Do you have an ‘endgame’ for your DB pension scheme – and are you looking at available strategic options? Where the traditional alternatives of run-off or buy-out may not be appropriate, Paul Brice summarises our new report, suggesting a rigorous approach to evaluating strategic options for schemes.
The universe of potential strategic options for defined benefit (DB) pension schemes beyond the traditional alternatives of run-off or buy-out has grown markedly in recent years. Despite this, take-up has anecdotally been comparatively limited.
There are, however, occasions where questions of sponsor longevity may call the success of a run-off into doubt, and a buy-out seems unaffordable in any but the most extended timescales. In these cases, I see a strong case for a methodical and proportionate assessment and evaluation of alternatives to ensure that:
opportunities are not missed
trustees and sponsors are prepared for any chosen option(s)
the chances of members receiving their benefits are maximised.
Statistics from The Pensions Regulator (TPR) illustrate the progressive increase in the combined number of DB schemes closed both to new members and to future accrual1. These are often seen by their sponsors as ‘legacy liabilities’ that need managing and containing in a financially efficient way, but of no direct value to their business.
Indeed, the cost and risk associated with funding a (relatively) substantial DB scheme can be seen as a source of strategic competitive disadvantage. This is especially the case when compared to newer competitors unencumbered by these liabilities.
Although there are inevitable tensions between scheme trustees and sponsors around the funding of legacy DB schemes, there are underlying goals that are more aligned than might otherwise be apparent. The sponsor may well wish to be decoupled from the scheme and the trustees may equally like to see it safely positioned to deliver its members’ promised benefits.
In cases of potential sponsor fragility, trustees may find agreeing to a separation challenging. This may either reflect a long-term sponsor/scheme relationship, or a ‘fear of the unknown’ and any associated regret risk by entering into a transaction involving separation.
Emerging strategic options
We anticipate that, for a number of schemes, a buyout - in the short and medium term, at least - may be unaffordable. Meanwhile, there has been developing regulatory commentary both on ‘journey plans’ and, more recently, long-term funding targets2.
Potential strategic alternatives for schemes outside of the traditional bilateral sponsor/trustee run-off model or scheme buyout have emerged. These include:
DB Master Trusts
other forms of pension scheme consolidators
Some models involve sponsor separation, while others include cost-scale economies or investment enhancements. However, the use of some of these alternatives seems to have been slow to develop.
This may, in part, be due to:
ongoing regulatory approval processes for some providers
trustees (and sponsors) wishing to see ‘others go first’
a clear and present focus on getting through the current COVID-19 situation
inertia given that so many alternatives seem to have arisen within the space of 2-3 years.
It's taking time for trustees and sponsors to appreciate what might be available.
The need for a plan
Trustees and sponsors need to ensure that they find the appropriate strategic option for a scheme – which may of course be to retain the status quo. For sponsors with a progressively atrophying covenant, simply running the scheme organically while ignoring available alternatives is not a reliable ‘endgame’ unless the sponsor survives until the last benefit is paid, which may be several decades away.
If the survival of the sponsor over a long period is of any doubt, exploring all options is key. Even if these may not be affordable now, they may become so in the medium term. And for those who cannot afford an alternative to the status quo, knowing that they have explored other options – albeit at a high level – may provide comfort that their ongoing strategy is the best option available.
The range of counterparties to different options is very wide, with a variety of business models and propositions. Given this, how can trustees and sponsors evaluate them and determine which might be right for their circumstances?
Strategic planning – getting started
Strategic planning should be approached methodically, with good project discipline established from the outset. The process might involve multi-disciplinary teams, including covenant, actuarial, investment and legal advisers. Albeit, for smaller schemes, these advisers may only play specific roles at specific times.
It's essential that there's a clear understanding of objectives and context from the outset. Depending on the nature of the scheme and the potential range of options available, trustee boards may wish to set up a delegated sub-committee to oversee the project, reporting back to the full board when appropriate.
From a timing perspective, it may make sense to initiate the project alongside, or at the conclusion of, an actuarial valuation, leveraging the ‘baseline’ work already undertaken.
Framework for strategic planning
Our full suggested methodology, including templates to aid decision making, is included in our paper. In summary, however, the identified steps are:
Decide on the objectives from any evaluation and consider an overall approach that is proportionate and cost-effective relative to the circumstances.
Set up and resource a proportionate project team (potentially including a trustee sub-committee) agreeing objectives, deliverables, timelines and budgets.
Define the key ‘boundaries’: sponsor longevity, cash availability, and potential funding needs.
Identify and ‘park’ options that are unlikely to be viable. These don't need to be discarded, but are options that are, at the time of preliminary evaluation, considered to be unlikely to deliver members’ benefits in full.
Seek preliminary discussions and indicative pricing around possible feasible options to see how large any financial gap might be. Form a view around possible timelines when these options may be realistic.
Consider non-financial factors around options that may be realistic.
Document the possible options and plans for ongoing monitoring. Identify the triggers for possible moves to further evaluation or execution.
Track the position dynamically and be ready to move forward if circumstances suggest an option may be capable of execution.
If an option does become capable of execution, decide whether and how to pursue it at that time, and under what terms.
We believe that this approach will require a multi-disciplinary team to support both trustees and sponsors. A robust project management approach is key to approaching this strategic issue in a systematic and effective way.