DB pensions: all pain, no gain? 

Author: James Maggs - Senior Investment Consultant, Mercer

I last wrote a public pensions article around 10 years ago, warning of complacency in the collateral management of leveraged LDI strategies. I was probably early to the party and mind-sets were still deeply entrenched in the status quo, which the responses to the article largely sought to maintain. It took an external shock to change mind-sets.

This article is about the government’s consultation regarding options for Defined Benefit (“DB”) schemes. The government had already committed to “consulting on measures to make surplus extraction easier” and now wants to “introduce reforms to the private sector DB pensions system that jointly benefit scheme members, sponsoring employers and the wider economy”. I set out a personal view, but one that I am not unique in holding. My view is:

  1. I agree with the government’s stated objectives. It would be of material benefit to have a system with a healthy mix of schemes that buy-out with an insurer and those that continue to provide benefits directly to members (or “run on”).
  2. To achieve these objectives will require a significant change in mind-sets to refocus decision-makers on the benefits of running on and satisfy concerns regarding the associated risks. This will be a challenge in the absence of concrete protections.
  3. Therefore, the government should provide an effective catalyst in the form of an option for full benefit cover from the PPF to have the best chance of achieving its objectives effectively and rapidly. 

The context

Decades of bitter experience have created the mind-set that DB pensions mean pain; sponsors pouring in money to fill unstoppable deficits, members hit by scheme closure or insolvency, and trustees under pressure to justify their actions. This was the reality for many.

The situation has now changed as a result of decades of sponsor contributions and higher yields. According to the consultation, 75% of DB schemes are in surplus on a low dependency basis, with a combined surplus of £225bn. Once full funding has been reached on a low dependency basis, it is perfectly feasible to run a DB scheme in a risk-controlled way with much more limited scope for downside but meaningful opportunity for gains over time. 

It is natural that insurers are happy to take on schemes that are in good financial shape and this is the right solution in many cases. It is also natural that many trustees are strongly drawn to insurance to mitigate potential risks to members’ benefits, and that sponsors are considering a buyout to remove downside risk that has limited upside. 

With this context, it is no surprise that the predominant aim of many decision-makers is to transfer DB schemes to an insurer.

What are the key benefits of more schemes running on?

A system with a healthy mix of schemes moving to insurers and those continuing to provide benefits directly to members (or “running on”) would hold many benefits compared with one in which the vast majority of schemes seeks to insure benefits. I will focus on the benefits that having many schemes run on can bring, assuming that surpluses can be put to good use, since the benefits of insuring are already well known. 

  1. Pension schemes can provide discretionary benefits.
  2. An effective surplus-sharing framework could further enhance member benefits.
  3. The trust-based nature of pension schemes has a high standard of care towards members.
  4. The existing shape of scheme benefits and member option terms can be honoured.
  5. Reduced risk, compared with insuring benefits, of locking into benefits that fall short of member expectations (for example, continuing with non-contractual member flexibilities).
  6. In some cases, continued accrual for existing and new members may be affordable.

  1. Up to £225bn of existing low-dependency surplus may be accessible through effective surplus-sharing (potentially more over time as surpluses grow).
  2. DB schemes that are fully funded on a suitable low dependency basis can be run in a risk-controlled way in which the need for future contributions from the sponsor is more limited.

  • Surplus-sharing provides a source of investment in the UK economy.
  • If the government is willing to further underwrite DB pensions risk by the PPF covering full benefits, it could seek in exchange some conditions which further encourage investment in the UK economy (see below).
  • DB schemes support the gilt market. Without them, government borrowing costs are likely to increase.
  • Whilst insurers are well capitalised, well regulated and highly secure, concentration risk is a concern and would become much more significant if the vast majority of DB schemes insure. DB schemes have a highly diversified range of sponsors and portfolios. In other words, a problem with the insurance market or a single insurer is unlikely, but if it did occur, dealing with the outcome could be very challenging. By contrast, it is likely that some DB scheme sponsors will become insolvent, but the outcome would probably be more manageable (and this is precisely the role the PPF plays and would continue to play – potentially with full benefit cover). A diversified split between the two regimes could be the best of both worlds.

How to make it happen

Opinions differ about the best way to encourage run on. Some schemes have already found a way to make it work, perhaps those with strong sponsors and some form of security. Encouraging trustees and sponsors to run on through facilitating surplus sharing could make a difference, but in my view would not be enough.

The consultation opens the door to two changes that together would result in a step change in the DB pensions landscape and quickly make running on a mainstream option:

  1. An affordable option for the PPF to cover 100% of benefits. 
    This would enable trustees to focus on the benefits of running on whilst fully protecting members’ benefits in the (in most cases) unlikely event of sponsor insolvency. It would level the playing field with the FSCS protection that members gain through buy-out.
  2. An effective framework for sharing surplus.
    The ability to access surpluses means sponsors, members and the UK economy can benefit from scheme surpluses.

The government’s consultation puts forward a potential cost of 0.6% p.a. for 100% PPF protection, which will not be attractive. A carefully designed approach with suitable entry and maintenance criteria, designed to be attractive to a large number of schemes, should be significantly cheaper. 

Entry criteria would need to cover areas such as the funding position and covenant strength. Maintenance criteria would critically need to include investment risk management, deficit correction, surplus extraction and benefit enhancements (amongst others) to mitigate moral hazard. 

It needs to be recognised that if the PPF covers full benefits, the government would be effectively underwriting more DB pensions risk. Whilst from the perspective of trustees and sponsors this would ideally come without conditions, realistically the government may want something in exchange. One option which could be acceptable, albeit radical, could be to require a certain proportion of assets to be invested in the UK productive investments to quality for 100% PPF cover.

After all the pain of recent decades, there is now an opportunity for members, sponsors and the UK economy to enjoy meaningful gains and manage systemic risks. The government has the tools it needs to make this happen and I hope that, following the consultation, it will grasp the bull by the horns and use them.
James Maggs

- Senior Investment Consultant, Mercer

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