SPONSORED BY Linklaters
Defined benefit pensions, known as DB pensions, have long been heralded the gold standard of pension funding, but their appeal has come at a price for sponsoring employers.
A perfect storm of fiscal policy measures, increased regulation, market volatility and changing life expectancy has added new layers of complexity and pressure to the market, and for many employers, pension liabilities have grown to become a significant source of financial risk.
Rise of pension de-risking
While the number of active DB scheme members has fallen dramatically in recent years, with the majority of schemes now closed to new members and/or future accrual, DB schemes remain an important part of the UK pensions landscape, and their future viability has become a pressing concern for both sponsors and trustees.
Sarah Parkin, managing associate at Linklaters, says: “Pension liabilities are one of the greatest financial challenges facing companies today. As the majority of DB schemes mature and have a shortfall between their funding and the level of benefits promised, there is growing interest from sponsors seeking to effectively remove or minimise their exposure to risk while improving the security of members’ benefits.”
The good news for sponsors, trustees and members is that growing demand has prompted exponential growth in the de-risking market with a wealth of solutions to suit schemes of all shapes and sizes.
Sponsors and trustees who have a strategy and plan ahead will maximise their ability to negotiate favourable terms. And better terms means better risk reduction - Sarah Parkin, Managing associate, Linklaters
At one end of the de-risking spectrum, trustees may simply look to minimise risk through investment strategies, while at the other end, there is the option to transfer risk to an insurance company through a bulk annuity policy, known as a buy-in or buy-out. Between them on that spectrum, a longevity swap deals specifically with reducing the risk of members living longer than expected.
Parkin explains: “Buy-outs have historically been viewed as one of the most secure ways of ensuring members receive their benefits. A buy-in or series of buy-ins will typically precede a buy-out and this can be an important step in the scheme’s journey to fully securing members’ pensions. But as with any transaction, it is vital that schemes consider all options before they conclude on and execute their strategy.”
Simply put, a buy-in is an insurance policy that covers a proportion of the scheme’s liabilities. The scheme operates as usual, paying members’ pensions, but to do so funds are put in by a regular stream of matching payments from the insurance company under the insurance policy.
In contrast, a buy-out transfers all the responsibility of paying members’ benefits to the insurer, removing risk and liability from the sponsor and trustees. Members cease to be members of the pension scheme and become policyholders of the insurer. If all benefits are bought out, the scheme typically winds up.
De-risking transactions are not only about removing liability and risk from the employer, but are often equally focused on improving the security of members’ benefits. This will be an important factor for trustees in considering strategy and de-risking options.
Preparation is paramount
The initial stages leading to a de-risking transaction require detailed and strategic planning, and a deep understanding of the goals and risks that need to be managed. Sponsors and trustees should be aligned on what they want to achieve and how they expect to get there, looking at factors such as benefit security, the scheme’s funding position, target timescales and the accounting impact on the sponsor.
Parkin says: “For trustees to be in a position to capitalise on opportunities they must have a clear objective and thorough preparation in place. Insurers are increasingly looking for evidence of well-prepared schemes. Those that have an understanding of insurers’ investment processes and appear serious about reaching their end-game will attract the best pricing available.”
Closely aligned with price are the contractual terms. As Parkin explains: “Sponsors and trustees, who have a strategy and plan ahead, will maximise their ability to negotiate favourable terms. And better terms mean better risk reduction.”
Arguably one of the most important components is data. Carrying out a thorough data cleanse to ensure member data and the benefit summary used in the policy are accurate will remove ambiguity for insurers, which could affect the price and place the scheme in a better position to move quickly.
Member communications is also a key factor. Members may feel apprehensive about change, particularly at the buy-out stage. However, moving to a buy-in or buy-out scenario can represent an improvement in the security of members’ benefits. All insurers are regulated by the Financial Conduct Authority and Prudential Regulation Authority. In the extremely unlikely event that an insurer becomes insolvent, 100 per cent of the value of members’ benefits will be protected by the Financial Services Compensation Scheme.
“It is important that schemes communicate the changes to members as soon as feasibly possible,” says Parkin. “Members may incorrectly assume any change to their pension arrangements is bad news, so companies must clearly explain what the changes entail. This gives them the opportunity to understand more about the process and the benefits for them.”
Act now or hold tight?
The financial and economic fallout from the coronavirus crisis has naturally begged the question whether now is a good time to de-risk.
According to Philip Goss, partner at Linklaters, appetite for de-risking has remained buoyant and the ongoing market volatility has created attractive pricing opportunities, particularly for those schemes that are well prepared.
“Counterparty risk and how the sponsoring covenant compares to what will be provided by the insurer always requires consideration, although the current environment does introduce additional complexities,” Goss explains. “What we have seen is schemes that had already made the decision to transact and were well progressed in preparing for a transaction have continued and have been able to capitalise on more competitive pricing.
“However, for schemes that are still at earlier stages of planning or preparation, our recommendation would be to keep going. Being well prepared will pay dividends, even if it is some way down the road.”
With the economy continuing through a period of deep uncertainty, there is the potential for further attractive pricing opportunities and, says Goss, well-prepared schemes would be best placed to take advantage of opportunities in such an environment.
Looking ahead, it is likely the regulatory framework around DB pension schemes will further strengthen sponsors’ resolve to de-risk.
As part of the Pension Regulator’s new funding code, all schemes will be required to set a long-term funding target and document how they expect to reach their target end-game.
Goss concludes: “What is clear going forward is that de-risking solutions will increasingly form a critical part of pension scheme management, in many cases offering a win-win solution for both scheme sponsors and members.”
Linklaters act regularly advising corporates, trustees and insurers on de-risking DB schemes. For more information please visit: http://www.linklaters.com/en/client-services/pensions/de-risking