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Is it legally permissible for trustees to secure pensioner benefits using sovereign annuities?

  • Ireland



    I am not going to focus in this article on what sovereign annuities are, what they may do for the funding position of schemes or what the investment risks associated with them may be.  There has been much useful commentary on these issues, both by advisory firms such as ourselves and by the Irish Association of Pension Funds and the Society of Actuaries in Ireland, which I am not going to rehash.

    Instead, I wish to focus on a point in time when, due to a number of other factors falling into place, trustees are faced with a decision as to whether to invest in sovereign annuities to secure pensioner benefits or not.   For this purpose, let us assume the following scenario:

    • A defined benefit scheme which is insolvent.
    • Employer funding is not available to bridge the gap, whether for legal or financial reasons.
    • The scheme is either likely or certain to go into wind up, but it has not done so yet.
    • The trustees have a choice of securing pensioner benefits by either traditional annuities or sovereign annuities.
    • If sovereign annuities are chosen, the non pensioner members will receive a materially higher cash equivalent transfer value on the wind up.
    • The transfer value will still be less than a full transfer value on the Minimum Funding Standard basis.
    In this scenario, can the trustees buy out the pensioners using sovereign annuities?

    Sovereign annuities can only be used to secure pensioner benefits if the trust deed and/or overriding legislation provides for this.

    A provision in the trust deed governing the scheme which specifies that the trustees can secure pensioner benefits by sovereign annuities – in effect an annuity that has investment as well as counterparty risk attached to it – is optimal.  The scope of what the pensioner is entitled to is then delineated by the trust deed itself. 

    If the trustees are relying on the Pensions Act for their power to secure pensioner benefits by the purchase of sovereign annuities, that the relevant provisions are Section 59(3), prior to wind up, and Section 48(3), following wind up. 

    The pre wind up power is wider.  It states that the trustees may at any time, notwithstanding anything contained in the scheme rules and without the consent of the members, discharge the liability of the scheme for benefits payable to pensioners by making on behalf of the pensioner one or more payments to a sovereign annuity certified by the Pensions Board.

    Section 48(3), which applies when a scheme has gone into wind up, also overrides the scheme rules and any member consent requirement.  However, it provides that the payment must be of an aggregate amount not less than the “actuarial value” of the benefits payable on winding up under the rules of the scheme.  Actuarial value under the Pensions Act means the equivalent cash value of a benefit calculated by reference to appropriate financial assumptions and making due allowance for survival in accordance with normal life expectancy for a member in normal health.

    While the pre wind up and post wind up provisions are framed in different terms, the differences may be of limited impact in practice.  Under the applicable professional guidance issued by the Society of Actuaries in Ireland, a discount rate of 4.5% and an inflation rate of 2% should be assumed post retirement when calculating transfer values.  An actuarial value calculated on this basis would, as I understand it, be no higher than the likely sovereign annuity buy out cost currently available in the market.

    Would the purchase of a sovereign annuity in accordance with Section 48(3) or Section 59(3) breach the trustees’ duties to the pensioner members?

    In my view, there is no intrinsic reason why it would do so.

    Pensioner benefits (excluding future increases) must be paid in priority to active and deferred member benefits on a wind up, but the same legislative provision which requires this allows such benefits to be discharged by the purchase of a sovereign annuity.  In other words, the legislation de-limits the statutory priority to this extent.  As a result, in my view it could not be argued that the purchase of sovereign annuities in the scenario outlined is an improper or invalid use of the statutory power per se.

    In summary, neither the nature of a sovereign annuity nor the priority accorded to pensioners under the Pensions Act is a fundamental barrier to the use of sovereign annuities in our assumed scenario.

    Exercise of the discretion

    So if the trustees can do this, should they exercise their discretion to do so in practice?  I am not going to embark on a discussion of the many factors which might go into such a decision (which will be scheme specific, and would exceed the scope of this article).  However, a couple of points can be made.

    Obviously, the trustees must make an objective decision, based on relevant considerations and appropriate due diligence, and having given due regard to the respective interests of the active, deferred and pensioner members.  As long as they do so, their decision is not in principle open to being challenged by a particular beneficiary as being “unfair” or less favourable to him or her than to other beneficiaries. 

    It is also well established that relevant considerations include the financial impact of the wind up on the entitlements of active, deferred and pensioner members, and how that would be impacted by using sovereign annuities to discharge certain benefits, as opposed to traditional annuities. 

    However, the trustees must not forget the issue of appropriate due diligence.  The investment risk associated with a sovereign annuity must be fully analysed, as well as the normal counterparty risk associated with an annuity.  The trustees should take definitive advice on these investment risks, and this advice may shape the nature of their final decision.

    This article originally appeared in the Winter edition of Irish Pensions Magazine, the online magazine of the Irish Association of Pension Funds.

    This article is a personal comment only, and does not constitute legal advice.


    This information is for guidance purposes only and should not be regarded as a substitute for taking legal advice. Please refer to the full terms and conditions on our website.

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