Events over the last three years, and you couldn’t make it up - global pandemic, war in Europe, CPI/RPI levels, LDI crisis - meant a seismic shift in funding. For many DB schemes this backdrop has, perhaps surprisingly, been good news for funding levels and end goals are much closer than anticipated. Trustees must now really take stock of the risks they run and the tools available to help them manage those risks. Effective management of these risks serves one purpose – to maximise the chances that all scheme members receive all their benefits due, at the time they are due – which is, ultimately, the ‘simple’ objective of all schemes.
Firstly, schemes need to understand the risks for them specifically and agree an “end-game” - what that is will influence which de-risking options to use and when. Some de-risking options, such as a full scheme buy-out, are the destination. Others are a bridge to, or part of the journey to, the destination.
The most common tools at a trustee’s disposal are of course investments, schemes can buy hedging assets, such as derivatives, to manage interest rate and inflation risks or longevity swaps which manage other demographic risks as well as longevity. A scheme can also consider professional trusteeship or master trust arrangements to manage expense and operational risks. They can also buy solutions that already package together various elements such as a capital-backed journey plan or a (full or partial) buy-in.
However, none of these tools above manage regulatory/legislative risk and only address employer covenant risk to a limited extent.
There are only two ways all risks can be removed:
Buy-out: This provides all members of a scheme with individual insurance contracts and transfers the obligation to pay members’ benefits to the insurance company, allowing the scheme to be wound up.
Superfund transaction: The scheme transfers into a commercial consolidator or “superfund”. The scheme trustees are replaced by those of the superfund and the sponsor is able to sever its link to the scheme, with its covenant being replaced by a capital buffer partly funded by the sponsor and partly funded by the superfund.
Under both these solutions, the sponsor has no further liability and regulatory/legislative risk passes to the insurer or superfund.
However, there is a slight sting in the tail here regarding the detail on what risks are covered. For example, a buy-out typically covers scheme liabilities limited to the data and the benefits specified in the contract. Such a “plain vanilla” buy-out would not cover data errors, benefit errors and missing members, so trustees still need to consider how to manage these:
- Provisions can be made in the scheme’s trust deed and rules that help protect trustees. Similarly, there are different ways to structure the trustees’ body, such as forming a limited company, that can provide some level of protection.
- Obtain an indemnity from the sponsor covering these risks. This relies on the sponsor still being around and happy to accept the risks.
- Take out some form of indemnity insurance. This might have liability limits and be time bound, although there are new solutions developing in this area.
- Seek to cover these risks with the buy-out insurer or superfund with which they are transacting.
Another way to manage the risks outlined above, and in any case a very sensible step when preparing for a buy-out or superfund transaction, is to have your scheme well prepared.
Trustees should consider:
Affordability: Solutions for managing risk have different costs and degrees of flexibility. Trustees and sponsors need to understand which solutions they can afford and what flexibilities they relinquish.
Benefits: A full assessment of scheme benefits should at a minimum:
- Make sure administration practice is consistent with scheme rules. Scheme administrators should have a benefit specification (or similar document), reviewed by legal advisors, that explains how they administer the scheme.
- Work with the scheme administrators and legal advisers to understand past practice on any areas of discretion, such as who qualifies for a dependant’s pension or whether one is paid at all, and how they should be dealt with longer term.
- Focus in on “big ticket” items like ensuring closure to accrual and the “Barber” equalisation window were implemented correctly.
Risk assessment: Before deciding on the best de-risking plan, it is critical to have an unbiased assessment of the risks the scheme is running
Investments: If looking at a buy-out or superfund transaction, consideration should be given to the current investment strategy and how that might need to change
Data: In all its glory… accuracy, spousal details (including other pensions), GMP…
Governance: Whatever the de-risking plan, there is a strong argument for not only having experienced advisers but also having trustees with the right expertise
Engagement: The de-risking plan will involve many different parties and it is critical that the project gets the right engagement, from the trustees and sponsor in particular. There will also be many advisors involved, so it is important they all understand their roles and are engaged and agree to the timetable and plans for the project to run smoothly
This market has provided an unexpected opportunity for many schemes that they should be capitalising on in order to secure members benefits – but the market is also very competitive – so schemes must get on top of their de-risking to reap the rewards the turbulent economy has provided.
Adam Davis, Managing Director at K3 Advisory
