To help defined benefit pension schemes reach their de-risking goals, Scottish Widows offers custom bulk annuity options. A bulk annuity is an insurance policy purchased by pension scheme trustees to better secure members’ benefits by eliminating longevity, investment, interest rate, and inflation risks associated with defined benefit pension schemes, either as a scheme asset (a buy-in) or by issuing individual policies to members (a buy-out).
A diversified and matched investment strategy
- Our immediate annuities, worth almost £23 billion, are well matched by assets maintained in a diversified portfolio of gilts and high-quality credit investments (at June 2020).
- Illiquid assets (such as social housing loans, education loans, and infrastructure) that are a good match for long-term annuity liabilities are among them.
How does bulk annuity work?
The system pays a fixed amount to an insurer up front, and in exchange, the insurer assumes responsibility for meeting the insured benefits, as well as the interest rate, inflation, longevity, and demographic risks that come with it.
What is a bulk annuity transfer?
A bulk annuity transaction is a risk-based transaction. There are numerous risks involved in funding and running a defined benefit pension plan. A bulk annuity transaction aims to transfer part of the scheme’s and sponsor’s risks to an insurer. “Some” is the essential word here. The general belief is that all risks must be transferred. The insurer’s position is a little more complicated. In the same way that Gandalf from The Lord of the Rings is never late or early, but always on time, an insurer’s purpose in a buy-in or buy-out is to take on exactly the risks that they plan. The more complex position, as is often the case, is a better explanation of what’s going on legally. The success of a buy-out or buy-in should not be determined by whether or not all risks are transferred to an insurer. In practice, the most significant and material risks will pass, but complete risk transfer is never realized and should not be the goal.
A bulk annuity contract (whether buy-in or buy-out) is designed to track the benefits of the scheme being secured extremely carefully.
It’s easy to fall into the habit of referring to the insurer as “securing the benefit,” but in reality, the insurer will take on the liabilities as a collection of administrative data that will be evaluated by a brief benefit definition.
The insurer does not embrace the scheme’s trust paperwork, and thus does not assume responsibility for errors in scheme data in a normal transaction.
Discrepancies between what is insured and the program benefit can occur in a variety of ways.
Benefit characteristics may be pushed to be simplified or crystallized by the trustee. Unusual increase rules, for example, may be impractical or extremely difficult for the insurer to price or administer; discretionary benefit rules may cause issues if the insurer is unwilling to make the necessary decisions; or, if a long-term buy-in is planned, the trustee may choose to simplify or take a position on a particular issue. These adjustments must be carefully considered.
Then there’s the possibility of making a mistake. It’s possible that the administrative record omitted to include the details of a pension-eligible member, or that the data record indicated an inaccurate final salary figure, or that the scheme regulations were incorrect. In these circumstances, the insurer’s responsibility is to pay the benefit based on the information and specifications provided to it. When a member is unable to recover the correct benefit from the insurer, he or she will naturally turn to the trustee and employer for assistance.
The easiest way to mitigate these kinds of hazards is to plan ahead of time.
These hazards should be modest for a well-run scheme that has gone through a rational procedure in preparing its data and specifications.
Certain types of residual risks can be secured in some situations for an additional premium.
Because residual risks insurance entails the insurer taking on greater risks, it usually necessitates more due diligence, and the approach to this must be carefully considered.
Importantly, bulk annuity providers are currently not writing general insurance policies aimed at covering risks specific to trustees (as opposed to members), which means that a claim brought against a trustee for trustee conduct or decision-making would fall outside the scope of a bulk annuity policy.
Costs and expenses are an essential factor in this regard.
Generally, the trustee’s fees in defending a claim made against them would be reimbursed from plan assets while the scheme is still active.
That layer of security is removed once the plan is completed.
Not only should the trustee evaluate how to make amends with members on residual categories of risk, but they should also assess their own practical position in the event of a claim.
Those interested in learning more about this topic should attend our next seminar on September 21, 2021, titled “Buy-ins and Buy-outs – How to Transfer Risk Successfully,” in which we will discuss some of the more complicated aspects of buy-in and buy-out transactions, such as deal preparation, benefit specification due diligence, residual risks, and trustee protections. Visit our events page for more information and to register.
In our December finance and investment briefing, we’ll go through residual risks in greater detail.
What is the difference between a pension and an annuity?
An annuity is just a type of insurance product that you can obtain by signing a contract with an insurance provider. An Annuity requires a buyer to purchase a contract for a specific amount of money, which they will fund either in one lump sum or over time. To earn income, the insurance company puts this money in a mutual fund, stock, or bond. According to the agreement, the customer would get a regular payment from the annuity. Insurance firms invest annuities in the stock market as a straightforward investment and income vehicle.
Key Differences Between Pension vs Annuity
Both pensions and annuities are prominent options in the market; let’s look at some of the key differences between the two.
- An annuity is a financial product that pays a fixed amount of money over a certain length of time, whereas a pension is a retirement plan that pays money after you leave the military.
- The pension amount is only received after retirement, whereas the annuity payment is not received after retirement.
- One of the most significant differences is that the pension amount is determined by the entire amount earned over a person’s employment. The annuity amount, on the other hand, is determined by the amount of money invested by a person over the course of a year.
- An annuity program can be purchased from the insurance provider by anyone. A person, on the other hand, cannot live on a pension; it is provided to employees as part of their benefits package.
- After a person’s death, his pension is usually turned into a family pension, whereas an annuity is provided to single life and joint account holders according to the arrangement.
- An annuity is a type of financial product that is widely used in the financial market, but a pension fund is not.
- An annuity has a significant advantage in that the individual who opens the annuity is the one who makes the decision. A pension account, on the other hand, is opened by an employer rather than an employee or individual.
- Because a person does not handle the day-to-day maintenance of the pension, there is less transparency in the pension account than in the annuity program.
What does annual annuity mean?
The solution you choose will be determined by your financial objectives. You should choose an immediate annuity if you want to start receiving annuity payments right away.
If you choose, you can acquire a deferred annuity and specify the start date in your contract if you want your payments to start at a later date.
What are longevity swaps?
A longevity swap is another option for reducing longevity risk. Because no upfront payment is necessary, your scheme can retain more assets in the future, either to generate greater asset returns or to support an interest rate and inflation hedging strategy.
What is a buy-in annuity?
Unlike “buy-out” annuities, buy-in annuities make periodic contributions to the pension plan fund equal to the aggregate pension amount covered by the policy, rather than giving individual certificates to covered members and paying pensions to them individually.
What is the difference between buy-in and buy out?
Buy-ins and buy-outs are comparable contracts in which the insurer is contractually obligated to pay members’ benefits in the future in exchange for a single premium paid by the scheme. The people covered by the policy are protected from investment, inflation, and longevity risk.
After the scheme pays the premium, the insurer is responsible for paying the monthly pensions to the scheme, which in turn pays the pensioners. A buy-in is an investment contract, and the trustees are still legally responsible for paying the benefits to members.
A buy-out would go much further, with the insurer taking legal responsibility for providing monthly pensions to each individual scheme member. The pension scheme can now wound up because all liabilities have been transferred to the insurer.
What is pension transfer risk?
- When a defined-benefit (DB) pension provider wants to withdraw some or all of its obligations to pay out guaranteed retirement income to plan participants, this is known as pension risk transfer.
- Companies that have promised retirement income to current and former employees face a huge risk in the form of defined pension liabilities.
- Alternatively, the pension provider could try to transfer some risk to insurance firms through annuity contracts or by renegotiating the conditions of the pension with unions.
What is individual annuity?
Individual retirement annuities, like other types of annuities, are a contract between a person and an insurance provider. The individual makes a pre-determined contribution, and the insurer promises to repay the money, plus interest, at a later date, either in a lump sum or in a series of regular instalments. Annuities are frequently purchased to augment other sources of retirement income, such as Social Security.
Individual retirement annuities are available in two types: fixed and variable. Variable annuities pay a portfolio of sub-accounts chosen by the annuity owner, whereas fixed annuities pay a fixed rate of interest. These sub-accounts resemble mutual funds in appearance, follow mutual fund strategies, and have mutual fund names, but they are not mutual funds.
The money in the annuity account grows tax-deferred during what’s known as the accumulation phase.
Is it better to take the annuity or lump sum?
Many lottery winners’ decisions about whether to take a lump-sum reward or an annuity are influenced by taxes. The benefit of a lump sum payment is certainty: the lottery winnings will be subject to current federal and state taxes at the moment the money is won. The money can then be spent or invested as the winner deems fit once it has been taxed.
The annuity’s advantage is the polar opposite: unpredictability. Each annuity payment will be taxed at the current federal and state rates as it is received. Those who opt for an annuity for tax reasons are frequently betting that future tax rates will be lower than current rates. Lottery winners, on the other hand, have the option of selling their annuity installments for a discounted lump amount if they change their minds about taking an annuity payout.
What is better than an annuity for retirement?
IRAs are investment vehicles that are funded by mutual funds, equities, and bonds. Annuities are retirement savings plans that are either investment-based or insurance-based.
IRAs can have more upside growth potential than most annuities, but they normally do not provide the same level of protection against stock market losses as most annuities.
The only feature of annuities that IRAs lack is the ability to transform retirement savings into a guaranteed income stream that cannot be outlived.
The IRS sets annual limits on contributions to IRAs and Roth IRAs. For example, in 2020, a person under the age of 50 can contribute up to $6,000 per year, whereas someone above the age of 50 can contribute up to $7,000 per year. There are no restrictions on how much money can be put into a nonqualified deferred annuity each year.
With IRAs, withdrawals must be made by the age of 72 to meet the IRS’s required minimum distributions. With a nonqualified deferred annuity, there are no restrictions on when you can take money out of the account.
Withdrawals from annuities and most IRAs are taxed as ordinary income and, if taken before the age of 59.5, are subject to early withdrawal penalties. The Roth IRA or Roth IRA Annuity is an exception.
Is annuity income taxable?
Annuities are tax-deferred investments. An annuity’s withdrawals and lump sum distributions are taxed as ordinary income. They aren’t taxed as capital gains, thus they don’t get the advantage.
