James Staveley-Wadham explains how to approach the buyout process when dealing with a hybrid DB/DC scheme

Historically, a number of defined contribution (DC) plans were established with defined benefit (DB) underpins (such as GMPs and Reference Scheme Test benefits). In these schemes, when members transfer or retire a test is carried out to see which of the benefits (DB or DC) is more valuable and which one should apply. Originally the intention behind these designs was that the DB underpin would only bite in a limited number of circumstances. Yet, over time, these underpins have become more valuable and the administration and cost associated with them has increased. As a result, many companies are keen to look at ways of removing these liabilities, which are more DB than DC.

Since primarily these schemes appear to be DC, in the past, any buyout solution looked to DC arrangements. The favoured approach was to use with-profit type funds with the expectation that the amount invested would be sufficient to provide the DB underpin at retirement. If this was not the case, the insurance company had to meet any additional cost. With reductions in investment returns over recent years, the number of DC providers willing to accept DB underpins and operate this type of arrangement on buyout has reduced dramatically. There is now a perception that buying out these arrangements is difficult – perhaps even more so than for traditional DB schemes.

Turning things on their head
If instead of regarding the scheme as essentially DC, you look at which benefit applies for each individual member then entirely new avenues open up.

For pensioners, the benefit payable is known and these can be secured (if they have not been already) via bulk annuities in the usual way.
For deferred pensioners which benefit formula will ultimately prevail is unknown. But, subject to legal advice, an approach which could be adopted is as follows.
• For each deferred pensioner calculate the current level of the DB underpin and compare the cost of buying-out that DB benefit with the current value of the DC pot. In many cases, the buyout cost of the deferred DB liability will be larger than the current value of the individual DC pot, so if the company wants to proceed with a buyout it will need to find some additional funds and purchase deferred annuities for these members.
• Where a member’s DC fund value is greater than the buyout cost of the DB underpin, then essentially there are two benefits to secure: a deferred annuity which will match the DB underpin and the excess DC funds which can then be secured using a DC vehicle, normally using a Section 32 contract.

When winding up this type of arrangement, the standard options, such as offering members early retirement and winding up lump sums, can be used to reduce the additional cost of securing members’ benefits.

Which provider should be used?
The trustees can choose one of two options when selecting a provider:
• Option 1 – appoint ‘best-in-class’ providers to buyout the DB and DC benefits separately;
• Option 2 – appoint the same insurer to buyout the DB liabilities and secure the excess DC benefits.

A key advantage of the single provider route is the simplicity of dealing with one entity, not just throughout the buyout process and for switching payroll functions, but also once the buyout is complete. In particular, the member has all their benefits in one place. However the number of insurers who are able to supply both contracts is currently limited.

Under this new approach, the member is able to transfer both parts of their benefits to another arrangement should they wish to which was not generally the case previously when with-profit funds were used.

Whilst hybrid arrangements are not the most common scheme design, for those companies which have such a scheme they give rise to administration and cost issues which have become increasingly time-consuming. This is mainly due to the realisation that a scheme which was thought to have DC liabilities actually provides a DB benefit. Knowing that, due to the continued innovation and growth in the buyout market, there is now a practical buyout solution will therefore be very welcome news.

Written by James Staveley-Wadham, senior consultant, Towers Watson

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