Pensions have often been viewed as a burden for companies in the UK, particularly defined benefit (DB) schemes. For many years, these schemes were gripped by funding shortfalls in the wake of the financial crisis, due to low interest rates and declining asset returns.
But times have changed. The UK’s final-salary DB schemes are in much better health, with The Pensions Regulator estimating that 54% are fully funded on an insurance-buyout basis. Another 22% are fully funded on a so-called low-dependency basis – where schemes don’t expect to rely on their sponsor for any further contributions to meet their liabilities. Only 15% of DB funds have a funding deficit.
“These schemes are now very well-funded,” says Stewart Hastie, partner and head of corporate at Isio. “Many don’t require any further cash funding and actually have surplus assets.”
While most DB schemes are now closed to new members, around 5,000 legacy schemes are still being actively managed in the UK, accounting for about £1.2tn of pension assets. Estimates from The Pensions Regulator suggest that there are some £160bn of surplus assets in these schemes on a low-dependency basis, which could be redeployed to help drive growth and productivity, says Hastie.
“There’s an argument that the surplus is there for security and as a safety net. In reality, these would be on top of the prudent reserves already incorporated. For strong enough sponsors, a lot of that money could be replaced by contingent agreements and then better utilised, with some released in a way that comes back to the company to fund the business or improve benefits for current and future workers,” he adds.
This means shifting the corporate narrative away from viewing pensions as a liability towards seeing them as providing opportunities that can help deliver better business outcomes. How far that narrative shift goes will likely be shaped by the forthcoming pensions bill and associated regulatory changes. The UK government intends to loosen rules around surplus assets in DB schemes, which are currently restricted and largely hinge on an individual scheme’s historical rules – something the legislation is expected to address.
If schemes can start to release surplus assets on an ongoing basis, some of them could potentially ‘run on’ for a longer period. This would allow trustees and sponsors to take a longer-term view on investment strategy, potentially boosting returns without taking on significant levels of additional risk, Hastie says.
“We’re already seeing some of that mindset shift,” he adds. “A lot will come down to how the legislation comes through and is implemented, but organisations are already thinking this way – the legislation is about making that flexibility more widespread.”
For example, in the right circumstances, a scheme that is fully funded on a low-dependency basis, trustees and sponsors could generate and release as much as 15% to 20% of assets as surplus over a 10-year period, says Hastie. “If you’re a billion-pound scheme, that’s £150m to £200m worth of surplus generated and released over 10 years, much of which could go to support a company’s growth plans.”
This could impact the pension risk transfer insurance market if trustees and sponsors delay moving to an insurance buyout, but there will still be significant demand for insurance, particularly for the many trustees and sponsors with a lower-risk tolerance and for most smaller DB schemes. Full insurance of DB schemes has never been more affordable.
“Considering the surplus as an asset is easier for larger schemes,” says Steve Robinson, an insurance partner at Isio. “When the size of the scheme starts to fall and the proportion of assets that are taken up by running expenses starts to increase, there is less of an opportunity for those cases to run on. Corporates and trustees also have long memories; just because a surplus exists now doesn’t mean that will always be the case so there has to be an acceptance of the ongoing risk. There will always be a case for insurance and we see there being continued high demand for years to come.”
Money could be better utilised to fund the business and improve benefits for current and future workers
While most schemes will end up being transferred to an insurer at some stage in their lifecycle, the timing will vary. For larger funds, it could be 20 years or more; but for many others the ideal timescale is as soon as possible, Robinson notes.
While the DB pensions market is in better shape, the defined contribution (DC) market is now experiencing strains, with fears that default contributions under auto-enrolment won’t be enough to provide savers with adequate retirement income. Contribution rates for DC pensions need to increase, but that is a challenge for cash-strapped employers and employees, and so could be funded from release of DB surplus in some circumstances. These challenges are also prompting more innovation in the DC pensions market.
“We’re seeing more interest in collective DC arrangements,” says Hastie. “These are based on delivering an income while also pooling investment and longevity risks enabling a long-term higher return strategy to be pursued. This doesn’t mean that the sponsor or the employer is underwriting it, but it does mean that you can create outcomes that are potentially 30% to 50% better.”
For example, if an individual and their employer contribute 8% to a scheme but the outcome is 30% to 50% better, that’s equivalent to putting around 11% or 12% into the scheme without having to increase contributions, says Hastie.
“It’s all about delivering better outcomes without it costing more upfront.” Some organisations are also using the surplus in their DB schemes to fund their DC arrangements to improve benefits for current and future workers, Hastie adds.
This greater flexibility should reinforce the shift in mindset among CFOs that DB pension schemes should be viewed as opportunities to benefit from rather than just a headache to manage.
“Pensions have probably been the least favourite part of the CFO agenda historically,” says Hastie. “But we’re now at a stage where they could become a source of finance for the business and can be used to support better outcomes for employees without it costing more.”
By viewing DB pension surpluses as a strategic opportunity, organisations can unlock the value trapped in those schemes and reinvest that capital into the business to drive growth and improve economic outcomes.
For more information please visit isio.com/pensions or email curious@isio.com
Pensions have often been viewed as a burden for companies in the UK, particularly defined benefit (DB) schemes. For many years, these schemes were gripped by funding shortfalls in the wake of the financial crisis, due to low interest rates and declining asset returns.
But times have changed. The UK’s final-salary DB schemes are in much better health, with The Pensions Regulator estimating that 54% are fully funded on an insurance-buyout basis. Another 22% are fully funded on a so-called low-dependency basis – where schemes don’t expect to rely on their sponsor for any further contributions to meet their liabilities. Only 15% of DB funds have a funding deficit.
“These schemes are now very well-funded,” says Stewart Hastie, partner and head of corporate at Isio. “Many don’t require any further cash funding and actually have surplus assets.”
