme of around 100 members.  This might prompt questions of what the corporate sponsor gains from managing this legacy (and mainly ex-employee) liability.  The historic human-resources advantages of recruitment and retention will be just that: history.  Increasing longevity, despite now being better analysed and refined, only re-enforces a perception of many decades of future liability management, risk and cost.

An existing annual cost of £100K over just 10 years gives an round, capitalised cost of £1m.  This figure assumes current real interest rates over RPI of 0% — if you factor in the actual increase in servicing costs over recent years, you will get a much higher figure.  Even scarier arithmetic applies over 20 years for schemes with younger members.

My suggestion is therefore to compare the buy-out estimate with your prudent technical provisions fund plus 10 or 20 times your total annual scheme expenses.  And don't forget the investment-management charges and your new levy for the Pension Protection Fund (PPF). You may be surprised how close you are to a potential “end game” in terms of a buy-out price.  If you can't afford the whole scheme buy-out, look at buying out pensioners only — those gilts your scheme holds for de-risking could be directly swapped pound-for-pound for another guaranteed investment, but with the additional benefit of a built-in longevity hedge (i.e. a buy-in insurance policy).

Looked at another way, what is the difference between a (prudent) Schedule of Contributions and similar payments under a bank loan?  The former involves additional administration costs, longevity risk, reputation issues and governance commitments.  So, if you don’t have the capital for the buy-out premium, why not borrow it?  Some insurers already lend for buy-outs paid, or partially paid, by future premium instalments.  Existing pension-scheme security may also be available to cushion the borrowing cost.

And finally, a buy-out of deferred and immediate pension benefits could be cheaper than individual buy-outs for each group.  The saving on reduced future re-investment (at unknown rates) is not just theoretical; However not all insurers automatically factor this into their quotes…unless reminded by experienced intermediaries!