In this blog, I explain why offering guaranteed “pensions” is something institutional investors are interested in. There is an opportunity right now to reopen a proposition, all but forgotten – the defined benefit workplace pension.
To me, the most interesting finding that came out of the recent ONS report on DB dynamics is this .
Private sector defined benefit and hybrid pension scheme deficit reduction contributions, which have been smaller since Quarter 2 (Apr to June) 2022, fell to their lowest level in the published time series in Quarter 3 (July to Sept) 2023, which may suggest these pension schemes required fewer contributions to make up for funding level shortfalls.
Corporates have a pension budget that for years has been spent on keeping the DB pension afloat. These contributions were required because of QE which required DB schemes to consider them in deficit when in normal times they would have been in surplus. Now are “normal times” and schemes are in surplus despite giving up £166bn in assets to keep LDI hedges in place through 2022 and into 2023.
If , as seems likely, the surpluses currently enjoyed by DB schemes are maintained, then we can expect to see deficit contributions drying up and schemes looking to divert money that would have been paid to the DB plan- elsewhere.
The pension budget may not shrink, it may be reallocated to funding DC contributions and that may extend beyond contributions to the redistribution of surplus.
The impact on contribution rates to DC could be quite substantial and most unexpected. I doubt many master trusts have DB windfall payments baked into their business plans for 2024 and 2025.
We have for some time considered that DC de-risks DB. This is a trope, DC merely diverts risk from employer to saver. If savers want pensions they have to make do with annuities, which aren’t pensions but contracts of insurance that do the pension job- badly.
The original idea of a funded pension was based on trustees being able to rely on employers and employees to contribute to a fund that could take short term risk because in the long term, risks were rewarded. So long as DB schemes stay in their sweet spot, they work, as soon as they are closed for future accrual , they lose the infinite time horizon that make them work
The pension industry has got itself into a collective funk about future liabilities to a point that some trustees would rather take DB schemes into the PPF than run their schemes on. Outrageously, I have evidence of two DB schemes that has preferred to give their members a pensions haircut than run on.
But this state of funk is not shared by everyone, the private equity industry has woken up to the opportunity of backing DB schemes to stay open and I know of at two firms who are now offering capital to schemes who are in distress or looking to extract unwanted surplus to invest in the sponsor or boost DC pensions.
It is only a small step , for these confident investment decision makers to choose to open schemes up to take more risk. This is what is being proposed by Pension SuperHaven , a DB scheme that is opening to pay pensions in exchange for DC pots.
If the aim of such investors is to take risk, the structure used to manage the inflow of money is of little importance. Such activities can be governed by a trust set up by the investor but as easily use an existing occupational trust – including a master trust.
It is reasonable to think of Pension SuperHaven being embedded in any mature large pension scheme where there are likely to be flows from savers more comfortable with a pension than a pot. Infact , this seems the eminently sensible way for an investor to attract the “wanted”pension risk.
Once the risk is captured, it can be mitigated by selling on the unwanted risk, for instance longevity risk for which there is capacity in the reinsurance market. Investors are in a strong position to choose the risks they keep and the risks they choose not to keep.
Because investors like Carlyle and Disruptive Capital are looking to take on the mantel of the employers who set up DB schemes in the second half of the last century. This is understandable. Had those employers not lost their nerve, or in some cases not been talked into closing their DB plans, the occupational DB plan would not be considered broken.
We are so used to the concept of de-risking that we forget that there is an immense appetite for risk from the investment markets. So far, insurance companies have had the de-risking agenda to themselves , could this be changing?
Might now be time to rethink the DB/DC dynamic and recognise that by using collective structures, the individual saver can once again enjoy the defined benefits of a workplace pension scheme?
Just a few random thoughts on this:
1. It is the TPR that effectively sets the assumptions about the future in a Scheme’s Technical Provisions valuation. Those assumptions take no cognisance of how the Scheme is invested.
2. If the current assumptions do prove more accurate than the previously set assumptions then then these previous assumptions must have been incorrect. So unless there have been substantial additional cash contributions into the scheme or there has been unpredicted high mortality of scheme members, a pension scheme now disclosing a surplus must have previously been in surplus.
3. The triennial nature of the actuarial valuations and the agreement of the Schedule of Contributions (required to be set against the TPR’s Technical Provisions valuation not the Scheme’s Solvency Valuation) means that it takes some time for changes in the underlying assumptions to filter through (potentially almost up to 5 years after the valuation date). We are therefore likely to see contributions into closed DB Schemes continue to fall/dry up for a few years yet.
4. It appears to be widely misunderstood that the Technical Provision valuation required under the Pensions Act 2004 is not the Scheme Solvency valuation set by actuarial standards. The Scheme Solvency valuation (sometimes called Best Estimate or Neutral basis valuation) appears to provide a better yardstick to guide Trustees’ decision making.
5. The capacity of a scheme to pay benefits as they fall due is dependent on the cash flow of the scheme. A closed scheme with no regular contributions is reliant on its income from investments (including buy-in policies) to avoid having to sell its capital assets at an accelerated rate, leaving little or no contingency for accelerated or unexpected events or the discretionary benefits provided under the Deed and as originally agreed by the employer establishing the scheme.
6. The pool of excess assets is diminished if they have been used to buy-in or buy-out benefits at a cost above that exceeded the income generation capacity of alternative assets. A buy-in may therefore have increased not decreased the risk to the full benefits potentially available to members.
7. Similarly part of the key features of a DB scheme is its pooled risk nature. If a scheme gives up the pooling of its mortality risks by securing annuities on an individual life basis for scheme members, it is giving up the benefit of pooling its risks. This is particular relevant to mature closed schemes, and in smaller schemes early mortality scheme experience can completely change its funding position. NB: this may be a significant contributory factor to the currently reported surplus levels in the PPF.
8. If however a scheme receives a regular stream of both Member and Employer contributions, it can use that cash flow to meet the current outflows leaving the existing assets to be productively invested to provide future benefits. Reopening to DB accrual should therefore be of interest to not only schemes in surplus as a way of reducing future contribution needs but also for schemes disclosing a technical provision deficit. The auto-enrolment minimum contributions still have to paid but the additional deficit recovery contributions can progressively reflect the decreased maturity of the scheme and its capacity to invest productively.
Thanks Oldie
As always, your posts compliment if not better the blog.
If I may correct just one of the points you make.
It is not TPR who set Technical Provisions, it is DB trustees on advice from the scheme actuary and a covenant adviser, if any.
TPR may, however, review and challenge the basis of the trustees’ assumptions.
Thanks Byron,
While technically you are correct. While it is the Pensions Act that sets out the requirement for technical provisions, it is the TPR that sets out in its Guidance and Codes how the Trustees should approach setting the assumptions adopted for the valuation. While it is possible to use an asset based model (which does reflect scheme assets) for a technical provision valuation, the TPR has strongly discouraged its use suggesting it is only appropriate for an open scheme with a strong employer covenant (Statement to the DWP Committee in November 2022).
Sorry the above should have read:
While it is the Pensions Act which sets out the requirement for a technical provisions valuation, it is the TPR….
On the topic of TPR overstepping its powers on the setting of Technical Provisions, in its consultation on its draft low dependency funding and investment statement, TPR is seeking to link the basis for SFO technical provisions to the low dependency basis.
In the consultation document, it says “By the time of the relevant date, the discount rates for Technical Provisions should be equivalent to or more prudent than the discount rates for low dependency.” And the discount rate for low dependency is gilt yield + 0.5% pa, or thereabouts. Lines 29 and 33 of TPR’s data specification spreadsheet both state an expectation that SFO technical provisions and low dependency basis will converge over time.
Important features of the SFO regime include:
• The prudent discount rate may be set by reference to either the yield on high quality bonds or to the expected return on the assets and future contributions.
• Technical provisions are set by the trustees in consultation and agreement with the employer. There is not a role for TPR in the setting of technical provisions, although of course TPR has a role in the review of the trustees’ and employer’s decision.
It is wrong for TPR to seek to exclude one of the statutory options for setting the discount rate for technical provisions (by mandating the bond yield option in preference to the expected return on assets option) and it is wrong for TPR to seek to mandate what technical provisions will be (by mandating a low dependency discount rate of gilt yield + 0.5% pa). TPR is not given these powers and role in the SFO funding regulations.