Pension de-risking: whose risk is it anyway?
From consolidation to transfers, de-risking is a hot topic for pension scheme trustees and sponsors, as Stephanie Hawthorne explains
Millions of members’ benefits are at risk of not being paid in full if their sponsoring companies fail; most schemes cannot currently afford buy-out and are unlikely to be able to do so in the foreseeable future. This is a major problem for the fragmented and declining defined benefit (DB) pension sector.
One option for some is consolidation. Two brand new consolidators have set up: Clara and The Pension SuperFund (PSF), which pension schemes that can’t afford buy-out can use. There are dangers; they are untried and there is no employers’ covenant to fall back on – just the operators’ capital, so member security is less than with a full buy-out with an insurer subject to the capital requirements of the Solvency II Directive.
There are differences in the two superfunds as Suzanne Vaughan, Head of Retirement at Willis Towers Watson, Edinburgh, explained: “Clara promotes itself as a ‘conduit’ vehicle with the stated aim of transitioning liabilities to the insurance market over the medium term, say around 10 years. The Pension SuperFund, on the other hand, is more a ‘destination’ vehicle looking to hold assets and liabilities over the longer term, benefiting from economies of scale to drive down costs and drive up investment return.”
Act now or sit tight?
Should pension fund trustees use them now? Or sit tight? Paul McGlone, Partner with Aon, said: “Whether either consolidator is appropriate for any given scheme is a complex question, but trustees need to be sure that moving into a consolidator is a better option than the other alternatives available to them – whether that be remaining with the sponsor long term or waiting for a possible buy-out. For the right scheme, a consolidator could provide a welcome boost to security that it would otherwise struggle to achieve.”
The proportion of schemes for which the current consolidators (Clara and PSF) will be the right choice is quite small, rather less than 5% of the pension fund universe, said Bob Scott, Partner, Lane Clark & Peacock: “To be in the consolidators’ ‘sweet spot’ a scheme needs to be reasonably well funded (so ruling out stressed schemes), of reasonable size (so effectively ruling out schemes with assets of less than £10m or more than £10bn), not too mature and with an employer who can afford a funding top-up but cannot afford to bridge the gap to full buy-out.”
The pension consolidator will require a substantial cash injection from the sponsor for the trustees to agree to the transfer, said Alistair Russell-Smith, Partner and Head of Corporate DB at Hymans Robertson.
He said: “For schemes with weaker sponsoring employers, it may also be preferable to be backed by the financial covenant from the capital buffer in the consolidator than to be backed by the existing employer covenant. For the employer, there is an attraction in getting a clean break from their DB scheme at a lower cost than insurance buy-out.”
Penny Cogher, Partner with law firm Irwin Mitchell, said: “There is a lot of emotion around the new consolidators. This is both at the individual trustee level and among members. Even at the professional trustee level, there remain concerns about the consolidators, perhaps because of the loss of a lucrative client or worries about liabilities if the consolidators don’t
live up to expectations five or 10 years down the line.”
First mover advantage
Trustees should not rush headlong into the new superfund although there may be advantages, as Penny explained: “There are bound to be unexpected technical difficulties that take time to resolve at the outset. Later on the process should become slicker and more streamlined and so potentially cheaper in terms of professional fees, in the same way that traditional buy-ins and buy-outs now follow a fairly set pattern.”
She added: “To be among the first could result in those employers and trustees perhaps being able to persuade the consolidators to be more flexible about terms and special requirements. This type of flexibility may fall away somewhat as and when the process
of joining a consolidator becomes more streamlined.”
Stewart Hastie, Partner with KPMG, said: “We are also seeing superfunds offering more competitive pricing and higher levels of third-party capital backing for early movers.”
The loss of the covenant
But giving up the employer covenant needs careful consideration, as Matthew Cooper CA, Head of PwC’s Pension Covenant Advisory in Scotland and Chair of the ICAS Pensions Panel, emphasised: “The reliance a pension scheme has on its employer to fund any deficit is typically the single largest 'investment' a pension scheme holds. Replacing the employer covenant with a capital buffer means that comparing the risk and volatility of a prudent investment strategy against a scheme's long-term employer covenant will be vital in evaluating consolidation for an individual scheme.”
Suzanne Vaughan put it simply: “Trustees will need to compare the likelihood of receiving potential future contributions from the sponsor versus the ‘bird in the hand’ of a contribution and additional physical capital today.”
Stewart Hastie said: “For schemes with an insolvent sponsor but above PPF levels of funding (‘PPF+ cases’), it may be possible to provide almost the full level of benefits for members, or at least a materially higher level of benefits than the scheme would otherwise be able to provide through a bulk annuity.”
He added: “For smaller schemes, they can give access to the efficiencies and economies of scale in particular in investment and governance.”
Until a legislative framework is in place, all superfund transactions will effectively require clearance by The Pensions Regulator: “Arguably, schemes acting now will attract greater scrutiny, but also obtain greater protection,” said Stewart.
He added: “It does also depend on the circumstances of the scheme – for example, if trustees have particular concerns around the sponsor covenant and the risk of default, it may be better to act now rather than wait.”
Tom Jackman, Associate Director of law firm Sackers, pointed out: “If the employer can find the money for the proposal, it’s not unreasonable to ask whether that money shouldn’t be available to the scheme on an ongoing basis (i.e. with the employer covenant standing behind it as well).”
Look before you leap
In the unlikely event of insurer failure, members may be compensated under the Financial Services Compensation Scheme. If a consolidator proves unable to meet its liabilities, members will have the Pension Protection Fund to fall back on.
Paul concluded: “Most schemes aren’t facing a short-term problem where they need to move quickly, so they would be well advised to wait and see what the regulatory environment looks like, and let other schemes go through the process first.”
Transfers gather steam
Since the new pension freedoms in 2015, DB schemes are also de-risking by offering pension transfer. According to pension consultants XPS, 70,000 defined-benefit-to-defined contribution transfers have been carried out each year. Members transferring from DB to DC schemes take on all the risks associated with the pension, investment returns and longevity as well as, potentially, losing irreplaceable index-linked guarantees.
Malcolm McLean, Senior Consultant with Barnett Waddingham, pointed out: “Members with large benefits may also see a more onerous tax treatment under DC than under DB due to the way that the Lifetime Allowance is calculated.”
But Penny said: “For the true HNWI [high net worth individual], a transfer out of their DB funds can be very much a win/win with careful planning. It is possible for personal pensions to be IHT efficient, and to enable pension savings to be passed down the generations. The true HNWI is also used to taking financial advice about how to invest the lump sum from the DB transfer.”
Where the difficulty can arise is when the HNWI reaches later life and perhaps is no longer as mentally competent to determine how his/her DC pension savings should be managed or perhaps if the HNWI dies and the spouse has to manage the DC savings pot.
Penny explained: “These types of factors can put huge pressures on the individuals that are not present in the same way with a pension being paid from a DB scheme. Also as the PPF rules have been altered to increase the benefits that are paid to the members with higher pension savings, there is not the same incentive for HNWIs to move their pension savings out of a DB scheme for fear that the scheme may fall into the PPF and their benefits be drastically reduced.”
Ian Neale, Director of Aries Insight, noted: “The cost of replicating an index-linked defined benefit pension is visible in the difference between a level annuity and an inflation-linked one: a £100,000 pot can buy a single-life level annuity of more than £4,500 a year, but if you want 3% inflation protection you will get less than two-thirds of that.”
Pension scheme perspective
From the perspective of the pension scheme, transfers are generally welcome but there are hazards. Transfer values are market-related and so the value calculated at a particular point in time will generally reflect market conditions at (or shortly before) that time.
This has potential dangers for the pension fund, as Bob Scott explained: “Transfer values are guaranteed for, potentially, as long as six months after the date of calculation. If markets move against the scheme during the guarantee period, the amounts paid out could place a strain on the fund against the values that would be calculated at the time of payment. If the take-up of transfer values is significantly higher than anticipated, that could necessitate asset sales in order to pay the promised amounts which may not be at opportune times.
“Schemes which have large deficits or which rely on favourable investment returns in their recovery plan may find that payment of transfer values, while reducing the deficit, makes it harder to fund the reduced deficit as the remaining asset base is smaller and with a greater proportion of pensioners who are drawing money out of the fund.”
Flagging up risks
Louisa Knox, Pensions Partner with law firm Shepherd and Wedderburn, also had some caveats: “DB schemes are increasingly coming under regulatory pressure to provide clear flags to members on the risks of transferring. Dusting down member communications to ensure that transfer information packs contain comprehensive information in an easy to understand format is key. Flags on risks, including pension and investment scams, and that tax advice may also be needed, should be added as standard.”
She added: “If the transferred benefits do not reap the returns anticipated by members, or worse, members lose out to fraud or scams, they only have one place to go and are likely to ask questions of their original scheme. The Pensions Ombudsman ruled in favour of a member who experienced a fraud on transfer. He ultimately had his benefits reinstated to the DB scheme where The Pensions Regulator’s ‘scorpion’ literature [an advertising campaign warning of pension fraud risks] had been omitted from his transfer pack. This serves to underline the importance of education for members and clear communications.”
From the perspective of the individual member, the key is to take good independent financial advice which considers the member’s overall financial circumstances, not just the DB transfer in isolation.