What effect has Autumn 2022 had on DB pension scheme end game options?

  • BlackRock

For trustees of Defined Benefit (DB) pensions, the events of Autumn 2022 have prompted a review of governance models. A debate surrounding the timing and options for endgame has been opened.

Overall, deficits have become smaller in DB pension schemes, and this has enabled trustees to reassess their endgame options. However, the events of Autumn 2022 were very challenging from a liquidity standpoint, and market conditions are very different to the previous few years.

In this environment, choosing the right options for a DB scheme endgame is even more important.

A number of new options have come to market in recent years, and trustees may want to consider these as part of their strategy.

New options for endgame in DB pensions in the UK

One traditional endgame route is self-sufficiency (where the pension scheme exists until the last pensioner is paid out). Schemes can administer this in-house or use a third-party organisation.

Alternatively, an insurance transaction or pension risk transfer – commonly known as a buy-out/buy-in – involves an insurer taking on the liabilities and relieving the sponsor of any link. This option transfers both the risk and the legal obligation from the sponsor company to the insurance company, and is seen as a “gold standard” for many schemes.

Due to shrinking deficits, many schemes are potentially in a better position for a buy-out endgame. Figures from LCP, the pensions advisory consultancy, suggest that DB schemes have seen a 15% improvement in buy-out funding positions in 2023 compared to the previous year. In addition, buy-in and buy-out volumes could be more than the record £44 billion in 2019.1

Over the past few years we have seen other endgame choices coming to market. These include superfunds, which act as consolidation vehicles. In effect, they pool the assets of multiple schemes and aim to provide economies of scale and diversification of risk, supported by money from external investors – an example of this is Clara pensions.

A superfund, e.g. Clara, is funded by capital injection from outside investors and may also involve an initial capital injection from the sponsor before liabilities are transferred. Once the transfer has been made into Clara, the employer covenant is removed and the sponsor link effectively replaced

There are also Capital Backed Journey Plans which gives an individual pension scheme access to external capital (i.e. without having to go through a consolidator vehicle). Such solutions can help schemes meet their funding or investment objectives using additional capital, and potentially provides more certainty and funding-level stability. However, Capital Backed Journey Plans can be more complex and place a monitoring requirement on the trustees, plus there is no change to the sponsor covenant, which effectively retains the reliance on sponsor covenant.

Does the size of your scheme affect your endgame options?

The answer to this question is not a simple yes or no. However, it's important to consider that the size of a scheme can have an impact on the range of viable options that may be funded by a third party.

Traditionally, larger schemes were seen as the most attractive for insurance transactions. Insurers tended to have a preferred deal size, which meant that schemes with sub-£50 million valuations historically found it more difficult to get quotes; albeit there has been a change in accessibility in recent years with some providers are now offering help to support smaller schemes, which has meant the insurance market has opened up to a greater range of DB pension schemes, whatever their size.

 In addition, self-sufficiency for small schemes can be operationally complex, and the ongoing cost of running the scheme over the long term might outweigh the value of the benefits remaining. This might encourage some smaller schemes towards insurance transactions.

However, covenant and affordability are ultimately the most important criteria in choosing an endgame option. Trustees must be able to demonstrate to the regulator that the decisions they make enhance the chances of pension scheme members receiving their full benefits, and that the covenant is being fulfilled.

As scheme deficits have fallen overall, a greater number of trustees are considering an acceleration towards an insurance transaction or buy-out. This has led to increased competition for a finite capacity in the insurance market, and may lead insurers to be more selective about the quality (or potentially size) of the schemes they transact with.

What are the key investment considerations for schemes as they move towards endgame?

There are various factors to consider when assessing endgame options. First, consider the quality of your data. Trustees should be able to demonstrate that their liability assumptions are fair and reflective of their members; good data quality is attractive to insurers. Good-quality data also enables you to make a more informed decision about which endgame you should choose. Data should be detailed, covering scheme members as well as current and future liabilities.

The employer covenant is also an important consideration. Trustees need to be able to assess the strength of the sponsor covenant, the longevity of the commitment from the sponsor company, and the ability of the sponsor to support the scheme financially – now and in the future.

The current levels of funding and future liabilities need to be assessed and quantified by trustees: in the event of a buy-out an insurer will ask for this information. This will also include consideration to asset liquidity – and whether this matches the needs for the insurer (or indeed any other endgame provider).

Proceeding to endgame can be a complicated and time-consuming process and trustees may decide that they would prefer to outsource the process and/or take advice on the options available. By using a third party they can look at ways to ensure the scheme is in the best financial shape, to make it attractive in a buy-out endgame.

How can an Outsourced Chief Investment Officer (OCIO) structure help schemes through endgame?

The final year and final months of a pension scheme’s life before it gets to buy-out are very important. Data must be robust, and trustees should be able to demonstrate that their actions will enhance the likelihood of members receiving their full benefits.

The preparation and implementation of a buy-out is a time- and resource-intensive process, and trustees need to be ready to move quickly. Using an OCIO structure can reduce the stress and burden on trustees. It can also be structured to allow flexibility for trustees who are unsure about their scheme’s destination.

Lara Edmonstone-West
Director, BlackRock UK OCIO Business