Thousands of South African businesses are facing unprecedented financial challenges; for example, figures released by Statistics South Africa show that company liquidations increased by 70% over the last year. The case has become far stronger for retirement funds to lower the risks associated with paying pensions.
One option available to trustees is to completely remove the liability from the fund by ’outsourcing’ the pensioner liability. This means the fund transfers the existing pensioner liability to an insurance company, and retirees purchase annuities in their own names. All current and future pensioners will thus own individual annuity contracts in their own name and have relationships with the insurer instead of the fund.
In the current environment, outsourcing pensioner liabilities may create a win-win solution for employers, retirement funds and most importantly, the pensioners themselves.
Pensioners who rely on their former employers for their monthly pensions face enormous risk if the business gets into financial difficulties. By outsourcing the pensioner liability to an insurer, the fortunes of the pensioners and the employer are split up. This means the pensioners do not carry the risk that the employer might go under or cannot afford pension increases any longer. As insurers are required to maintain a minimum capital adequacy ratio, the assets with a large, stable insurer are generally considered to be far more secure than most other companies.
Besides the extra security offered by insurers, in the complex and ever-changing retirement funds environment, outsourcing provides access to the insurer’s investment knowledge and expertise. The insurer managing the pensioner assets has a focus on optimising returns for the pensioners. Having a larger pool of assets to manage enables effective diversification of investment risk, thus increasing the stability of returns. Pensioners will enjoy greater security in the long term and the investment return can be passed onto them.
For the retirement fund, outsourcing the liability means pensioner mortality risks are transferred to the insurer, which has the expertise to price products more accurately. The fund does not have to hold excessive reserves to back pensioner liabilities, so these reserves can be invested in a more aggressive investment strategy to optimise investment returns for the fund. The opportunity even exists for the fund to outsource the administration services.
There are also benefits for the employer. Pensioner outsourcing enables alignment and focus. Employers can focus on their core business, secure in the knowledge that the management of retired employees’ pensions are in the hands of specialists. It also allows access to expertise, critical skills and current information and provides economies of scale, keeping real costs down and increasing real returns.
There are a number of factors influencing the outsourcing decision, the most important being the provider’s reputation for delivering on the service level agreement, its capital strength and the internal expertise to optimise returns and benefits to pensioners. In the past the decision to outsource related to the full service, but now funds can choose which functions to outsource. These include investment risk, mortality risk, pensioner administration, ownership and pension increases.
The outsourcing of pensions can be an emotional issue for pensioners and active members, as it involves exchanging one set of considerations for another. This process must be carefully managed and trustees and employers should communicate decisions to outsource in good time and with great sensitivity. Trustees of pension funds can also outsource their communication and counselling services to providers who have specialist expertise in this field.
Outsourcing is a strategic option for retirement funds, helping them to fulfil their most important obligation. Provided that trustees have considered all the relevant issues and have chosen the correct provider, outsourcing can result in a win-win situation for the pensioners, with their interests being a key driver.
Besides outsourcing the pensioner liability, funds have other options to remove the risks associated with paying pensions from the fund:
- Pensioner Liability Reinsurance: The fund makes an investment decision to purchase an annuity policy from an insurer to re-insure some or all of the pensioner liability. The annuity policy effectively becomes an asset of the fund that matches the pensioner liability. The fund therefore retains the pensioner liability, but owns a matching annuity policy.
- Partial Pensioner Liability Reinsurance: A variation on the former method is to reinsure only a part of the pensioner liability. Instead of purchasing an annuity to reinsure the current pension and future increases, trustees can choose to reinsure only the current pension amount. The trustees can then deal with pension increases from within the fund. Another approach is to reinsure the current pension and a small level of increase and use the remaining assets in the fund to supplement the pensioner increases.
- Pensioner liability immunization: The fund invests the assets backing the pensioner liability in a portfolio of fixed interest securities, which are invested in such a way as to ‘immunize’ the pensioner liabilities (allowing for future pension increases). This means that the assets fluctuate in tandem with the liabilities, with no resultant surplus or deficit resulting from changes in interest rates. The fund would usually employ a specialist investment manager or insurer with a constrained investment mandate to achieve this.
All of the above options aim to remove the investment and mortality risk and thus remove the source of surplus (or deficit) in the fund. However, while they may effectively manage the risks of providing the pensioner benefits, they may result in lower investment returns and correspondingly lower increases being awarded to pensioners. Trustees should carefully consider the advantages and disadvantages of these methods in conjunction with the needs and circumstances of the fund before making a final decision.