Despite recent market volatility, a combination of strong long-term returns across growth assets, company contributions and, latterly, real interest rate increases have resulted in improvements across the funding levels of many defined benefit pension schemes on an endgame basis. With the endgame now in sight, trustees have begun to turn their attention to what a suitable target might be and how to get there.
For lots of schemes, buyout is seen as the ultimate endgame objective. But how do you decide whether it’s right for your scheme and what the next steps are once you have? In this blog series, we’ll be guiding you through the six steps to buyout to help you navigate your journey. If you need any support along the way, please get in touch.
Step 1: Is buyout right for your scheme?
There are a lot of decisions to make as a pension scheme trustee, and one of the most important for closed schemes is deciding on your scheme’s ultimate endgame objective: buyout, low dependency, or something else. But how do you decide what is right for your scheme and its stakeholders?
Beginning with the end in mind
Defining your endgame objective upfront gives you a clear, long-term goal to work towards – helping to align all stakeholders in the decision-making process. This is important, because the nature of your endgame target not only affects your investment strategy once you reach your funding target, but also in the years leading up to this.
Defining your endgame also helps to fulfil The Pensions Regulator’s brief for all schemes to have a long-term target in place, although this isn’t a requirement (at the time of writing!).
So, what are your options?
Typically, there are two main options: buyout or low dependency (similar in concept to self-sufficiency). However, some newer variations have surfaced in recent years, such as consolidation within a superfund or master trust.
Buyout involves transferring all the scheme’s assets and liabilities to an insurer (for a premium), taking the scheme off the sponsoring company’s balance sheet. Low dependency means continuing the day-to-day management of the scheme until payment of the final pension benefit, after which the scheme is wound up.
While buyout is seen by many as the goal that all schemes should aspire to, several considerations mean it’s not a suitable target for all.
Why might you choose buyout?
As mentioned above, when a scheme is bought-out, the liability is transferred to an insurer. This removes not only all investment-related risks, but also longevity risk, the need for trustee oversight, ongoing sponsor covenant reliance and the costs of administrating the benefit payments.
As the buyout market has continued to develop and expand, the size of schemes for whom buyout may be realistic has moved from small-to-medium-sized schemes to larger schemes, with transactions sizes now reaching in excess of £4bn.
Why might you go down another route?
The main reason may, quite simply, be cost. Schemes going to buyout not only have to pay a premium to the insurer for the transaction (i.e. the liability price quoted by the insurer), there are also costs associated with preparing for the transaction and adapting the investment strategy.
Additionally, if your scheme has a non-standard benefit structure in place, this could add complexity to a buyout and therefore make the transaction more expensive. From a sponsor’s perspective, there may also be concerns regarding the loss of influence on the scheme once it’s transferred to an insurer and the impact on its balance sheet (which can be of particular concern to financial institutions).
Where a scheme already enjoys a good level of security afforded by a very strong sponsoring employer, the trustee may question whether buyout would in fact improve the certainty for members of receiving their benefits.
For schemes that either cannot or do not want to pursue buyout, low dependency might be a more appropriate option – particularly if your scheme falls in the larger camp. However, the strength of the sponsor covenant relative to an insurer is a crucial consideration here.
We also mentioned consolidation, an emerging endgame alternative, above – the general pros and cons of all three options are outlined below.
Once you’ve decided which endgame is most appropriate for your scheme, the next step is to align your investment strategy appropriately to maximise your probability of success. In our next blog, we’ll discuss how you can monitor your scheme’s readiness for buyout.
Unless indicated, these are the views of the author and may differ from those of the firm.
