When reaching “self-sufficiency” doesn’t mean being self-sufficient

Given the high cost of buy-out and with Defined Benefit (“DB”) consolidation yet to take off, many schemes are being forced to target ‘self-sufficiency’– a funding level which, if reached, is intended to minimise reliance on the covenant. But this is not the same as having no reliance.

Setting aside the non-trivial risks which will still remain, the term ‘self-sufficiency’ had become confused with meaning that a scheme can operate without its sponsor.

Notably, even for companies with BBB (investment grade) credit ratings 5% are expected to default on their obligations over a 15-year period. This should come as a sobering thought for many trustees who risk overlooking continued covenant reliance and not delivering full benefits to their members as a result.

Much of the focus until now has been placed on how ‘self-sufficiency’ or ‘low dependency’ is defined in terms of actuarial assumptions or investment returns.

This misses the core problem that a scheme may not be able to exist without a sponsoring entity for two main reasons:

  1. Pension scheme rules determining what happens when a scheme loses its last solvent employer can vary – some require that the scheme is wound up and bought out with an insurance provider (even below full benefits) and
  2. Even if a pension scheme was funded above Pension Protection Fund (“PPF”) benefit levels, it would still require regulatory approval to transfer to a new sponsor to continue operating. This approval has only been granted a few times in the past (and one of these schemes has since failed), so to assume that it would be given, even if a scheme was ‘self- sufficient’, is a significant assumption.

If regulatory approval is given (under point 2), the PPF has stated that it will require a power to wind up the scheme if funding falls below an agreed level. Unless schemes can maintain a material surplus on a PPF basis with a low risk investment strategy, the annual PPF levy could become a ‘drag’ on the funding level and could ultimately require the trustees to wind up the scheme to prevent a further reduction in benefits for members.

Large PPF surpluses can be eroded as the benefits underwritten by the PPF increase over time, known as ‘PPF drift’. Unless a PPF surplus can be safely maintained over the life of the scheme, it isn’t ‘self-sufficient’.

For these reasons the market has moved towards the term ‘low dependency’ which is more reflective of some of the risks set out above.

So, what should trustees be thinking about before setting a strategy based on ‘low dependency’

  1. Review the rules of the scheme (taking appropriate advice), including wind up requirements on insolvency. If so, a strategy based on reaching ‘low-dependency’ may not be appropriate.
  2. Understand the projected evolution of the scheme’s funding level and whether headroom can be maintained over PPF benefits. If not then, even if a ‘’low-dependency” target is reached, the scheme is unlikely to be able to deliver full benefits if its sponsor becomes insolvent.
  3. Monitor the covenant and put in place actionable contingency plans that can be implemented if the covenant deteriorates.
  4. Be mindful that low dependency does not mean no dependency!