Final destination: setting a journey plan

UK Defined Benefit (“DB”) pension schemes are maturing.

The Pension Protection Fund’s (“PPF’s”) 2019 Purple Book shows that of the 5,422 schemes surveyed, 88% are closed to accrual or closed to new members, and only 11% of aggregate members are active. The continued maturing of liabilities has prompted greater focus on end-game planning amongst trustees, sponsors, advisors and regulatory bodies.

Broadly, there are three possible positive end game outcomes for schemes:

  1. Transfer liabilities to a regulated insurer
  2. Target a so-called ‘low-dependency’ funding level, and / or
  3. Transfer scheme liabilities to a consolidator vehicle.

Whilst the first option is well understood, consolidation and ‘low-dependency’ targets remain relatively newer concepts.

What are the pros and cons of each option and how should you choose one?

1. Transfer to insurer

Securing member benefits with an insurer (e.g. through a buy-in or buy-out) is well-known and considered to provide maximum security for members, in so far as insurers are generally considered to be the safest place for liabilities to sit due to protections offered by the insurance regulatory regime and Solvency II framework. However, it’s also expensive, as insurance providers must meet stringent Solvency II capital requirements (and also make a profit). This means that this option will likely only be available to schemes which are very well funded, able to secure the ‘top-up’ needed from the sponsor, or who are willing to wait until pricing for their scheme becomes more attractive.

2. A ‘low-dependency’ funding target

The focus on setting a formal end-game objective has led to discussion of ‘low-dependency’ funding targets – funding levels which, if achieved, are expected (based on investment modelling) to allow a scheme to pay benefits as they fall due without any additional contributions from sponsors.
Whilst targeting a low-dependency funding basis has merit (compared to a TP basis which can be seen as a ‘staging-post’ to a scheme’s end game), achieving this funding target is not easily done. Even if investment risk has been minimised, significant risks (e.g. credit defaults, model risk) will remain and must be supported by the covenant. Furthermore, a sponsor insolvency creates legal and regulatory risks which are too often ignored by investment advisors.
In other words, even if the scheme reaches a ‘low-dependency’ funding target, covenant reliance is likely to remain until such a time as when the liabilities have been secured or transferred to a third party (e.g. an insurer) – trustees should consider the implications of this carefully.

3. Transferring scheme liabilities to a consolidator vehicle

Full consolidation in the DB space (as opposed to consolidation of certain scheme operations) remains a relatively new and innovative concept, with potential providers still being scrutinised by TPR. These commercial consolidators effectively monetise a scheme’s existing covenant – trustees agree to ‘cash in’ the sponsor’s obligation to the scheme in exchange for a sizeable up-front capital injection from the consolidator.

However, consolidation will sever the link to scheme sponsors and, if it results in a transfer to a vehicle that is less secure than an insurer, trustees will need to understand why this is in the best interests of members. This issue will be particularly important for schemes which are backed by a strong employer covenant, and / or schemes which are close to being in a position to transfer to an insurer.

Choosing between these outcomes is just one of the first steps in the journey planning process. Once agreed, trustees will then need to decide on a strategy to achieve the desired option based on the covenant and its ability to support the scheme’s evolving risk profile.