Is buyout right for every pension scheme?
For many UK pension schemes, a welcome consequence of last year’s gilt crisis was a dramatic improvement in their funding level. This brought buyout and wind-up into sharper focus for many trustees.
But whilst buyout is often seen as the ‘gold standard’ endgame solution, trustees and their corporate should carefully consider what it means for them and their members.
The “gold standard” of pension scheme endgame solutions
There are several reasons why buyout has over the last few years been the favoured endgame solution amongst trustees.
First and foremost, insurers are required to be well-capitalised under the strict regulatory environment in which they operate; as a result, insurers are better funded than most pension schemes. Alongside this capital, insurers’ well tested risk management frameworks tend to give trustees comfort.
That framework and capital operates under the close supervision of the Prudential Regulation Authority (PRA) and their comprehensive array of powers to protect insurer policyholders. Plus, at the moment the expectation is that the Financial Services Compensation Scheme (FSCS) would pay out benefits in full in the event of failure of an annuity provider, which is more generous that the PPF.
These factors mean that most trustees expect a buyout to deliver a high degree of benefit security for members. The good news is that the cost of accessing that security has become more attractive, with competition in the reinsurance market driving good pricing particularly for deferred members.
From the corporate sponsor’s perspective, a proportion will support buyout given the reduction (and ultimately removal) of the risk and volatility that the pension scheme poses to their balance sheet, noting that future asset or liability volatility could reverse recent funding level improvements, taking buyout back out of reach.
There is, therefore, much to be said for striking while the iron is hot.
A premium opportunity with a premium price
However, for many it is impossible to ignore the glaring fact that buyout is an expensive option. This is particularly the case when compared to a DIY run-off strategy. In fact, a buyout is likely to cost significantly more than the best estimate cost of meeting members’ benefit promises into the future.
So what solutions are there for schemes where buyout is not an attractive option?
Alternative de-risking structures, such as commercial pension fund consolidators and capital backed funding arrangements, could provide vital de-risking paths for such schemes. What these solutions lack in precedents – few have been transacted unlike well-trodden buyouts – they make up for in their ability to be tailored to a scheme’s specific circumstance. They are also more affordable than buyout.
With renewed Government and regulator support, these alternative de-risking solutions merit consideration from certain pension schemes, in particular those with less robust sponsor covenants. In its recent response to the consultation on the consolidation of defined benefit pension schemes, the Government set out the parameters for a permanent regulatory regime for commercial consolidators. Once it has been put in place, it will result in this de-risking option being 10% more affordable than buyout, according to research by the Government Actuary’s department.
The market has already seen an increased number of alternative de-risking solution providers. Additionally, the easements and flexibilities put forward by the Government for the permanent regulatory regime should motivate new market entrants and provide room for further innovation in this space.
Scheme trustees considering alternative de-risking solutions will take some comfort in the fact that the solutions are under the regulatory supervision of the Pensions Regulator. As a result, their member benefits would still be covered by the PPF in the event of sponsor and/or solution provider failure.
Alternative de-risking solutions
The key is the optionality that these alternative de-risking solutions provide. They can be the key that:
- helps a scheme where buyout is currently out of reach;
- get to buyout over a defined period with potentially lower volatility during that journey; or
- enables a scheme that is looking to run-on with its sponsor build up a comfortable funding buffer to continue that journey into the future.
Unlike buyout, which is an irreversible step for pension schemes and limits the flexibility they might have been able to enjoy under the sponsorship of their employer, some alternative de-risking solutions could preserve the possibility of member benefit enhancements. They could also give the opportunity for the trustees to drive investment strategy (such as actively investing in the green economy), or for surplus funds to be used for other purposes by the company (for example funding their DC pension arrangement).
We are seeing an increased number of trustees and corporate sponsors willing to challenge market norms by considering whether there are solutions that strike a more attractive balance between risk-reduction, benefit security and affordability. Alternative de-risking options are addressing that need.
Balancing risk and reward
The decision to move to buyout is one of the most important ones a trustee will make. Cardano takes a product agnostic approach to endgame planning and encourages pension schemes to work with key stakeholders to identify which solution will deliver the best outcome for members based on their own unique circumstances. It is clear to us that trustees and corporates should stand ready to challenge herd mentality and ensure the path they choose is right for them.
