CP1 - Chapter 29

[kimiko]

Can you kindly help me understand this on page 8 of Chapter 29? I thought buying an annuity from an insurance company would reduce liquidity risk as the pension scheme won't have to reserve for the pension anymore and I am confused with the last paragraph. Thank you in advance for you kind help:

"In addition to the relative costs and the variability of those costs, the liquidity risk of retaining the risk or buying reinsurance also needs to be considered in making a decision.

This liquidity risk also arises for pension schemes purchasing insurance. Insurance is to pension schemes as reinsurance is to insurance companies.

For example, the purchase of annuities by a pension scheme may in itself create a liquidity risk for the pension scheme.

The purchase of cover for death-in-service lump sums will, however, remove a potentially significant liquidity risk. This may be particularly important for a pension scheme that is immature or small, as the investment income may be low relative to the death benefits."

 

[James Nunn]

Hi Kimiko

You are correct that, once the annuity is purchased, future liability risks reduced or removed for the pension covered by the annuity. However, there is a greater liquidity risk each time an annuity is, or annuities are, purchased. This is because a relatively large amount of cash is needed at one point in time to to buy an annuity, or annuities - much more than if you just paid each pension payment as it fell due.

This means there's a greater liquidity risk - the risk that the pension scheme won't have enough liquid assets to cover liability payments as they fall due (given these are much larger if they are the cost of purchasing an annuity rather than the cost of each pension payment) - if annuities are purchased.

I hope this helps.