Defined Benefit are becoming a legacy issue
Around the globe the provision of Defined Benefit (DB) type pension is increasingly becoming a legacy issue. Within employee benefit arrangements, DB pensions have been replaced by Defined Contribution (DC) schemes for the majority of new hires and current employees are progressively being moved to DC for future service benefits.
In the UK, of an eligible universe of DB plans (based on the TPR and PPF definition of DB schemes in the UK) of around 6,225, 65% of plans were closed to new members and 30% were closed to future accrual, compared to 26% closed to future accrual in the previous year.*
Managing DB plans is less and less about using a HR benefit to help attract, retain and motivate the workforce, and more and more about dealing with the finance issue of managing longevity, interest rate and inflation risks. In addition to this, sponsors also have to grapple with the regulatory and compliance requirements associated with pension provision. In a sense, a sponsor of a DB arrangement now owns and runs the equivalent of an insurance company. A key difference in this comparison is that insurers are willing to take on these risks, as they are well-placed to manage them and generate a profit by doing so.
What are the options for managing DB risks?
Sponsors have two choices. The first is to maintain the risk on their balance sheet and manage this as efficiently as possible within the parameters of the relationships with the Trustees and the tools available. These tools would typically comprise of investment solutions, such as LDI, the use of longevity swaps and encouraging member choice exercises (such as transfer options and retirement flexibility) to reduce the liabilities of the plan. The second choice is to transfer the risk to an insurance company.
Underlying both choices is the need for the sponsor to think like an insurer when considering DB provision. The approach insurers adopt to handle and price risk should be emulated as much as possible. For example, on operational risks, plans should aspire to improve record keeping to ensure they pay the right benefits at the right time to the right person.
Furthermore, plans are increasingly looking at how the ongoing running costs can be managed more efficiently. A market could develop whereby multiple plans are centralised via one “Master Trust” arrangement, with one Trustee board, single administration, actuarial and legal suppliers to achieve economies of scale and share costs. Finally, the use of technology should be embraced, to improve record keeping and ensure the scheme is transaction ready when market opportunities arise.
So I don’t want to be an insurance company…
The removal of a DB pension plan has a number of significant advantages. Whilst a plan might not be perceived as a major current risk, this is subject to a number of factors staying broadly in favour of the sponsor, as follows:
- Strong sponsor covenant: will it stay robust enough to ensure that Trustees will be comfortable about the funding regime designed to reflect this strength?
- Investment markets: will they produce ongoing positive equity returns over the long term and inflation continue to remain benign?
- Longevity improvements: will a cure for significant illnesses be found, or will the ongoing treatments and care continue to improve, thus extending lives?
- Availability of investment instruments: will there be enough suitable long duration, appropriate yielding investments available for DB plans?
- Regulatory risk: will the change in solvency regime, such as Solvency II being introduced for insurers, be introduced for pension schemes too?
By removing the exposure to these risks, a sponsor would be in a far better position to focus on the business they and their shareholders wish to be in.
In addition, there are a number of significant advantages of transferring risk to an insurer, covering these areas:
- Market perception: a buyout removes risk, with the sponsor being seen to have taken decisive action. This could be driven by peer/competitor activity or the desire to take advantage of market opportunities. Even a buy-in is generally viewed positively, when communicated as a step in the journey plan to ultimate buyout.
- M&A: a business without an attaching DB plan can be far easier to deal with during a sale or purchase process.
- Management time: in addition to the expenses of running a plan, the finance community within the sponsor is spending more and more time on pension plan issues. Ongoing valuations, rounds of negotiations with Trustees and regular accounting, all take up valuable resources.
When considering setting the price at which they would transact, sponsors should take into account all these costs and payment of these over a number of years. However, the biggest value could be exiting the insurance business.
Ok, but this is going to cost
Part of dealing with this point is understanding what the true cost of removing the risk of the pension plan is. Within the decision to annuitise (i.e. transact with an insurer) is the acceptance that a premium will be paid to an insurer. This premium will not be valued based on what the Trustees would like the plan to be funded on, versus what the sponsor wishes, overseen by the actuary. It will represent the actual cost of hedging the risk in the current market, with the appropriate administrative, risk and profit loadings and understanding that the current view of the liabilities makes no allowance for the present value of the future costs of running the plan – such as annual investment management, administration, actuarial, legal, auditing, etc. An insurer’s premium factors these in.
The sponsor doesn’t have to accept that premium. It does, however, need to decide at what price it would be happy to trade at and the steps needed (along with market movements) to reach a realistic point for a transaction to proceed.
The beginning is always today
Whilst many sponsors aspire to de-risk, many defer implementing a process to achieve their objective. Broadly this would comprise of the following steps:
- Define: agree objectives, governance and timings
- Prepare: data, benefits and assets, along with activities the plan can undertake to reduce the annuity purchase cost
- Execute: enter the market, select insurer and transact
Some sponsors will have good reasons not to proceed. However, many cite concerns over whether this is the right time, wishing to see better equity returns/more insurer competition and wanting to de-risk everything in one go. These may be justifiable reasons, but it means that these plans will miss opportunities and run the real risk of not meeting their objectives. Why is this so? Even with the best governance, excellent preparation and utilising technology effectively, if the plan is not in the market with insurers, it can’t move rapidly and take advantage of market movements.
Once the decision has been taken to de-risk and the plan starts to think like an insurer, the final element of preparation is to have an opportunistic mentality and be prepared to move quickly when opportunities arise. This perspective will pay dividends, as the plan can work in conjunction with insurers to set triggers and transact on these.
It would be very hard to take advantage of real-time, time limited market movements, without being in the market.
Much has been made of insurers’ capacity and appetite to absorb longevity and interest rate risk, estimated to be tens of multiple billions. Whilst this has yet to be tested, the operational ability within the insurers and advisers has. The operational constraints will limit the number of transactions that can take place. Plans are increasingly better prepared when they enter the market and the execution processes are constantly improving and evolving. However, there is only a certain amount of operational resources and those plans in the market, or those that already have relationships with insurers, will be able to proceed first.
One piece at a time
Not everything needs to take place all at once. Some sponsors are able to buyout in full in one go. This could reflect a business need, the funding status of the plan prior to a buyout, or the availability of cash within the sponsor. However, the objective of a buyout can be achieved over time, by the use of opportune buy-ins for certain members of the plan such as pensioners only.
Going forward, plans could sectionalise and purchase annuities for that section, then, subject to the appropriate funding, accounting and legal implications, wind that section up. For sponsors that aspire to a buyout, but are unable to afford it for the whole plan, this approach could be beneficial.
Following the 2014 UK Budget, which removed the need for UK individuals to purchase an annuity, insurers’ appetite in the bulk annuity space has increased as they look to make up for revenue elsewhere. We believe this will lead to greater innovation and an increase in transactions.
Complete removal of risk
Once a buyout has been completed, the sponsor will still be exposed to an amount of residual risk on behalf of the Trustees i.e. errors in the data, missing beneficiaries and maladministration/fiduciary failings. Typically, most sponsors will look to remove this risk completely, increasingly via the additional “all risks” premium.
*Source: The UK’s Pension Protection Fund and The Pension Regulator.