Your questions answered

This is an attempt to manage the risk of the fall in the value of one asset ('Asset A') by purchasing another offsetting asset ('Asset B'). The aim is for the value of Asset B to respond in an equal and opposite manner to Asset A to a given set of factors. For example, you could try to hedge the risk of wet weather if you own equity in an ice-cream company by buying equity in an umbrella company.

For a pension scheme, hedging is also used to refer to investment in assets which behave in the same or a similar way to liability cashflows in response to a range of economic factors – eg changes in interest rates and inflation – with the objective being to reduce both the likelihood and size of any divergence between the value of the scheme’s assets and its funding target.

Often offered as an option (and very often the default option) for defined contribution (DC) arrangements, lifestyle is a term-to-retirement dependent investment strategy. While retirement remains in the distant future, a member’s contributions are invested normally in a range of assets (eg equities) expected to deliver “real” returns (ie above inflation). In the run up to retirement, the member’s contributions are moved gradually into an appropriate mix of assets whose final allocation depends upon whether the member has chosen a drawdown, cash or annuity option.

Productive finance refers to investment in assets that support long-term economic activity, including infrastructure, private equity, venture capital, affordable housing and growing UK businesses.

Pension scheme trustees may choose to “buy-in” some of their scheme’s expected future benefit payments by purchasing a bulk (ie one covering many individuals) annuity contract with an insurance company. This allows the trustees to reduce their scheme’s risk by acquiring an asset (the annuity contract) whose cash flows are designed to meet ie “match” a specified set of benefit payments under the pension scheme. The contract is held by the trustees and responsibility for the benefit payments remains with the trustees. Common uses of buy-in arrangements have been to cover the payments associated with current pensioners or a subset of those members. Contracts to meet payments to members who are yet to become pensioners can also be purchased.

A pension buy-in is an investment where a pension scheme purchases an insurance policy to cover the benefits payable to some or all of its members. This means that the insurer takes on the responsibility for paying the pensions of those members to the scheme, effectively transferring the risk from the pension scheme to the insurer. The scheme retains the legal responsibility for paying the pensions, but the insurer is responsible for funding the scheme so the payments can be made. The scheme transfers assets to the insurer to the meet the buy-in price.

Pension scheme trustees may choose to “buy-out” some or all of their scheme’s expected future benefit payments by purchasing a bulk (ie one covering many individuals) annuity contract from an insurance company. The insurer then becomes responsible for meeting pension benefits due to scheme members (effected ultimately by allocating an individual annuity contract to each scheme member). Following a full buy-out, (ie one covering all scheme members) and having discharged all of the trustees’ liabilities, the pension scheme would normally be wound up.

A pension buy-out involves a pension scheme assigning an insurance policy into the names of the members or other beneficiaries of the scheme. A buy-in is a necessary first step before a buy-out. The buy-out transfers legal responsibility for paying the members from the pension scheme to the insurer. Pensions are then paid directly to members by the insurer rather than by the scheme, and the buy-in ceases to be an asset of the scheme. This process is used to transfer all or part of the liabilities of a scheme to an insurer and is often associated with the winding up of the scheme. It is not normally necessary to make any additional payment to the insurer to move to buy-out.

In a defined contribution (DC) arrangement, a form of lifestyle in which, in the run up to the point at which a member starts to take their benefits, assets are gradually moved fully or mostly into cash. The member will then typically take their pension pot as a single cash lump sum or small number of cash lump sums.

Often used in relation to defined contribution (DC) arrangements, the default option is the fund or mix of funds in which contributions in respect of a member will be invested in the absence of any explicit fund choice(s) by that member. The three broad options members have at retirement are cash, annuity purchase or drawdown.

A deferred member is a person who has benefits in a pension scheme as a result of a previous employment.

A pension scheme in which the primary pension benefit payable to a member is based on a defined formula, frequently linked to salary. The sponsor bears the risk that the value of the investments held under the scheme fall short of the amount needed to meet the benefits. Contrast with defined contribution (DC).

A DB pension scheme surplus occurs when the scheme's assets exceed its liabilities—that is, the total value of promised pension benefits to members. This surplus indicates that the scheme is more than adequately funded, providing a buffer that can potentially be utilised for other purposes. (PLSA)