With recent improvements to defined benefit scheme funding, many trustees will be looking to complete a buy-in transaction in the near future. In doing so, one of the first questions they will need to answer is exactly what benefits they should insure.
It sounds straightforward, but in practice can be trickier than trustees might expect. This latest article in our buy-in series examines some common issues, and suggests top tips for success.
Specifying your benefits
A trustee’s primary duty is to ensure that members receive the right benefits at the right time, in line with the scheme’s trust deed and rules.
In a buy-in, the insurer will only pay specific benefits to the trustees (and ultimately to members, on buy-out), as set out in the benefit specification attached to the policy.
A key job in any buy-in transaction is to therefore ensure that the benefit specification matches members’ accrued benefits.
Understanding accrued benefits
The starting point for working out members’ accrued benefits is the trust deed and rules. This is the primary legal document that grants benefits to members, and the scheme’s legal advisers will have a key role in supporting the trustees to confirm what benefits the rules provide.
Some tips for ensuring a smooth process include:
- Not forgetting about ‘old’ benefit provisions. While on a day-to-day basis trustees will often focus on the current rules of the scheme, members’ benefits are usually governed by the historical rules that were in force when they stopped accruing benefits.
- This can mean, for example, that deferred members’ benefits are set out in historical documentation. Trustees will need to make sure they’ve dug all the old rules out of the cupboard, so that nothing gets missed.
- Making sure you’ve taken account of any benefit entitlements that sit ‘outside’ the rules – for example, a pensionable salary cap agreed contractually between members and the employer.
- While trustees should already know about any arrangements, there’s no harm in asking the employer to confirm at an early stage.
- Thinking about important details that might not appear in the rules at all – for example, the date for payment of pensions and pension increases.
- The administrator has a key role in helping the trustees to understand scheme benefits, and in practice it is often easiest to use the scheme’s administration record as the ‘starting point’ for preparing the benefit specification.
Dealing with discretions
Many benefits are subject to employer or trustee discretion – for example, members might need employer consent to retire early, or the trustees might have discretion to pay a spouse’s pension to a long-term co-habitant.
These discretionary benefits will need to be ‘codified’ in the benefit specification, as insurers are often unable (or unwilling) to insure them.
While this can be straightforward – for example, insurers are typically comfortable with allowing any member to retire early, subject to an actuarial reduction in their benefits – particular care needs to be taken where there is an established practice of granting particular benefits on a discretionary basis.
A number of determinations from the Pensions Ombudsman have served as a helpful reminder – or a warning – that members’ views on what benefits are (and are not) discretionary can be very different from the black and white wording of the rules.
Insuring the uninsurable
Other benefits may be tied to members continuing in service with the scheme’s employer, even in a closed scheme – for example, a salary link or enhanced death in service benefits. These ‘active deferred’ benefits can effectively be uninsurable, because insurers are unwilling or unable to take them on.
Trustees have a number of options for dealing with these kinds of benefits:
- The benefit specification can ignore them entirely - with the trustees accepting that there will be an insurance mismatch and therefore a residual funding liability in the scheme.
- They can be insured on a proxy basis – for example, using an estimate of what a salary link benefit will mean for benefits in practice.
- Enhanced terms offered to members still in service, such as children’s pensions or favourable early retirement terms, can be crystallised at buy-out based on the member’s service status at that date.
In any case, a decision will ultimately need to be made on how to deal with these benefits if the scheme intends to proceed to buy-out. Trustees should seek early input from the scheme employer on this, and keep in mind that ongoing benefit provision – for example, the removal of a salary link – may ultimately be a matter for the employer.