Aon have worked out that buy-out has limited attraction. It has limited attraction for a pension consultancy that makes its money from actuarial and investment advice, often extended to fiduciary management and it makes little sense to sponsors who pay up to a 20% premium to an insurance company to get them to buy-out a scheme. It leaves trustees redundant and offers members no prospect of discretionary benefits. While a buy-out removes a problem, it looks like a wasted opportunity to members, trustees, sponsors and advisers.
Having marched clients to the top of the hill and given them the prospect of buy-out, is the Grand old Duke of York about to march them down again?
Aon’s answer to that is “ASTRO”, an investment strategy which is an acronym for “active strategy to run on”.
It claims to enable schemes to “target material levels of surplus over time whilst maintaining exceptionally high levels of security for members“.
As we all know, there is no such thing as a free lunch, so “active” readers will be asking what gives. What gives is that 20% premium that schemes don’t need to pay to an insurance company. Assuming all else is equal in terms of asset returns and the unwinding of the actuarial prudence in mortality assumptions, schemes get to keep the 20% of scheme assets which can be paid to members , sponsors and advisers.
For those who follow these things , this is the DIY capital-backed journey plan where “strong/trending strong” sponsors, keep the scheme on their balance sheet and pocket the premium.
Aon say that such an idea is written into the Mansion House reforms but I think this is a stretch. My reading of the deal is that Jeremy Hunt & Co were happy to see a relaxation on the rules surrounding scheme funding (the DB funding code) in exchange for a scheme committing to a long-term growth strategy which benefited the economy. There is a quid per quo here which isn’t quite reflected in Aon’s proposal
Putting it into numbers, our modelling shows that a mature £1 billion scheme that has sufficient money to buyout, could instead invest in the same way as an insurer for the next 20 years and generate around £300 million of surplus
The security offered is that there is only a one in two hundred chance of things going wrong and a 99.5% chance of things going right – which isn’t far off the risk of an insurance company going wrong.
Put this way, why would a pension scheme want to buy-out in any circumstances?
As Aon accept in a question asked at the end of a webcast on ASTRO, ASTRO is unlikely to pass the “fast-track” test laid down by TPR as part of its funding code. It requires too feisty a discount rate.
The answer is of course that this kind of arrangement needs a sponsor with the deep pockets to stand behind the arrangement (“a strong to trending strong covenant”). You also need a scheme of a size where the fixed costs of running the scheme don’t make the scheme unviable (even with a 20% kicker).
Not being an insurance company, Aon can , through Astro, offer the heads the insurer wins , tails the sponsor and member win ( and whatever happens Aon wins) solution ! What is not to like?
What I don’t like is the paucity of ambition. Do occupational scheme trustees aspire to invest like an insurance company in corporate debt and in funding infrastructure. Why not aspire to own real assets and put them to good use? Why not aspire to own companies and ensure that they are managed in a way that is beneficial to society and the planet and that offer the good governance that pension schemes can demand?
Why in short, should there be constraints placed on trustees to invest like an insurer?
As I have recently written, the advantages of being a long-term investor are not about “harvesting an illiquidity premium” , a theoretical construct, but in entering into long term ownership of assets where your capital cam make a difference to the asset itself”. In short, the advantage is in equity ownership over debt.
So I’d like ASTRO a whole lot more if it offered a way to invest that wan’t like an insurance company!
Is there merit in running on?
Undoubtedly there is. There is merit for a scheme in running on, either to guarantee future benefits or to offer future accrual on a non-guaranteed CDC basis. The cost of running on is greatly increased when schemes close (the red box below). The best way of running on is as a scheme open to new accrual (DB or DC)
The second best way of running on, is to lengthen the duration of the scheme to invest in assets with as long a time horizon as possible. This requires a purposeful investment strategy which needs a committed sponsor and trustees who take a long term view on asset ownership.
Most sponsors are not prepared to take this long term view on their own, they want to know there light at the end of that tunnel, whether that light is a buy-out, a superfund or a handover to a second sponsor offering contingent assets in lieu (the capital backed journey plan). The sponsor might even want to hand on to a superfund, if the market for that structure develops.
Tax-payer regrets
There is one further stakeholder in the mix, the tax-payer. Through various corporate and personal reliefs, the UK tax-payer has subsidised a funded DB plan over the years to a point whether much of the scheme’s value (surplus) is down to tax-breaks.
It seems reasonable that Government, as agent for the tax-payer, has some influence over the disposition of assets within the scheme. Investing like an insurer means ripping out the gilts base of a scheme and replacing them with corporate debt- that usually means the debt of overseas companies. It also means reducing exposure to growth seeking “real” assets so that a gilts + investment strategy is driven by the increased yield from corporate bonds over gilts without the volatility of investing in equity.
This is a recipe for stability, but not for growth. Britain is stable at the moment to the point of stagnation. Were the Mansion House reforms no more than the chance of pension schemes to behave like insurance companies. As a tax-payer, I want more value for my money than that!
In conclusion
Aon are demonstrating the loss in value to pension stakeholders when schemes transfer to insurers through buy-out. So ASTRO has done some a priori good.
But by asking occupational schemes to behave like insurers, it is asking a sponsor to be an insurer (albeit with the long-stop of the PPF and without the matching adjustment and solvency rules.
To those who want to see pension schemes solve societal problems, this arrangement does no more than an insurance company can do, and probably rather less.
I think ASTRO is a step in the right direction , but a missed opportunity – unless it adopts a more positive approach to the management of a scheme’s asset base.
For more information on Astro, watch the seminar and the corporate blurb here.
An article on Astro has been published in Professional Pensions here
Another advantage of scheme run on to the sponsor is that they may avoid a P&L A/c hit triggered by a buy-out. Under IAS19 the projected liabilities of the scheme have been discounted using the Corporate Bond yield as the discount rate giving a lower liability figure than the cost of the buy-out, usually assumed to be priced on lower gilt yields. Therefore part or the entire surplus represented in the previous balance sheet asset figure disappears. As I understand it, and I stand to be corrected, that hit as a result of a specific action, namely the buy-out, is taken as a current year cost to the P&L A/c, whereas changes to the asset value arising from scheme experience or actuarial assumptions in run on are taken “below the line” to the Statement of Comprehensive Income.
On reopening to DB accrual, if minimum auto-enrolment contributions rise to 12%, a new section with benefits above the minimum auto-enrolment requirement of 1/120th funded on an LPI indexation basis, especially if there is some downside protection provided such as by conditional indexation, must surely be an attractive proposition. For risk analysis, it should be fairly easy to model the interest rate at which the 12% contribution will not cover the targeted benefit accrual. Any surplus from the closed section can also be applied for the benefit of the members in the new section. The question is whether that DB arrangement is likely to provide a better outcome for Members than a 12% contribution into an alternative DC arrangement?
On opening up to new benefit accrual (whether DB or DC) one of the major factors influencing the investment policies will be the impact of the contribution cash inflow, possibly making the scheme cash flow positive on an annual basis or at least lowering the outflow requiring either secure annual income flows or the sale of capital assets with volatile market prices. This surely should make “productive finance” investing lower risk for the open Scheme.
You are correct administration costs, including any PPF levy, have a major impact on smaller schemes restricting the advantages of run on or run-out over buy out. Some form of Scheme consolidation is therefore advantageous. However as the PPF pointed out with regard to their own consolidation aspirations, member administration and investment pooling are the key efficiencies offered by consolidation. LGPS type investment pooling arrangements and multi-employer pension schemes are currently possible and go some way to address these issues.
On tax relief, I recall that in the 1980’s the key issue faced by many sponsoring employers was the requirement under the Finance Act 1986 for a pension scheme with a surplus in excess of 5% when measured on a prescribed basis to reduce its surplus by increasing member benefits (up to Inland Revenue limits), or reducing employer and/or employee contributions, or by refund to the employer taxed at 40%. Failure to do so resulted in the loss of tax relief on the Pension Scheme’s investment income. The Act replaced an Inland Revenue power to require a refund to the employer subject to tax – dividends were taxed at source then. James.pdf (actuaries.org)
I am afraid I also old enough to remember that the justification of tax relief for pension schemes and contributions was that the Members were less likely to require means tested benefits during retirement and those with higher pension incomes in retirement also paid higher rates of income tax.
My only wonder on the “ASTRO” suggestion, is why it has not been obvious all along and why it should now come as a surprise. Doesn’t say much for the quality of advice given to pension schemes and employers.
The link above is to http://www.actuaries.org/IACA/Colloquia/Munich/Vol_2/James.pdf