Underfunded DB schemes: What’s the solution?
Liz Duffy provides an update on the PLSA's DB Taskforce
Defined Benefit (DB) schemes could fail to provide employees with their promised benefits. That is the risk facing the members of many DB schemes, according to the final DB Taskforce report, Opportunities for Change, (September 2017) from the Pensions and Lifetime Savings Association (PLSA).
There are almost 5,800 DB schemes in the UK of which nearly 5,000 have fewer than 1,000 members.
Smaller schemes are more expensive to operate as they lack scale with each having to pay administration fees, consultants fees, investment management charges etc. Today only 13% of schemes in the private sector are open to future accrual compared with 43% ten years ago.
Closed schemes lose out on cash flow from on-going employee and employer pension contributions but have significant liabilities in the form of current or future pension payments. In the current economic climate of historically low government bond yields, the trend for funding deficits is upward meaning that many DB schemes could be facing a bleak financial future.
Some sponsoring employers with weak employer covenants which are struggling to support their DB schemes will see these enter the Pension Protection Fund (PPF). The PPF itself is proving sustainable and this is good news. However, the members of schemes entering the PPF receive a cut in promised retirement income.
What is happening?
Employers, depending on their finances and access to advice, have several restructuring options available, up to and including insurance company buy-out, to manage pension liabilities and bring stability to scheme funding. Not all employers’ finances will afford them the option to restructure and according to the PLSA doing nothing is not an option.
The PLSA’s DB Taskforce identified challenges facing DB schemes across three reports. Its Interim report (October 2016) concluded that there were long-term structural weaknesses in the make-up of the DB sector; its Second report: The case for consolidation (March 2017) outlined proposals for merging scheme functions or merging schemes; and its Final report: Opportunities for change explored how sector consolidation may be achieved.
In February 2017, the Department for Work and Pensions (DWP) issued a Green Paper on the ‘Security and Sustainability in Defined Benefit Pension Schemes’ which posed a series of questions on the challenges facing DB pension schemes with a view to considering how to support these schemes’ journey towards maturity.
In its response to the Green Paper the ICAS Pensions Panel stated “…we are not convinced that those schemes which could benefit most from consolidation, for example, through cost savings from economies of scale, will necessarily find this achievable".
The next stage is a White Paper on the future of DB schemes expected in February next year.
What is the solution?
The PLSA is proposing the following four options:
- Shared services merger
- Asset merger
- Governance merger
- Scheme merger: superfunds
Schemes could reduce costs through, for example, shared administration services, pooling assets or shared governance. In other words, small schemes could benefit from economies of scale. At the other end of the spectrum the PLSA are proposing full mergers where superfunds are created to replace existing pension schemes and removing the employer from the equation.
All the options have pros and cons, with significant barriers to addressing the cons.
Scheme merger options
Shared services merger
Merging administration functions is probably the simplest to achieve and is already used by some schemes, but many schemes do not take up this model for various reasons, including among others the fragmentation of the DB sector, upfront costs and differences in member benefit structures.
Pooling scheme assets which can be managed centrally is another option. This model should reduce scheme investment costs but is complex to achieve due to the resources required to understand the asset structure (including the legal aspects) of each participating scheme and set up the new operating structure.
The governance merger model is an extension of the first two models whereby participating schemes sharing back office and administration functions are then managed and governed by one trustee board. The participating schemes become sections within new scheme thus maintaining segregation of the liabilities of each scheme taking part.
This arrangement ought to save costs and enhance the bargaining power of the schemes in negotiating services.These three models could deliver savings for the participating schemes but are unlikely to deliver sufficient savings to plug the funding gap or mitigate the risk of the employer defaulting on deficit contributions or becoming insolvent.
Scheme merger: superfunds
The fourth model proposed by the PLSA is more radical and involves the creation of superfunds where individual schemes are merged into one scheme with one sponsor. The sponsor would be a single purpose commercial venture with capital at risk which is independent of the trustee board: this is one key aspect of the superfund model which needs greater clarity.
In a superfund, the assets and liabilities of participating schemes are consolidated and, in return for a fee to reduce the underfunding, the existing employers would be discharged from their responsibility towards their schemes. This model could provide more secure pensions for members and would be authorised and supervised by The Pensions Regulator (TPR). The intention is to set entry criteria, maintain a minimum funding level, provide standardised benefits with common rules, operate within the existing regulatory framework along with other rules for operating the superfunds.
There are clearly issues with this approach. The PLSA acknowledge that many employers will be unable to afford the fee required to join a superfund at the current benefit levels and recognise that more work is necessary to understand the trade-offs between affordability, benefit level and benefit certainty.
Superfunds are to be targeted at schemes at risk i.e. those with weaker employer covenants, but the schemes at risk are those least likely to be able to afford to join a superfund. The PLSA believes that the superfund option could create an incentive to raise capital in the market or from creditors to enable schemes to transfer to the superfund.
While discharging the scheme responsibilities would no doubt be welcomed by many employers, the question of how to raise the necessary capital is key. The PLSA suggests superfunds could be more accessible if schemes could reduce benefits on entry or reduce the indexation rate: both controversial measures.
In truth there is no easy solution to the establishment of DB superfunds.
What can we expect in the way of DB reform?
Guy Opperman MP, the Minister for Pensions and Financial Inclusion, spoke about the forthcoming DB White Paper at the PLSA’s Annual Conference. The Government is supportive of consolidation but proposals for reform are expected to fall short of compulsion.
Legislation formed on the back of the White Paper is not expected to be in place until 2020. Most notably, Opperman confirmed that this would be the last opportunity for reform of private sector DB schemes.