A “sovereign annuity” initiative has been introduced to assist employers and trustees in addressing the funding issues associated with defined benefit (DB) schemes. The main advantage of this initiative is that schemes can avail of a credit in their funding standard calculations to the extent that their liabilities are matched with sovereign annuities. Furthermore, sovereign annuities are expected to be cheaper than conventional annuities and therefore will be a more cost-efficient way for trustees to meet their obligations to pensioners.  In light of these advantages, trustees will undoubtedly come under pressure from sponsoring employers to avail of the sovereign annuity option.

Operation of Sovereign Annuities

Under a sovereign annuity, the payment of the annuity is linked directly to the proceeds of bonds, known as reference bonds, issued by Ireland or any other EU Member State. The primary difference between sovereign annuities and conventional annuity products is that the agreed payments from the sovereign annuity can be reduced if there is an event of non-performance (e.g. a default or restructuring) of the reference bonds. Sovereign annuities are expected to be less expensive than other pension products on the market because (i) insurance companies will not be carrying the credit risk; and (ii) Irish sovereign bonds (to which many sovereign annuity products are likely to be linked) are expected to trade at a higher yield than AAA bonds.

Potential Uses of Sovereign Annuities

The Pensions Act has been amended to enable trustees to meet their obligation to pensioners by securing their benefits with sovereign annuities. Trustees can avail of this option regardless of the provisions of the scheme’s governing documentation. Trustees who decide to purchase sovereign annuities can either buy the annuity in the name of the pensioner (a “buy-out”) or in the name of the scheme (a “buy-in”). Where trustees purchase the sovereign annuities in the names of pensioners, the scheme’s liability to those pensioners ceases. However, where sovereign annuities are purchased in the name of the scheme, the scheme will continue to be responsible for payments to pensioners and will assume the credit risk.

Buy-Out
Trustees may be hesitant about availing of a buy-out option in the case of ongoing schemes given that this will involve transferring the credit risk to pensioners. However where a scheme is being wound up, trustees may consider that purchasing sovereign annuities in the names of pensioners is a more equitable way to proceed with the winding-up process. This is primarily because the Pensions Act currently prescribes that pensioner liabilities must be discharged in full before scheme assets are applied to secure the benefits of active and deferred members. Given that sovereign annuities are likely to be cheaper than conventional annuities, availing of this option will allow trustees of underfunded schemes to achieve more equality in distribution.

While trustees are not obliged to purchase sovereign annuities in such an instance, it is arguable that, in light of their fiduciary duties to all members, this option should at least be considered. Trustees who wish to purchase sovereign annuities in the names of pensioners can do so without the pensioners’ consent.

Buy-In
Trustees of many ongoing schemes may be more prepared to consider a buy-in option rather than transferring the credit risk to pensioners. In such instances, trustees may seek some form of additional security (e.g. by requiring the employer to offer contingent assets as security for funding obligations) before they are prepared to proceed with a buy-in option. While schemes may avail of a “credit” for these annuities in their funding standard calculations, trustees must:

• take advice on the appropriateness of securing pensions in this way
• commit to using sovereign annuities on any subsequent wind up of the scheme, and
• communicate their intentions (and the default risk to pensions in payment) to scheme members and any authorised trade unions, although they do not require members’ consent.

Alternative Annuity Products

It is anticipated that “blended” type annuity products will emerge whereby, for example, a conventional annuity is used to secure the core pension and a sovereign annuity is used to fund promised pension increases. Trustees are likely to be more comfortable in purchasing such products for pensioners as the risks attached are less than those attached to pure sovereign annuities.

Risks

In addition to the credit risk highlighted above, there is no doubt that trustees will be conscious of a reputational risk associated with sovereign annuities. In particular, trustees will be mindful that availing of these options may change the nature of the promise made to DB members.  However, trustees can take a certain level of comfort from the amended Pensions Act which provides that a court can relieve a trustee from liability (wholly or partly) for breach of trust in relation to the purchase of sovereign annuities where it appears to the court that the trustee acted honestly and reasonably and ought fairly to be excused.

Comment

The sovereign annuity initiative widens the options available to trustees of DB schemes. However, in light of market changes, it is questionable whether sovereign annuities will prove to be as beneficial as originally thought. It is clear that the initiative will not be a suitable option for every scheme. Trustees will face difficult decisions in trying to balance benefit entitlements with pension security and the most appropriate solution will very much depend on the circumstances of the particular scheme. The cost of sovereign annuities will be an important factor for trustees when deciding whether or not to avail of this option and will, to a large extent, determine the success of the sovereign annuity initiative. In reaching their decision, trustees will need to carefully evaluate the different options open to them and be mindful of their fiduciary duties to all scheme members.

Contributed by Lorna Osborne & Mary Greaney