Will DB pension consolidation work?
Many defined benefit pension schemes are facing significant funding challenges, in large part due to low interest rates and increases in longevity. Could consolidation be the answer?
David Davison takes us through the options and highlights the potential benefits and barriers to success as part of our Challenging Conversation on pensions.
The more I read about defined benefit (DB) consolidation, the more it appears to have a key parallel to Brexit, namely: everyone seems to have a different expectation of the outcome.
The DWP’s White Paper “Protecting Defined Benefit Schemes” was published in March and followed up last year’s Green Paper with further proposals on the benefits of consolidation.
Having larger schemes reduces cost and improves governance, but smaller schemes are better funded.
There are multiple consolidation options. Each will have a different impact and will be complicated to achieve.
The suggestion is that bigger is better. Having larger schemes reduces cost and improves governance. Interestingly, however, the 2017 Purple Book suggests that smaller schemes (i.e. those with less than 100 members) are on average better funded than those with more members.
So, in considering consolidation, what options are possible, what are their potential benefits and what might be the associated considerations?
Investment consolidation
The potential to consolidate investments seems relatively simple, can reduce costs and provide schemes with access to a greater level of investment choice.
Access to investment platforms can provide cost and administrative benefits.
Access to investment platforms can provide cost and administrative benefits even without wholesale changes to underlying governance or administration.
Governance consolidation
Consolidating governance, for example, in the form of sole ‘professional’ trusteeship also seems to present schemes with a straight-forward path to governance improvements and can be achieved without upheaval to the schemes’ delivery services.
Going beyond the above there is further potential, but the benefit improvements are much less certain based upon the specific circumstances of each scheme and employer.
Operational consolidation
There may be operational opportunities to merge key scheme services such as administration and actuarial.
It’s far from clear cut, however, that such a move will result in cost savings.
There is little evidence that the provision of services within a DB Master Trust are provided at a materially lower cost unless some form of benefit consolidation can be achieved.
In addition, the likely scheme time horizon will have a huge bearing on the cost effectiveness of any move given the inevitable set-up costs of a service change. If, for example, the time horizon to buyout is within 5-10 years then annual savings may not outweigh initial transition costs.
Any move to a DB Master Trust must be reviewed in terms of flexibility. Such a move will require a scheme to fit within the DB Master Trust model where any pricing improvements which can be achieved are done so via some form of standardisation.
What is the Master Trust approach to employer covenant and is it likely to incur additional costs?
The timing of valuations or the approach to administration may not be something that suits all schemes or employers.
What is the Master Trust approach to employer covenant, member communication and benefit options and is any approach outside the norm likely to incur additional costs which may negate any savings?
This will be an important initial consideration as in my experience these schemes are much easier to join than they are to exit.
Benefit consolidation
This is even more problematic.
Converting one scheme benefit basis to another has long been fraught with difficulty given that ultimately a guarantee will have to be provided that members will be no worse off.
This will undoubtedly result in up-front costs that again have to be considered against any savings which can be made in future.
There have been calls for Government to standardise benefits to make consolidation easier, but it remains to be seen how this can be achieved.
Ultimately a Scheme Actuary will have to sign-off any benefit conversion to confirm that the change does not detrimentally impact on members’ accrued benefits, which is far from an easy hurdle to get over.
It is difficult to envisage how consolidation can happen for schemes with unequal funding levels.
It is also difficult to envisage how consolidation can happen for schemes with unequal funding levels, as trustees would surely seek a “levelling-up” of funding. This has been an issue which has undoubtedly slowed the pace of consolidation in Local Government Pension Schemes (LGPS).
There must also be a concern that close links to key personnel in a scheme sponsor who can provide valuable insight from an employer covenant and operational perspective could be lost through consolidation.
Are ‘Superfunds’ the answer?
There have been proposals that a middle way between own-scheme funding and buying-out with an insurer may be possible.
This would be via what have become known as ‘Superfunds’ which would consolidate scheme benefits from multiple schemes. The suggestion is that sponsors would benefit from lower costs than that required to fund a buyout.
Any transfer in to Superfunds would need to be fully assessed by Trustees as being in members’ interests.
Proponents have been quick to highlight that any transfer in to Superfunds would need to be fully assessed by Trustees as being in members’ interests and that any agreement is likely to result in accelerated employer contributions over those paid under a funding plan in order to gain access.
An initial entrant to the market has suggested that revised legislation is not required as their scheme is just the same as any other occupational pension scheme and could run under existing regulation.
This, however, differs from proposals put forward by the Pensions and Lifetime Savings Association (PLSA) where it was expected revisions to the regulatory framework would be required.
Clearly we are at a very early stage in terms of this potential solution and it is likely to evolve over the coming months. Undoubtedly questions remain over this approach, particularly around the break in the link to the sponsoring employer and therefore the strength of the employer debt security.
Industry unconvinced by consolidation
The Association of Consulting Actuaries’ Pensions Trends Survey 2017 suggested that only 16% of sponsors would consider consolidation and only 32% thought that potential cost savings were real.
That would seem to suggest there are real concerns about how successful any consolidation might be and a high level of scepticism that promised improvements can be achieved.
There are undoubtedly opportunities for improved investment and governance available through some form of consolidation.
It is interesting that LGPS schemes where the benefit basis is the same have primarily gone for investment consolidation. This may well be a first step, but where funds have merged for delivery services the impact in the end-user experience has been patchy.
There are undoubtedly efficiencies and opportunities for improved investment and governance available through some form of consolidation, however, the extent will be very much based on individual circumstances and requirements.
Those in favour of much greater reform certainly have a lot of convincing to do.