Funding DB schemes is becoming ever more challenging
Many employers with a defined benefit (DB) workplace pension scheme struggle to cope with the connected funding costs. Where the employer has chosen to maintain the scheme as active, with at least some employees continuing to accrue benefits, those costs are accepted as a cost of doing business. However, for those who have decided to close their scheme – a large majority – the ongoing funding costs for benefits accrued in the past can be difficult to bear.
Costs continue to escalate, seemingly never-ending. Deficit contributions continue to make a substantial impact on the sponsor’s bottom line whilst only providing temporary improvements in the funding level. After a generally positive period up to the beginning of 2020, the impact of the Covid-19 restrictions on businesses and the economy has put most schemes even further back in deficit again, at a time when the supporting business will struggle to rebuild profitability. Despite the welcome benefit from government interventions and temporary regulatory easements, businesses will once again face calls for more contributions to fund their DB pension liabilities. The issue has acquired a new urgency.
Employers are increasingly focusing on their endgame strategy
Employers and trustees work hard with their advisers to keep contributions affordable, but for many employers the Holy Grail would be to remove the liability altogether. The traditional method is to buy it out with an insurance company. However, that market is of limited and fluctuating size and availability, and the premium cost is beyond many employers.
The size of the problem – and potential market – is so great that it is attracting commercial interest offering new solutions, many involving consolidation of unconnected individual schemes into fewer larger ones that can exploit benefits of scale. The superfund is a manifestation of that movement, and one that looks likely to gain traction over the next few difficult years at least. Businesses will want to look carefully at the potential benefits from moving their members into a superfund, and where those are deemed attractive, trustees will find themselves under pressure to agree to the move. Trustees will however have to be satisfied that any such move will be in the best interests of scheme members.
New protections from The Pensions Regulator
The superfund format creates a new type of scheme that does not fit exactly within traditional scheme design parameters, meaning that current regulatory oversight rules need to be adapted. Both the government and The Pensions Regulator (TPR) are happy with the superfund principle, as it fits with their ongoing agenda for radical consolidation in the DB scheme sector. However, they need to ensure that effective protection is in place for members, without it being so onerous as to kill the commercial model that allows superfunds to exist.
It was thought that a new regulatory regime might be introduced under the Pension Schemes Bill currently going through parliament, but the Bill is silent on the matter, and a new regime appears to be at least five years away. Consequently TPR has developed an interim regime using existing powers, which can be applied because the superfunds are technically occupational pension schemes and therefore fall under TPR’s regulatory remit. Guidance, published on 18 June 2020 and effective immediately, sets out how TPR will regulate the new kids on the consolidation block. TPR says that the guidance is not prescriptive, but is “clear and directive” about the steps that trustees should take to manage the risk within the superfund model.
The regime will be extended and refined over time. Employers and trustees considering moving to superfunds will want to be aware of the new rules and to be satisfied that their members’ pensions would remain safe.
So what constitutes a superfund?
So what exactly is a superfund? It is an occupational pension scheme, established under trust by a corporate sponsor (“employer”), and run by trustees in accordance with its governing trust deed and rules. As such it conforms to the features of the traditional workplace pension scheme.
However, as a consolidator, it assumes the liabilities of multiple existing individual pension schemes transferred into it. Its employer takes the place of all the ceding employers, with one important distinction – it does not provide a covenant to underwrite the pension promise. Members of schemes that transfer into a superfund instead have the benefit of an alternative, commercial, protection mechanism funded by third party investors requiring a return on their investment.
This mechanism can take one of two forms, depending upon how the superfund’s employer is financed:
- The capital-backed vehicle. Here the fund’s assets are backed with a capital injection to a capital buffer, which will be created by third party investor capital and a contribution from the original employers.
- The special purpose vehicle (SPV), where the original employer is replaced by a superfund employer that is an SPV. This arrangement allows the continuation of protection under the Pension Protection Fund (PPF).
Since the “open cheque book” of a trading sponsoring employer’s covenant is lost, there needs to be a greater emphasis on funding levels and access to backup funds where necessary to protect pensions. In the case of a buyout policy with an insurance company, that is achieved through imposing strict capital adequacy requirements upon the insurer, supported by a backup facility under the Policyholders Protection Act. Superfunds are not insurance companies, so this regime will not apply.
The capital buffer will be key, given the finite level of resources available to the superfund. It is not an asset of the superfund, but as a replacement for the ceding employer’s covenant provides a “fallback” facility if required. The TPR guidance imposes requirements in respect of adequacy, investment policy and governance, including value extraction through payments to commercial investors. Additionally there is a requirement for effective separation of roles between those responsible respectively for members and commercial investors. Involved parties will need to pass “fit and proper person” tests. Further protection will come through a planned process to transfer assets and liabilities to another approved fund in the event of an unrepairable fall in the funding level.
Compliance will be monitored by a comprehensive information and reporting regime, including strict information when trigger events occur that require urgent corrective action to protect funds.
Buyout, move to a superfund, or carry on?
These three options are likely to be the main contenders for consideration by employers and their DB schemes over the next few years. The decision is likely to be a difficult one.
The financial position of the employer and the funding position of the scheme might mean that carrying on could be the only financially viable option. Many employers, particularly SMEs, find that buyout terms put that option out of reach. Time will tell whether the superfund route will offer more favourable terms, but the requirement for a boost to the scheme funding level ahead of a transfer to compensate for the loss of the employer covenant may rule out that option too.
However, many employers who can make the numbers work for them will surely be keen to move the scheme on, thereby relieving them of all liabilities. They will want to encourage their scheme’s trustees to agree a transfer.
Trustees will focus on member protection. They will need to weigh up the different levels of protection provided through each of the options, including under their existing scheme through the employer’s covenant and the potential availability of the PPF if things do go wrong. They will also want to compare the likely level of governance and service standards under any new arrangement with those they currently provide.
However, the future for trustees of DB schemes is likely to continue to get tougher, as TPR ramps up its governance and oversight regime. Pressure to meet increasingly higher standards, along with the requirement to actively review whether the scheme offers the best option for members, may tip the balance in favour of change.
Professional help and guidance is essential
There is no doubt that this is an issue that will be high on the agendas of both employers and trustees. Addressing it will be difficult, involving assessment of a large number of factors. Even if change is rejected, the decision will have to be revisited periodically.
Employers and trustees should be discussing the options regularly and agreeing a policy. The implications, complexity and breadth of the issue point to the need to take into account high quality professional advice, which the parties will need to be in a position to demonstrate when asked to do so.
The next few years promise to be very challenging.