Growth in the pension risk transfer (PRT) industry is accelerating, with new research forecasting insurance companies will secure more than $335 billion of liabilities across the U.K. and the U.S. markets over the next three years. But with many insurers now looking at opportunities in both countries, it is vital to recognize the differences between the U.K. and the U.S., particularly when it comes to deferred lives.
PRT transactions — often described as bulk purchase annuity deals in the U.K. — enable employers to shift the responsibility for paying pensions promised to staff to a third party. The effect is to de-risk employers’ balance sheets without putting employees’ retirement benefits at risk.
Such transactions can be structured in a variety of ways, but in both the U.K. and the U.S., the broad principle is that the plan pays the insurer to take on its pension risk. The cost and terms of the transaction are determined by the nature of the transfer, potentially with nuances according to the differences between the U.K. and the U.S. markets.
Note, for example, that when U.K. pension plans talk about deferred members or lives, they typically mean members who are no longer active in the plan but have yet to start claiming their retirement benefits; in the U.S., the term has a broader meaning, including anyone who has not yet started receiving benefits from the plan. For the purposes of this article, “deferred lives” will be used in the broader sense, referring to anyone who has not yet begun receiving benefits.
The total amount of retirement benefits to be eventually paid will be a critical factor in what the insurer charges for accepting responsibility for those payments.
For U.S. plans, calculating this charge is often straightforward. With a traditional defined benefit plan, employees’ benefits are frozen before the PRT takes place, meaning any additional pay or years of service will not impact benefits. The value of those benefits is based on a formula — a pension income defined in terms of a yearly accrual schedule, or a percentage of pay multiplied by the number of years of service. The salary definition can be either average salary over the member’s career or the member’s pre-retirement salary.
Cash balance plans — where a percentage of pay is paid into the account each year, with interest then paid on the balance — operate similarly. Benefits are frozen prior to the PRT here too, though interest growth may continue.
In the U.K., benefit accrual practices for traditional defined benefit plans are broadly similar to those in the U.S. However, unlike the U.S., cash balance plans are not common in the U.K.
All PRT transactions require insurers to assess the period over which they will likely have to pay out benefits, with detailed actuarial analysis of life expectancies. Mortality expectations therefore play a key part in determining the total size of the insurer’s liability.
However, one critical difference is that while U.S. plans rarely offer annual increases in pension benefits for inflation, this is routine in the U.K., with the precise details varying between service periods and from one plan to the next. This requires insurers to make an allowance for benefits increasing in line with the inflation expected in deferment and post-retirement for members of the plan.
Another important distinction lies in member options. Calculations will also need to reflect possible values of dependents’ (or dependants’ as the U.K. refers to them) benefits, such as ongoing payments to a spouse following the member’s death. U.S. pension plans generally offer a wider range of forms of payment. This may include:
Plans in the U.K. generally offer fewer choices. Plan benefits tend to be more standardized and typically include survivor pensions for spouses or dependents along with features such as tax-free lump sum commencement payments.
One final nuance on benefits is that while U.S. pension plans rarely stipulate any minimum value for pension benefits, this is not the case in the U.K. Most defined benefit plan members will have guaranteed minimum pensions related to part of their service. The U.K. has also legislated for mandatory benefit revaluations and inflation-linkages at certain times.
In both the U.S. and U.K., the normal retirement age — when members can typically begin drawing their benefits in full — is often 65, though it can vary by plan design.
In most cases, both U.K. and U.S. plans allow early retirement from age 55 onward, with the pension income available usually reduced actuarially so the total value of benefits is the same; U.S. plans are more likely to offer more generous benefits in this regard.
Pension plans in both the U.S. and U.K. may allow members to defer taking their benefits, with pension income typically increased on an actuarial basis for later commencement. While specific rules vary by plan, benefits usually must begin by age 75 to avoid tax penalties or other restrictions.
Insurers’ calculations will need to reflect policyholder behavior assumptions as well as the benefit effects stemming from members retiring early, late or at the normal age.
In addition to pension plan design considerations, insurers also need to be conscious of the regulatory environment. In particular, the U.K. has relatively onerous capital requirements for insurers undertaking PRT transactions. In turn, and depending on risk appetite, some U.K. insurers reinsure the PRT risks that they take on, typically via longevity swaps or funded reinsurance.
This approach frees up assets and capital — supporting pricing and the capacity to write new business — although it also introduces counterparty credit risk.
In the U.S., while regulators have recently put longevity capital requirements in place for PRT business, these remain less exacting than the equivalent U.K. regime.
Our experts help pension plans as well as insurers and reinsurers navigate PRT in both the U.K. and the U.S. We can provide assistance in areas such as market entry, transaction support, benchmarking and deferred lives expertise.
