Preserving protection – how members’ benefits are protected through and beyond bulk annuity transactions

With more pension schemes turning to bulk annuities as a way to offload risk, it is particularly important for trustees to consider the implications of such transactions at an early stage. Aside from more immediate and pressing issues, such as cleansing scheme data, other considerations also merit early thought, such as the strength (and, in particular, the solvency position) of possible insurers whose long-term security and ability to pay benefits to members as intended is vital.

When thinking about insurer strength, it is also helpful for trustees to understand how the safety net provided by the Financial Services Compensation Scheme (“FSCS”) works, in the unlikely event that earlier controls are unsuccessful.

From the PPF to the FSCS

The statutory lifeboat for members of defined benefit schemes is, of course, the Pension Protection Fund (“PPF”). While PPF protection still exists during any buy-in, following the completion of a buy-out, compensation – if all else fails – becomes the responsibility of the FSCS instead.

The FSCS is the UK’s statutory compensation fund for customers of UK authorised financial services firms. It was founded in 2001 and is independent from, but accountable to, the Prudential Regulation Authority (“PRA”) and the Financial Conduct Authority (“FCA”).

 FSCS protection
 Following a buy-in  Following a buy-out
 Available to the trustee (s)  Available to members
Compensation as a last line of defence

Once members’ benefits have been secured with an insurer under a buy-out, such benefits are backed in the first instance by the financial standing of the insurer. Insurers are expected to adhere to stringent capital requirements, over and above the assets that they must hold against their insurance liabilities.

There are then various mechanisms in place for the PRA and, if necessary, the FSCS to intervene and help stabilise the insurer’s position or – in extreme cases where an insurer cannot continue – safeguard policyholder benefits (for example by securing continuity of cover with another insurer).

If all of these earlier mechanisms have been unsuccessful, compensation should, provided the relevant eligibility conditions are satisfied, be available from the FSCS.

Understanding the FSCS

How it’s funded and how it responds to major disruption

The FSCS is funded by levies on financial services firms. The FSCS stands ready to pay compensation to customers if a firm is in default and unable (or unlikely to be able) to pay claims, and relevant eligibility criteria are satisfied. In 2009 – as bulk annuities began to emerge in the market – it was confirmed that such policies would, in principle, be covered by the FSCS. With no annuity provider having folded since the FSCS was established, the provision of FSCS compensation in this specific context has never been tested.

However, the FSCS has a proven track record of being able to step in and provide substantial financial support through periods of disruption or as a result of major failures. For example, following the default of Bradford & Bingley in 2008, the FSCS – working with HM Treasury, the Bank of England and the Financial Services Authority (as it was at the time) – supported 2.5 million affected customers; under the rescue package, the FSCS ultimately made payments of nearly £16 billion.

Compensation – what’s provided

As a reminder, the FSCS will only pay compensation if, among other things, it is not reasonably practicable or appropriate to secure continuity of cover, e.g. through another provider willing and able to take on the policies. The FSCS’s main aim will always be to obtain continuity of cover for policyholders with long-term insurance contracts. For buy-ins and for the individual policies issued directly to members on buy-out – which qualify as “contracts of long-term insurance” – provided by a UK-regulated insurer, compensation is available (so long as the eligibility criteria, which insurance policies issued in respect of buy-ins and buy-outs will usually satisfy, are met) as a last resort at 100% of the claim, with no upper limit. Broadly, this compares favourably to the PPF, where compensation is limited in a number of ways.

Considerations for trustees

Trustees and scheme members should be reassured by the robust controls in place to ensure that members’ benefits will be paid following a bulk annuity transaction – particularly as the protections previously afforded by the PPF will no longer be available. However, it may be useful for the trustees to consider, as part of any transaction:

  • how many scheme members currently live overseas – FSCS compensation may not extend to such members (depending on the relevant jurisdictions), and further legal advice on ensuring these members are eligible should be sought if this is the case;
  • the financial strength of the chosen insurer – an exhaustive assessment of the insurer covenant may need be carried out by (or on behalf of) the trustees; and 
  • member communications – when writing to members about the proposed transaction, information about the continuity of protection (albeit via the FSCS rather than the PPF) should be provided at an early stage to allay any concerns.

If you have any questions about the FSCS in the context of a proposed bulk annuity transaction, please speak to your usual Linklaters contact.